Keep calm and re­bal­ance into eq­ui­ties

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

The in­vest­ment en­vi­ron­ment has not fun­da­men­tally changed since De­cem­ber. Then as now, the sit­u­a­tion nei­ther jus­ti­fies be­ing “all in” nor “all out”. Since the eco­nomic sit­u­a­tion is wors­en­ing, a bal­anced port­fo­lio of some type makes sense—this view rests on there be­ing no clear ev­i­dence of a loom­ing US re­ces­sion and in­evitable as­so­ci­ated bear mar­ket for eq­ui­ties (at which point tin hats should be donned). In my view, that time has not yet come. So, with stocks down about -9% YTD (in the US and glob­ally), in­vestors should look to re­bal­ance out of bonds or cash and into eq­ui­ties to main­tain what­ever “bal­ance” they had be­fore this sell-off.

This sug­ges­tion is based on our frame­work that con­nects the eco­nomic cy­cle and re­turn on in­vested cap­i­tal. The idea is that when the re­turn on cap­i­tal is above its cost, and the spread is ei­ther widen­ing or sta­ble at a wide mar­gin, in­vestors should be “all in” risk as­sets. That was gen­er­ally the case from mid-2009 to mid-2013. Things be­gan to change in mid-2013 when the re­turn on cap­i­tal started to slide, and at the same time the Fed­eral Re­serve be­gan to re­treat from its highly ac­com­moda­tive pol­icy. Thus, based on our frame­work, the se­cond half of this in­vest­ment cy­cle be­gan in mid-2013, and since then a bal­anced port­fo­lio of some sort has been jus­ti­fied. It still is.

Re­cent data con­firms the trend of a grad­ual de­te­ri­o­ra­tion, but does not yet in­di­cate a re­ces­sion is nigh. The US min­ing and en­ergy sec­tor con­tin­ues to suf­fer se­vere pain. But the story else­where is less ex­cit­ing. The shale bust has nei­ther caused a fi­nan­cial cri­sis nor ush­ered in a con­sump­tion driven boom. Bank credit growth has been strong and sta­ble, grow­ing at 7-8% YoY since late 2014 (sug­gest­ing that the pri­vate sec­tor was in­deed ready to ex­pand credit on its own, with­out more as­set pur­chases by the Fed). Retail sales are grow­ing at a real rate of about 2%, which is on the low end of their range since 2012 but still in­dica­tive of sta­ble con­sump­tion.

Mean­while, US man­u­fac­tur­ing growth has slowed to a snails’ crawl—up just 0.8% YoY in De­cem­ber. This is mostly due to the emerg­ing mar­ket slow­down and the un­com­pet­i­tive US dol­lar. Add to those woes an el­e­vated stock of in­ven­to­ries to work off and US man­u­fac­tur­ing out­put may well de­cline YoY in the com­ing months. Wor­ry­ingly, such an event most of­ten oc­curs dur­ing re­ces­sions; but it can oc­cur with­out re­ces­sion.

It is a fools er­rand to rely on a sin­gle sec­tor as a poin­ter to US re­ces­sions, but if pushed we’d opt for home con­struc­tion as it pro­vides an ear­lier sig­nal of im­pend­ing trou­ble. This is prob­a­bly be­cause the hous­ing sec­tor is un­usu­ally sen­si­tive to in­ter­est rates (along with job and wage growth). It is thus quick to re­bound af­ter the Fed slashes rates, prone to over­build­ing dur­ing booms, and then quick to cor­rect as the cy­cle ma­tures, in­ter­est rates rise and af­ford­abil­ity falls. While the hous­ing boom took pause af­ter in­ter­est rates rose in 2013, it now looks to be back on track.

This makes sense as in­ter­est rates re­main low, hous­ing is de­cently af­ford­able and the mar­ket is still un­der­sup­plied rel­a­tive to house­hold for­ma­tion.

Bet­ter than re­ly­ing on any sin­gle sec­tor, we sug­gest look­ing at the re­turn on cap­i­tal for the en­tire US busi­ness sec­tor. Such re­turns are de­te­ri­o­rat­ing (as will likely be high­lighted once again by this earn­ings sea­son and 4Q15 na­tional ac­counts data). How­ever, re­turn on cap­i­tal re­mains well above the cost of cap­i­tal (de­spite the re­cent Fed hike and the widen­ing of spreads). As such, the sit­u­a­tion re­mains con­sis­tent with a bal­anced port­fo­lio. Keep calm, and re­bal­ance into eq­ui­ties.

Newspapers in English

Newspapers from Cyprus

© PressReader. All rights reserved.