Over the last four months the S&P 500 has essentially traded sideways, within a 6% range. Markets are having to deal with significant headwinds and tail winds. From a cautious perspective, concerns continue over political uncertainty surrounding trade wars which, although primarily focused on the US-China axis, has caused pain to the European economy, particularly Germany.
The Brexit debacle continues and one questions how much the UK economy can sustain the uncertainties. Global economic data held up very well during the summer months but the Citigroup economic surprise index has dropped like a stone since mid-September (see chart 1 Bloomberg: CESIGL Index GP), suggesting the global economy is now underperforming even the gloomy consensus forecasts. In addition, Q3 earnings results look like a mixed bag.
The rhetoric coming out of the ECB recently suggests that the major central banks think that monetary policy has run its course and governments need to take the helm with fiscal stimulus at a time when deficits are worryingly high. There seems to be little global co-ordination to resolve the economic malaise as the trend appears to be in favour of protectionism, which will have a negative impact on global trade.
Citigroup Economic Surprise Index
However, these concerns have been around for some time and, while they are very real issues, have not been the main drivers for markets. On the positive side, equity markets in aggregate are not expensive compared to historical measures across a number of valuation matrices. In fact, if we look at our screening tool (see chart 2 attached) we can see that it suggests that portfolio positioning should be at 54% versus neutral at 50% across global equity markets. There are many discrepancies and we need to drill down to select the opportunities in various geographical areas.
Technically, markets are not overbought and continued buy backs result in an ever decreasing stock of publically quoted equity. If we value equity markets versus bonds, the former continue to look cheap. It is fair to say that monetary policy is likely to remain very loose for the foreseeable future and this to date has been the major driver and support for risk assets. We expect the Fed to cut rates one more time at the end of this month and then possibly pause, but intervention in the repo market supporting the financial system will keep liquidity in abundance.
We have been cautious on long duration assets in the bond market and continue to be so. While we expect the front end of yield curves to be anchored by central banks, we fear that longer dated assets will come under severe pressure as increased funding of government spending, leading to greater issuance, will crowd out the market. The implication of this is surely that there remains no competition between equity and bond markets, on a valuation basis, in favour of equities. The question therefore, is not ‘should we be long of risk?’ but ‘which part of the market should we be focused on?’
As yield curves steepen we would expect zombie entities to come under pressure and for those growth/momentum sectors to underperform sectors that have strong balance sheets, are still growing dividends and can withstand higher long term bond yields. These sectors are what might be called ‘value’.
In conclusion, we are selectively and marginally overweight global equities and focused on areas where we think there is medium term and robust value, but remain very cautious on fixed income.