Note October 15,2018: Q4/2018 – A Time for Reappraisal not Jingoism: Our asset mix focal point in this cycle has been on the unusual nature and extent of quantitative ease with the collateral side effects potentially obscure but likely to unfold with the passage of time. Hence, we have suggested above benchmark cash reserves, fixed income investments at below benchmark especially in long dated instruments , a quality focus in equities with diversification focused on sectors rather than simply on geography and last but not least, inclusion of alternate investments like precious metals as well as direct and private investment vehicles. Incorporating recent developments in particular in fixed income markets, we see aspects of foggy clarity as being at work in global political and business discourse. We favor quality, better balance between value and momentum as well as need for cash reserve accumulation for redeployment later. It is a time for reappraisal not jingoism.
Capital markets have until recently been ignoring myriad risk adjustment signals like geopolitical stress, violent conflagration the rise of populism worldwide with the U.S. mid-term elections imminent on November 6, 2018 and trade friction. Meanwhile, deficit reduction planning of the type suggested by the bipartisan Simpson-Bowles Commission back in 2011 have been skimmed over, not just by the politicians in the United States but elsewhere. In marked-to-market investment portfolios, the capital decline of close to 10% even in 10 year U.S. Treasury Notes from yield lows to the present is likely to be uncomfortable for pure fixed income and even for multi asset portfolios especially were equities to also turn volatile as has recently been the case. We maintain a low duration focus for fixed income and a quality bent appears as also appropriate. In a tougher capital market, supra-agency like IMF and World Bank backed foreign currency fixed income may yet again come back in vogue.
In equities, the primary factors since 2009 and into 2017 appeared to be momentum linked with quantitative ease, share buybacks especially in the United States, recovery in the earnings cycle and concomitant valuation expansion with scant focus on quality as was also seen in junk bond fixed income markets. The first signs of change came early in 2018 in that the cycle extension did not come to pass (and which many appeared to expect) namely rotation into Japan and Europe ostensibly on lower valuation as well as broad based outperformance in emerging market equities including China and India, ostensibly backed by higher than global growth.
In our opinion and despite global economic growth continuing but in the lower end of a 3 ¾ – 4% annual band, withdrawal of quantitative ease led by the Federal Reserve and higher fixed income yields are likely to constrain valuation expansion and fervor for concept while a more likely upcoming 2019 environment of traditional 7% per year earnings growth for the S&P 500 drives increased focus on quality as well as better balance between value and momentum.
Furthermore and unlike recent equity behavior, we would expect the Financials sector to resume its critical role of leadership but with those most ruthless in restructuring still at the forefront, even after a decade of such restructuring. This aspect appears to have been underappreciated in many geographic rotation strategies. Overall, we also anticipate that more so than experienced recently, a diversification role exists for direct and private equity investing as well as for exposure to precious metals, hitherto U.S. dollar strength notwithstanding.
Asset Mix
Our asset mix focal point in this cycle has been on the unusual nature and extent of quantitative ease with the collateral side effects potentially obscure but likely to unfold with the passage of time. Hence, we have suggested above benchmark cash reserves, fixed income investments at below benchmark especially in long dated instruments , a quality focus in equities including better balance between value and momentum. Diversification needs to be focused on sectors rather than simply on geography and last but not least, on inclusion of alternate investments like precious metals as well as direct and private investment vehicles. Incorporating recent developments in particular in fixed income markets, our stance remains intact.
For reasons likely related to the fervor in this cycle for complacency driven by reliance on quantitative ease, capital markets have until recently been ignoring myriad risk adjustment signals. Such signals have included geopolitical stress, violent conflagration across the LeVant as well as affecting oil producing regions with domestic stress ranged from Iran in the east to Turkey, Saudi Arabia in the south and to Libya in the west of the troubled region. Recent elections from Brazil to Europe show the rise of populism worldwide with the U.S. mid-term elections imminent on November 6, 2018. Trade friction including that of tariffs abound as do issues of the efficacy of prolonged quantitative ease. Meanwhile, deficit reduction planning of the type suggested by the bipartisan Simpson-Bowles Commission back in 2011 have been skimmed over, not just by the politicians in the United States but elsewhere.
Currency stresses appear in emerging countries and indicate change in capital markets. More recently and also as benchmark of change, 10 Year U.S. Treasury Note, yields have increased to 3.16% from the lows of yields of 1.36% in mid-June 2016. Not coincidentally in this period amid strong domestic growth and low unemployment, the Federal Reserve has emphasized and reasserted its path of measured reduction in quantitative ease and concomitant increases in Fed Funds rates. Our long held position has been that while apt initially, the last two tranches of Federal Reserve quantitative ease were steps too far. As such ease is reversed, we expect likely by late 2019, Fed Funds could rise to 3.50% and 10 year U.S. Treasury Note yields rise to 4.50% before being regarded as policy neutral.
In the fervor for momentum, this path was once regarded by many as an outlier but currently is likely well underway with classical results. Structure vulnerabilities appear being exposed in foreign currency fixed income debt undertaken especially in emerging countries. Many emerging countries and initially those in weaker positions like Argentina, Brazil, Venezuela and Turkey have experienced currencies remaining under stress, despite raising rates. More recently and despite their economic growth, such stress has included India with its Rupee at close to 74/U.S. Dollar and China with its key renminbi rate back close to 7/U.S. dollar. Advanced country fixed income has not been immune either, not least in Japan despite its vaunted focus on domestic funding and in the European Union despite their economic heft. In corporate fixed income, yields have also increased towards 12 month highs but in a curious ode to momentum, much less so in the CCC and below junk credit categories. In marked-to-market investment portfolios, the capital decline of close to 10% from yield lows to the present even in 10 year U.S. Treasury Notes is likely to be uncomfortable for pure fixed income and even for multi asset portfolios especially were equities to also turn volatile as has recently been the case. We maintain a low duration focus for fixed income and a quality bent appears as also appropriate. In a tougher capital market, supra-agency like IMF and World Bank backed foreign currency fixed income may yet again come back in vogue.
In equities, the primary factors since 2009 and into 2017 appeared to be momentum linked with quantitative ease, share buybacks especially in the United States, recovery in the earnings cycle and concomitant valuation expansion with scant focus on quality as was also seen in junk bond fixed income markets. The first signs of change came early in 2018 in that the cycle extension did not come to pass (which many appeared to expect) namely rotation into Japan and Europe ostensibly on lower valuation as well as broad based outperformance in emerging market equities including China and India, ostensibly backed by higher than global growth. The geographical leadership of U.S. equity market was maintained but in ways that many may have not expected. Namely, tax cuts did boost corporate earnings to the 20-25% year-over-year gains for the first half of 2018 and likely for 2018 as a whole for the S&P 500. Share buybacks continued at record pace but market index levels showed stress and bifurcation emerged below the surface with gains dominated by a few stocks driven by concept and pullbacks wide spread elsewhere. Furthermore and instead of rotation into other markets, there has appeared an also classically greater pullback in non-U.S. equities in the face of uncertainty. In our opinion and despite global economic growth continuing but in the lower end of a 3 ¾ – 4% annual band, withdrawal of quantitative ease led by the Federal Reserve and higher fixed income yields are likely to constrain valuation expansion and fervor for concept. A more likely upcoming environment in 2019 of traditional 7% per year earnings growth for the S&P 500 is expected to drive increased focus on quality as well as better balance between value and momentum.
In the upcoming environment of change in quantitative ease as well as more stress from tariffs on world trade and taking into account current equity price levels driven in part by momentum, we expect sector selection and more important quality of delivery and balance sheets to dominate over geographical rotation. Furthermore and unlike recent equity behavior, we would expect the Financials sector to resume its critical role of leadership but with those most ruthless in restructuring still at the forefront, even after a decade of such restructuring. Overall, we also anticipate that more so than experienced recently, a diversification role exists for direct and private equity investing as well as for exposure to precious metals, hitherto U.S. dollar strength notwithstanding.
Equity Mix
After a decade of basking in quantitative ease that in equities included massive mainly U.S. share buy backs, capital markets will likely search for different solid ground. Capital markets will potentially be more volatile. Common for a more mature phase in capital markets, fraying in 2018 can be seen for example in emerging market equities, in a narrower composition of the stocks driving up U.S. equities and in not being limited to fixed income. We expect another 25 basis point increase in Fed Funds in December 2018 as well as a 3.50% rate by September 2019, just above but earlier than the Fed FOMC forecast of a potential cycle peak. Globally, we anticipate quantitative ease as being in flux, led by the Federal Reserve reduction and hence to be a reason for lesser complacency.
Even as some espouse high valuation as appropriate amid quantitative ease, we hold two equity episodes to be historically instructive. Namely, neither prebubble 1980s Japan suppositions of superior management and low interest rates driving valuation held nor did the prebubble 1990s NASDAQ suppositions of valuations being irrelevant for secular growth. The reformulation of sector composition post September 30, 2018 seems more of an ETF and leadership composition issue. Differentially in terms of equity market impact, the potential for U.S. 10 year Treasury yields to rise to 4.50% into late 2019 would likely constrain both valuation and share buybacks. The next phase of earnings and corporate performance will start soon. While the first half of 2018 did recorded year-over-year earnings gains of 20-25% on tax cuts and record share buybacks, with likely more of the same for the S&P 500 in the rest of 2018, we anticipate for 2019 a more traditional 7% annual gain in earnings. Performance and valuation risk appears for a variety of reasons but is more classical than many appear willing to countenance.
Recently, equity markets have taken a bruising in the erstwhile momentum favorites in equity like social media as well as concept manufacture equities, and not just in fixed income emerging markets. So far in 2018 as well, freewheeling Hong Kong markets have been in significant downdraft and have a well-deserved reputation for being especially sensitive to change. Tighter Federal Reserve policy is corroborated by data and its September 12 2018 Beige Book. We see aspects of foggy clarity as being at work in global political and business discourse. We favor quality as well as need for cash reserve accumulation for redeployment later. The erstwhile widespread favor for geographic rotation appeared to us to overlook some key sector composition aspects in the event momentum faltered. Financial Services have a heavy weighting in most equity markets. However, heavy bruising can be seen in the bifurcation in Financial Services where those lagging in restructuring have been hard hit, not just in Europe overall but also within the United States and in faster growing Asia. Despite recent market volatility, Information Technology likely has stronger growth while Europe and Japan have heavier representation in Consumer Staples that may be defensive but seem to be under business stress due to lagging restructuring.
While we have maintained an overweight in Information Technology after the restructuring of indices, we have moved Communications Services down to underweight, favoring telecommunications and entertainment over social media. We are underweight Consumer Discretionary but within it, prefer travel and resort experience. We have underweight Consumer Staples as their valuations seem to us as not reflective of defensiveness, albeit with notable dividend yields. Assessing this mélange and the restructuring of energy amid a paucity of value alternates, we favor Energy with an overweight but focused on stronger companies. In our overweight in the Financials, we still favor those financial institutions that have been earliest and most ruthless in restructuring. After over a decade of M&A driven gain, we see Healthcare as being in consolidation linked to delivery as a business and are underweight. We favor Industrials over Consumer Discretionary within the cyclical space but with a quality tilt. We continue to overweight Information technology using a broad mix of communications, software and hardware companies where lower valuations and strong financial strength are also present. Notwithstanding U.S. tariffs linked ostensibly on security grounds in aluminum and steel as well as globally slowing growth risks, we believe restructuring in industrial metals to be constructive. We have overweight Materials via precious metals and industrial metals. From New York to London to Mumbai, real estate prices now appear to have turned sticky alongside actual sales. Such stickiness could be a lesser factor in the industrial and office space segment where technological obsolescence requires infrastructure changes not easily retrofitted in existing space. Overall, we would underweight REITs. U.S. Fed Funds potentially could rise to 3.50% and U.S. 10 year Treasury Note yields potentially to 4.50% as quantitative ease exits as a primary risk. Pipelines such as for energy and natural gas in particular seems attractive but overall, we have underweight Utilities.
Communication Services: The Communications Services space now includes social media spun out of Information Technology as well as entertainment from Consumer Discretionary. Communications Services may be more diversified but now its equity market performance is also subject to volatility emanating from including equities with concept driven high valuations. More traditional telecommunications companies have been bundling services and acquiring content. Meanwhile, online retailing offers entertainment content in rising diversity. While we have maintained an overweight in Information Technology after the restructuring of indices, we have moved Communications Services down to under weight but do favor entertainment and telecommunications over social media.
Consumer Discretionary: The entry of online specialists into grocery bricks and mortar as well as online based delivery followed by the response of bricks and mortar based enterprises into also vast online presence both underscore fast paced change. Meanwhile, changing consumer spending patterns have meant a plethora of empty space in shopping malls that are now attempting to enhance experience offerings such as fine dining. Meanwhile in the key U.S, market, employment may be up but higher tariffs may also mean more expensive imported goods for retail offerings. Meanwhile in the key market of China, for a variety of reasons including a crackdown on corruption, luxury goods purveyors face growth challenges after years of unfettered growth. Entertainment which we favor has been reclassified into Communications Services as of September 30,2018. We are underweight Consumer Discretionary but within it, prefer travel and resort experiences.
Consumer Staples: Even before the recent market selloffs and a rise in considerations of defensiveness, the business reality in Consumer Staples had been that much like the mid-1990s, major Consumer Staples multinationals in recent years have appeared to have misjudged product business dynamics in emerging economies. It has meant that more nimble and smaller locally driven companies have not been as vulnerable as assumed and in some aspects have been thriving. By contrast, private equity groups appear to have multinational Consumer Staples in their sights for restructuring which we believe is still nascent and similar to the situation chronically experienced by Healthcare over a decade ago. We have underweight Consumer Staples as their valuations seem to us as not reflective of defensiveness, albeit with notable dividend yields.
Energy: At $71/Bbl. WTI and somewhat above until recently, we still assess $60-70/Bbl. WTI as representing an adequate balance between politics that never far from energy, consumer demand and the expansion of energy alternates to hydrocarbons. Crude oil as a commodity remains volatile in having swung in just a few years up to $145/Bbl. WTI to down close to $25/Bbl. and then up beyond our range towards $75/Bbl. WTI as well as close to $80/Bbl. Brent to now back into our range. Recent political events have included stresses not seen for almost 45 years from Saudi Arabia as well as a harder line by the United States linked to its withdrawal from the nuclear agreement with Iran and which has pressed on its oil exports. Elsewhere, there has been the strengthening of the U.S. dollar exchange rate and indications of the potential for increased oil exports by other producing countries. Assessing this mélange and the restructuring of energy amid a paucity of value alternates, we favor Energy with an overweight but focused on stronger companies.
Financials: The restructuring of Finance is far from complete as demonstrated in ongoing financial industry events that range from uncertain asset value assumptions in European banking to regulatory admonishment over management oversight in U.S. banking as well as credit impairment developments in many emerging countries, several of which appear in currency crisis. From central banks and certainly underway in the United States in light of domestic economic data has appeared a measured path of lesser quantitative ease. Fixed income yields have globally risen with 10 year U.S. Treasury note yields close to 3.16% from a low of 1.36% in mid-2016. They are likely, in our view, to reach 4.50% by late 2019 with Fed Funds then likely to be closer to 3.50% – levels once regarded with wide spread skepticism but now within sight. It means that traditional skills involving net interest margins are likely to interplay with ongoing restructuring as well as and not least, the monitoring of real asset values ranged from that of derivatives to that of sovereign debt held in reserves. Credit impairment is likely to be a differentiator not just in emerging country fixed income but also in junk corporate fixed income. In our overweight in the Financials, we still favor those financial institutions that have been earliest and most ruthless in restructuring.
Healthcare: After several years of euphoria over the benefits to shareholders of restructuring, we see Healthcare as being in the assessment of delivery phase of performance. In addition, whether for generics operations based in emerging countries or elsewhere, more oversight appears evident on product quality as well as on pricing overreach. Among both standalone operations and integrated massive drug companies, in biotechnology and elsewhere have come releases of less than successful trials in hoped for blockbuster new products. In medical devices and services, disruption from new on line entrants have meant another series of Merger and Acquisition (M&A) activity. We assess that much like Consumer Staples and in contrast to prior experience, Healthcare currently is far from defensive. After over a decade of M&A driven gain, we see Healthcare as being in consolidation as a business and are underweight.
Industrials: For over a decade and globally, the Industrials space has had more than its share of hitherto marque companies either disappearing or being forced to restructure drastically. Some had attempted to become diverse business conglomerates by adding unrelated areas while others had attempted ill-fated international takeovers. Companies appear to have fared better when they remained in their circles of excellence or were in areas like the rapid growth aerospace industry. We believe that the need for global infrastructure expansion and for corporate asset refurbishment are likely to be positive factors for Industrials within the cyclical space. For Industrials, actual business realities and tribulations do also point to a need to focus exposure on those with a quality reputation in products and in management. We overweight Industrials with a quality tilt over Consumer Discretionary within the cyclical space.
Information Technology: Information Technology as an investment space has been restructured but we remain overweight for growth, over the alternates of Healthcare and Consumer Staples. The social media segment of Information Technology in the prior to September 30,2018 classifications of global indices has now been moved to Communications Services. The social media segment also happened to contain significant euphoria over concept that was reflected in high valuations. As markets become more tangible delivery oriented and less quantitative ease driven as interest rates rise in the United States especially, the social media investment space can be expected to be under stress. The tariff and market place tussle between the United States and China appears to be linked to a struggle over dominance in high growth areas like 5G and cloud computing communications. Software and cyber security appear yet another area for growth as do linked support services. We continue to overweight Information technology using a broad mix of communications, software and hardware companies where lower valuations and strong financial strength are also present.
Materials: One of the anomalies for us in this cycle has been that, despite global tensions and outright war in many key regions as well as continued financial stress, albeit below 2008/9 levels, precious metals and gold bullion in particular have been poor performers. It is in contrast as well for instance, with fine art and general collectibles. An upswing in the exchange rates for the U.S. dollar amid rising rates and emerging country uncertainty could provide further headwinds but we still regard precious metals as potential portfolio diversifiers. It could gain traction as turbulence in capital markets increases. Tariffs in tit for tat mode add to uncertainty in areas like agricultural commodities as well as housing linked areas like lumber. Notwithstanding U.S. tariffs linked ostensibly on security grounds in aluminum and steel as well as globally slowing growth risks, we believe restructuring in industrial metals to be constructive. We have overweight Materials via precious metals and industrial metals.
REITs: As fixed income yields and those in U.S. Treasuries in particular have increased, interest in equity yields has increased. There is however another side of the equation for REITs and in particular, real estate overall. Real Estate prices have been particular beneficiaries of the massive quantitative ease infusions globally even as suppressed interest rates reduced capitalization rates. Early and spectacular beneficiaries were located in the financial centers of the world. From New York to London to Mumbai, real estate prices now appear to have turned sticky along with actual sales. REITs do offer the benefit of diversification and professional management but overall risks of mired real estate pricing and more constrained capital availability environment should not be ignored. It could be a lesser factor in the industrial and office space segment where technological obsolescence requires change that cannot be retrofitted in existing space. Still, we would underweight REITs.
Utilities: U.S. Fed Funds potentially rising to 3.50% and U.S. 10 year Treasury Note yields potentially at 4.50% as quantitative ease exits as primary factor but economic growth continues would likely mean that utilities are less attractive than many appear to anticipate. Separately, tangible asset investment needs in power utilities remain substantial and not least for climate change reasons. Water utilities remain subject to political uncertainty on pricing. Pipelines such as for energy and natural gas in particular seem attractive but overall, we have underweight Utilities.
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 telecom, ent.
Cons. Disc. 5.0 6.5 Under-weight – favor travel resort
Cons. Stap. 5.0 4.0 Under-weight on valuation excess
Energy 12.0 13.0 Over-weight via strong companies
Financials 19.0 16.0 Over-weight restructuring leaders
Healthcare 9.0 12.0 Under-weight as M&A needs 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 broadly
REITS 2.0 2.0 Under-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