Note April 13,2019: Q2/2019 – Conundrum Rests With Central Banks: Markets appear reverting in early Q2/2019 to in this cycle, once more focusing on quantitative ease, momentum and taking cues from the United States amid slowing global growth. Just a cycle or two prior to this one and from central bankers, gaining currency in the 1990s was the notion of the conundrum of capital markets demanding extra risk premiums. After a decade and more of massive quantitative ease about which the latest statements appear to indicate extension, the present conundrum may rest with the central banks. Irrespective of responsibility for the leadup to credit freeze by 2008, the initial rationale for quantitative ease was clear and understandable. Now amid increased political volubility to boot, and whether inadvertent or deliberate, central banks appear reflexive about market twitches even in its normal role of allocating capital while metering risk. A portfolio implication is that momentum activity in markets may be extended therefrom but the imperatives of a quality and diversification tilt remain.
Such market realities make diversification essential, including above benchmark cash and shorter duration fixed income to be supplemented by precious metals in asset and equity mix. The yield on 10 year U.S. Treasury Notes at 2.55% is above the cycle lows of 1.36% but close to 90 basis points below recent highs, with many sovereign and other fixed income yields following. Within underweight fixed income, in addition to shorter duration, we favor emphasis on high quality corporate paper. In light of the yields and liquidity available, North American currency fixed income should be in favor within global fixed income mix.
With practically universal heavy weightings in indices, developments in financials underscore their crucial role for equities. On core growth and defensiveness dependent on meeting business challenges, we favor Information Technology. We have moved Healthcare up to market weight over Consumer Staples and Utilities. In cyclicals and despite stress, we favor Industrials over Consumer Discretionary. Despite recent prominence being given divestment of Energy, we overweight it. These sector aspects also hold the U.S. markets in good stead compared to Europe, for instance while emerging markets should be in favor for growth within global equity mix.
Asset Mix
Unlike the 1980s, central banks appear more cohesive but also reactive. Latent distortion risk seems little understood, even amid a decade and in the case of Japan, two of massive quantitative ease. As well, central bankers appear currently increasingly reticent to challenge political assumptions.
Deficits and trade tensions are all flared up. Even from Brexit with an extension to October 31,2019 as flexible deadline and from other issues, policy tensions remain in Europe. Trade talks between the United States and China remain ongoing, recalling the similar prolonged U.S./Japan trade talks of three decades ago. Moving beyond one-off announcements, trade talks appear fragile worldwide Absent crisis management, addressing deficits currently fight for profile around the world. In wars like in the Levant and in the many elections around the world, populisms abound. Risk could arise from political misunderstandings. In recent cycles, markets have appeared reactive rather than being proactive.
On policy pronouncements, seemingly also are the central banks. Recently corroboration came from the Federal Reserve (Fed) in its March 19 2019 FOMC Minutes that in effect, the Fed now seems espousing a policy freeze rather than its prior measured change stance. Similar tenor appeared in the post April 10, 2019 meeting release of commentary by the European Central Bank (ECB). Many advanced and emerging country central banks appear to be following these leads. Discord risk took place in the late 1980s, most famously between the Fed and the Bundesbank with spillover elsewhere. The justification for policy freeze may be that currently measured inflation seems low but it can lag change. To us, it does seem to be odd to be considering a decade as being near term and hence having little distortive effect to worry about. For decades before, central banks had been warning about debt, deficits and the importance of the long term for public policy and company management alike. Central banks appear nowadays to be taking for granted a lack of latent risks. This comfort in numbers may reduce the present risks of monetary policy discord but conundrum remains. As well and compared to three decades ago in particular, central bankers appear increasingly reticent currently to challenge political assumptions. We believe these aspects of current central banking positioning add to a reactive tinge in capital markets.
Within capital markets themselves, there has been tumult in individual emerging country currencies, especially so when interest rates in the United States seemed to be rising. Over time and for capital markets as a whole, the sheer volume of trade in currency markets has long been considered to be a harbinger of crisis. This positioning has been as a result of the heft of the participation from individuals to companies to countries alike, replete with technical and fundamentally based analysis. Yet recently among the major currencies, activity has appeared remarkably stable when compared to times of turmoil in the past.
Despite much higher U.S. Treasury yields, the reactive impact appears to have been minimal on broad currency movements versus the U.S. dollar. In Europe, sovereign bond yields have generally followed Bund yields lower and thus suggest little change in risk differentiation. In North America, the Canadian dollar did weaken earlier but more recently appears flat, notwithstanding lower yields in Canada versus those in the United States. Within the U.S. fixed income market, not just Treasury yields but also lower grade corporate bond yields appear once more to have declined, even as data indicates slower growth (as the Fed FOMC also highlighted) and concerns build about corporate margins. There appears a return in the markets towards momentum and more acute focus on quantitative ease central bank policy rather than on broader balance. This lack of concern about risk appears to us markedly different from prior cycles and thus remains potentially distortive to capital markets. We believe this aspect in the Fixed Income, Commodities and Currency (FICCs) markets also adds to a reactive tinge to capital markets.
Such market realities make diversification essential, including above benchmark cash and shorter duration fixed income to be supplemented by precious metals in asset and equity mix. The yield on 10 year U.S. Treasury Notes at 2.55% is above the cycle lows of 1.36% but close to 90 basis points below recent highs, with many sovereign and other fixed income yields following. Within underweight fixed income, in addition to shorter duration, we favor emphasis on high quality corporate paper. In light of the yields and liquidity available, North American currency fixed income should be in favor within global fixed income mix.
A fresh set of corporate results are currently emerging. Compared to prior cycles of hubris, companies do appear more cognizant of the importance of revenues, margins and the like. Still needing care are share buybacks and IPO volume increases in sectors in vogue. It is classical as equity markets mature. As has appeared de rigeur in this cycle, consensus earnings estimates appear once more being reduced but in the case of the S&P 500 to close to or below the zero earnings gain line. Still, markets globally appear taking their momentum cue from U.S. market leadership and considering the beating of the most recent consensus earnings estimates as being sufficient, however much reduced. Previously considered defensive and not the exception, areas like Consumer Staples have been issuing warnings of unfavorable change. In the equity markets in recent cycles and not least in the performance of U.S. indices like the S&P 500 into 2000 and into 2008, markets have tended to follow and not lead earnings peaks. By contrast, more classical behavior in equity markets has been for prices to lead earnings and not vice versa. We believe standards should be higher and note that global annual GDP growth rates appear being reduced towards 3 – 3 ½% while below the surface response has been severe in individual equity prices to earnings shortfalls.
Noteworthy is that share buybacks in the United States did peak at $589 billion reportedly in 2007, just ahead of the S&P 500 peak. In the present cycle, share buybacks in 2018 have reportedly set a new record at $806 billion. Further as markets mature, initial public offerings (IPO) have a history of being in crest in sectors in vogue and their volumes are currently expected to be strong. The S&P 500 group of companies can be expected to face cost headwinds even as global growth slows and U.S. tax cuts run their course. It likely is indicative of earnings pressures as developing, almost a decade since the S&P 500 earnings cyclical bottom of 2009. We believe these aspects of valuation gains already attained and of earnings cycles in equities markets also accentuate volatile reactive tinge risks to capital markets.
With practically universal heavy weightings in indices, developments in financials underscore their crucial role for equities. On core growth and defensiveness dependent on meeting business challenges, we favor Information Technology. We have moved Healthcare up to market weight over Consumer Staples and Utilities. In cyclicals and despite stress, we favor Industrials over Consumer Discretionary. Despite recent prominence being given to divestment of Energy, we overweight it. These sector aspects also hold the U.S. markets in good stead compared to Europe, for instance while emerging markets should be in favor for growth within global equity mix.
Equity Mix
Within equities amid a renewed company reporting season, global indications from institutions like the IMF and the OECD of global growth in GDP slowing to 3- 3 ½% annually with close to recession in some regions, equity leadership appears to returning to taking its cues from U.S. markets.
We regard S&P 500 P/E levels of 16x as hardly inexpensive. Markets seem still momentum sensitive, irrespective of geography or sector. Further reversion may appear towards momentum and on exceeding the most recent consensus in earnings releases as being sufficient, however low it is. Still, there appears more volatility below the surface amid the equity price response to individual releases. With their practically universal heavy weightings in equity indices worldwide, collective and individual developments for many financials underscore their crucial role in equity markets. From markets as disparate as Germany and India and even in the United States where the restructuring of the Financials was among the earliest in starting. Recent events demonstrate restructuring needs to still be strong over a decade after the unveiling of credit crisis in 2007/8.
On core growth and defensiveness based on management skills in meeting business challenges as opposed to historical precedence, we favor Information Technology (especially software and hardware). We have also increased Healthcare back up to market weight from Consumer Staples and Utilities on valuation as the latter grapple with earlier phase restructuring. In cyclicals and despite stress, we favor Industrials over Consumer Discretionary.Last but not least and despite the recent prominence being given divestment of Energy, we overweight it. Energy majors have long been attuned to managing business risk and managing to prosper even when crude oil was mandated at $2.50-3/Bbl. for decades from 1948 to 1970.
These sector aspects also hold the U.S. markets in good stead compared to Europe, for instance while emerging markets should be in favor for growth within global equity mix.
Communication Services: We earlier moved to underweight the Communications Services sector on the basis that the newly included social media segment added to concept driven euphoria that was subject to volatility due to high valuation and business models. The political pressures about oversight from Europe, controversy about postings by extremist views as seen from New Zealand and oligopoly driven electioneering chatter in the United States and elsewhere appear harbingers of changes that are likely to affect social media business models. Meanwhile, the amalgamation of entertainment and telecommunications appears gathering acceptance but does face competitive pressures from independent streaming internet media in key areas like movies and specialist programming. In view of the investment capital required amid change, we would focus on strong balance sheet and revenue companies over concept oriented entities.
Consumer Discretionary: As global growth rates apparently slow from advanced and emerging countries alike, we expect consumer activity to be more careful, even more so as countries like the United States opt for tariffs rise. Meanwhile, entertainment appears gathering pace as a way to utilize shopping mall space. It does however require significant investments in leasehold improvements and in management skills. Some purveyors of luxury goods have suggested that exclusivity of their brands and quality work to their advantage. In contrast, those online retailers expanding to that including bricks and mortar in basic goods have apparently been forced into old fashioned price cutting. In the current environment, others that have depended on global logistics to fuel just in time fashion have apparently felt income statement pressures. We assess the business cycle in retail to be maturing with much in flux. Consumer discretionary seemed especial beneficiaries much earlier in a global recovery process but are currently underweight. Within it, we would be more favorably disposed to travel and resort experiences.
Consumer Staples: We have underweight Consumer Staples as having attaining elevated valuations early but increasingly to be under business line pressures. In this market cycle of suppressed interest rates due to massive quantitative ease, demand for income by investors as well as swings to and from risk off likely combined to elevate Consumer Staples valuations. Meanwhile as businesses, several Consumer Staples companies have discovered that transferring brand demand into emerging economies was not straightforward. Further, in advanced economies also, competition for shelf space including from private labels requires more extensive brand business line pruning. We believe this process of restructuring is still be at a stage at which businesses are likely to be under the stress of restructuring rather than demonstrating the excellence needed to outperform and justify their high valuations.
Energy: Our steadfast assessment on crude oil pricing has been that $ 60 – 70/Bbl. WTI represents likely balance on both politics and competition within and without. In actuality and in line with its history, crude oil prices have been volatile from $145/Bbl. WTI a few years ago to a low down close to $25/Bbl. WTI and now just back into our balance range. Notwithstanding the current emphasis on implementing alternate energies and sources, the current reality for both conventional and new source development is that hydrocarbons remain a critical chemical building block for both ancillary products and energy use. This aspect and the inherent volatility of hydrocarbon pricing likely to mean that less diversified and highly leveraged companies are likely to be under stress while the strongly financed and diversified are likely to have the risk metrics needed to benefit both from political realities and the opportunities thrown up by companies with limited internal financial wherewithal. Opportunities exist for such an overweighting as within markets in a momentum phase, consensus appears far from convinced.
Financials: We expect the Financials to be generally crucial harbingers for capital market performance. If any corroboration were needed of the urgency of early restructuring for this cycle, it has come from the tribulations of the Financials in Europe even in strong economy countries like Germany, in the stresses in finance and likely in net interest margins as a result of central banks seemingly moving back to a stance of ample quantitative ease and limiting changes to minimal administered rates. This conundrum now from central banks has emerged even after a decade of quantitative ease and two decades of such from Japan. The Federal Reserve hitherto seemed most clearly to be in transition but in its March 19, 2019 FOMC meeting then signaled interregnum to market driven rates for 2019. Currency and interest pressures have been flaring in several emerging economies. Still and in light of the interest rate differentials involved, currencies in major advanced areas have appeared to us to be docile. At one level such an environment implies profitability pressures in fixed income, currency and commodities (FICCs). It translates into us overweighting the Financials by utilizing those that were earliest and most severe in restructuring are likely to accrue advantages as seen not just in Europe or emerging economies in Asia but even within the United States.
Healthcare: More prosaic issues loom for Healthcare like the success or lack thereof of expensive trials of new treatments and in the business management trials and tribulations of integrating numerous acquisitions while also reducing duplication. These issues are not easy to navigate as it may seem. Healthcare and the locations of facilities and management also have strong political overtones. It seems the case not just for the pharmaceuticals and biotechnology spaces that are increasingly being integrated but also in facilities and medical facilities where spinoff requirements also exist. Still and in comparison to elevated valuation Utilities and Consumer Staples, we have raised Healthcare to be a market weight candidate in investment portfolios
Industrials: For a broad range of end use industries moving to higher technology platforms as well as for that matter, in public infrastructure that includes transportation, infrastructure and physical investment appear to us to be key contributors in improving efficiency and performance. However for individual industrial product purveyors, the path seems far from smooth. As seen earlier in Japan and Europe for conglomerates and now more recently for the same in the United States, challenges range from diversified industrials now being forced to divest and to high technology aircraft manufacturers now investigating flight shortcomings leading to crashes. Still and within the cyclical space at this stage, we prefer to overweight Industrials over Consumer Discretionary.
Information Technology: Information Technology has waxed and waned on product anticipation and so called risk on/off assessments in this cycle but has generally been the growth segment of choice for investors. We continue to have Information Technology as overweight but do differ from general views displaying many concept preferences. We believe that the focus should be on how technologies like 5G networks and cloud computing could transform both business management as well as end product consumer products. As such in overweighting Information Technology, we prefer areas like software, including security, and hardware from semiconductors on up into telecommunications equipment.
Materials: Global growth rates for GDP have apparently been reduced again by institutions like the IMF and the OECD to levels close to 3- 3 ½% annually and which seems to us to incorporate several areas to be just skimming the surface above recession. Central banks have apparently extended the interregnum of an already long period of massive quantitative ease. Momentum investing appears to have had a reprieve as well. Many have pointed to inflation as being low, therefore supportive of continued quantitative ease and even its expansion. Nonetheless, we believe that precious metals have a diversification role to be emphasized in equity and asset structure alike. On the broader front, debt financing has expanded considerably in the last decade. In the longer term, deficit financing has led to stress. As well, we see currency volatility and political stress as being latent considerations. In sum, while consensus may appear to have supreme confidence in the abilities of central banks, it has not always been the case. In overweighting Materials, we include precious metals as more of a hedge against uncertainty flaring, not just inflation.
REITs: We have underweight REITs on the basis that fundamentals like the utilization of retail space amid changes in demographic preferences and space excess appear bifurcating opportunities. The interregnum extension in quantitative ease apparently pivoted towards by central banks in many major economies that has included interest rate reductions in some emerging areas does likely form a reprieve for some otherwise financially overstretched entities. However, we would expect the focus among vulture financiers to be seeking bargains rather than, as occurred earlier in this cycle, being willing to pay up.The more attractive real estate for us is of the industrial and office space.
Utilities: We have underweight Utilities on the basis that at the margin, other areas such as telecommunications in the Communications space have stronger finances. Healthcare offers opportunities as well to bring back to market weight. Central banks extending the suppression of rates and extending quantitative ease does alleviate some concerns about the cost of financing for Utilities that are particularly dependent on external financing. However, tangible asset investment needs remain substantial in power utilities and not least for climate change reasons. Water utilities remain subject to political uncertainty on pricing.Within Utilities, as global transmission and delivery of oil and gas expands, we favor opportunities in pipelines and linked facilities.
Asset Mix
Global U.S.
Equities-cash 52% 57%
-priv. 6 6
Fixed Income 25 20
Cash 12 12
Other 5 5
Total-% 100 100
Geographic Mix
Currency/ Equities Fixed Cash
Real Income
Americas 61% 65% 67% 55%
Europe 22 20 26 37
Asia 9 13 6 3
Other 8 2 1 5
Total -% 100 100 100 100
Global U.S. Stance
Comm. Serv. 8.0 % 7.5 % Under-weight – favor telco, enter.
Cons. Disc. 5.0 6.5 Under-weight – favor travel resort
Cons. Stapl. 5.0 4.0 Under-weight in restructuring
Energy 12.0 13.0 Over-weight via strong companies
Financials 19.0 16.0 Over-weight restructuring leaders
Healthcare 9.0 12.0 Market-weight focused on delivery
Industrials 13.0 13.0 Over-weight for capex recovery
Info. Tech. 17.0 19.0 Over-weight tangible prod./serv.
Materials 8.0 5.0 Over-weight esp. precious
REITS 2.0 2.0Under-weight esp. retail space
Utilities 2.0 2.0 Under-weight – favor pipelines
Total-% 100.0 100.0 () prior weight StrategeInvest’s independent consultancy operates as Subodh Kumar & Associates. The views represented are those of the analyst at the date noted. They do not represent investment advice for which the reader should consult their investment and/or tax advisers. Any hyperlinks are for information only and not represented as accurate. E.o.e