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Market Perspectives
October 2016
Oct. 14th, 2016
www.finlightresearch.com
What the wise do early, a fool does in the end
“Since 1947, every time profits fell this much,
or for this long, a recession was either
underway or about to begin. […] The only
exception was the middle of 1986 to early
1987. The argument can be made that
corporate profits fell in 1986/1987 because a
collapse in crude oil prices crushed energy
profits. This is similar to the current fall in
profits… Despite this collapse in profits in
1986/1987, stock prices marched to new all-
time highs. The same is happening now.
However, by the fall of 1987 the market
became overvalued by most measures and
crashed, reversing all the gains over the
previous 18 months.
”
– Jim Bianco (Bianco Research)
2
FinLight Research | www.finlightresearch.com
Executive Summary: Global Asset Allocation
Markets are relatively too calm, but appear to be at a crucial point.
Equity market is still locked in a tight range, but breakout seems
imminent
Equity volatility is unlikely to stay this low. We expect it to increase
through the US election due to the global uncertainties (Brexit, next US
rate hike…)
EM has been one of the main beneficiaries from the risk appetite
revival following the Brexit vote. Nevertheless, we feel cautious about
how resilient EM assets would be in the face of rising US rates.
Looking ahead, fundamentals appear to have improved.. That has
renewed speculation that the Fed could raise rates as early as
December
With elevated valuations and crowded long positioning in equities
and bonds, the market appears vulnerable to shocks over the
near term.
Said another way, current market conditions imply small potential
returns and big latent risks across almost all asset classes. Thus, we
remain defensive in our asset allocation.
The moral of the story? Be prepared for anything…
We summarize our views as follows
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FinLight Research | www.finlightresearch.com
MACRO VIEW
The Good
Jobless claims in the U.S. dropped to the second-lowest level since 1973.
With September data release, the global manufacturing PMI seems to be breaking its downtrend
The ISM Non Manufacturing report was excellent
We are probably at an inflection point on equity earnings
The Bad
The Atlanta Fed model projects Q3 GDP growth at just 2.1%, down from 2.8% expected a few
days ago. Two months ago, GDPNow was predicting Q3 GDP growth nearly 1% higher
US Commercial real estate (CRE) suffers. The Dodge Momentum Index (a leading indicator for
new non-residential CRE investment) fell 4.3% in September to 129.0 (vs 134.8 in August)
The Ugly
Main systemic risk resides in China: China is not recovering but rather just re-leveraging.
Chinese debt bomb is ticking. Debt is used to create the illusion of growth. The Chinese banking
sector is going to end up needing a bailout.
A Hard Brexit has become a meaningful risk
Something huge is probably gathering in Japan: Abenomics has failed! Contrary to every
economic theory, debt accumulation, debt monetization and record amounts of currency creation
have resulted in a rising yen and falling prices.
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5
FinLight Research | www.finlightresearch.com
The Big Four Economic Indicators
The current picture is characterized by relatively strong Employment and Income, a weak Industrial
Production (probably in recovery mode since its Mar ‘16 lows) and Real Retail Sales hovering
around a flat line.
The average of these indicators has been trending lower since Nov. ‘14, suggesting that the economy is
still moving sideways. Industrial Production has been the weakest link in the economic recovery since
the GFC. But the picture has been getting mildly better since June.
6
FinLight Research | www.finlightresearch.com
The Big Four Economic Indicators
Looking at an aggregate of
the four indicators, we see
that:
Things have gotten
much better since the
end of the last
recession.
But we are still far from
catching up with the
secular trend.
The gap to that
secular trend is even
getting wider.
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FinLight Research | www.finlightresearch.com
ISM Manufacturing & Services ☺
Both ISM manufacturing and
services indices are now in
expansion territories
The manufacturing index
rebounded to 51.5 in
September, up from 49.4 in
August. Its new orders
component rebounded to 55.1
in September from 49.1 in
August.
The ISM Non Manufacturing
report was excellent. The
services index jumped to 57.1
from 51.4 in August. Its new
orders component soared to
60 (up from 51.4)
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FinLight Research | www.finlightresearch.com
Global Manufacturing PMI
The global PMI is also
getting much better.
The JPM Global
Manufacturing PMI has been
in a continuous downtrend
since 2013, and clearly
pointing to a global recession.
With the last monthly moves
(50.8 in Aug and 51.0 in Sep),
the downtrend seems broken,
and global recession avoided
for the moment.
Is that a sign of an improved
global growth? Just wait and
see...
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FinLight Research | www.finlightresearch.com
US Employment – U6 Unemployment Rate vs Wage Growth
Since the end of the GFC, the U6 unemployment rate (including unemployed + underemployed, such
as involuntary part-time workers) has decreased from 17% to around 10%. However,
Current levels remain too high (near the peak of the previous cycle).
Wage increases (at a meager 2.6% YoY in nominal terms) remain pathetic
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FinLight Research | www.finlightresearch.com
US Employment – Adjusted for Population Growth
Labor market improvement
cannot go forever…
When adjusted for
population growth, nonfarm
Employment data tend to
show a similar trend to that
of the seventies.
Given where we stand within
the business cycle, the
current level may constitute
a new interim peak.
11
FinLight Research | www.finlightresearch.com
US Capex
US capex picture remains
bleak with nonresidential fixed
investment continuing its long
slip down.
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FinLight Research | www.finlightresearch.com
US Capacity Utilization
One of the main factors weighing on inflation and growth is excess capacity.
Overcapacity is more and more obvious in the global economy.
Capacity utilization has been trending lower and stands now at a level that has been historically
indicative of recession.
Source: St. Louis Federal Reserve
Capacity Utliization
13
FinLight Research | www.finlightresearch.com
GS – Global Leading Indicator (GLI)
The September Final GLI
came in at 2.8%yoy. Its MoM
momentum came at 0.31% (up
from its last month’s 0.27%)
The September GLI reading
now signals economic
expansion after a brief
summer excursion in the
slowdown quadrant.
Seven of the ten underlying
components of the GLI
improved in August.
We continue to think that the
acceleration we’ve been
witnessing since Jan. ‘15 is
quite modest for a typical
expansion phase
14
FinLight Research | www.finlightresearch.com
EQUITY
Our equity outlook remains cautious. We see the market more vulnerable than ever to growth,
earnings and policy disappointments.
Stocks have flirted with making a move above the recent highs but conviction seems missing.
The US equity valuation picture has hardly changed since last quarter. Whatever metrics we consider,
US stocks look expensive, making the pressure to deliver a positive earnings growth very substantial
Relative to alternatives, though, valuations are a lot more reasonable than what many perceive. The S&P
500 earnings yield is nearly twice the yield on the 10 year treasury. Its dividend yield is 0.5% points
higher than the 10 year UST.
In order for valuations to cause problems, there has to be a catalyst (a rate hike, a recession,
disappointing earnings, a geopolitical event…) to get it started.
Market volatility remains very subdued. We still expect an increase in VIX futures over the next couple of
months and through the U.S. presidential election.
Given the current congestion in indices, due to a convergence of supports and resistances, a break out
of the tightening range is likely coming, but the direction is uncertain at this time. The trigger for
that movement could be the Q3 earnings season. Given the current VIX level, we think it is less likely a
significant rally will occur from here.
A stronger dollar will induce another headwind to already weak earnings
Capital spending continues to contract and to be replaced by stock buybacks and other forms of financial
engineering.
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FinLight Research | www.finlightresearch.com
EQUITY
We remain Neutral on S&P 500 but with a bearish bias as we see increasing political uncertainty into
the US elections and some headwinds from the resumption of the Fed rate hike cycle and a strong
Dollar.
We remain UW Europe into year-end because of elevated political uncertainty (from Brexit and the
Italian referendum) and uncertainty on ECB policy
We still think that key fundamental data will eventually matter… in a BIG BIG way. For now, investors
are buying the rumor of better future earnings. One day, they will be selling the news of bad effective
earnings.
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FinLight Research | www.finlightresearch.com
EQUITY
Our scenarios are unchanged.
Our main scenario from here (70% chance) : A massive top forming around 2170-2190
Equities remain expensive, earnings growth poor and profit margins are showing increasing
evidence of peaking. On Price/Sales metric, equities are trading at the top of the historical range.
A resumption of earnings growth going into 2016 will be necessary for equities to move higher.
Our alternative scenario (30% chance) : The S&P500 breaks the 2170-2190 resistance, opening
the way to 2225 - 2300. Such a breakout would need a new round of stimulus and/or a new impulse
to macro fundamentals
A pull back below 2060 is needed in order to confirm our primary scenario!
Above 2200-2225, we’ll be obliged to recognize the alternative scenario is in.
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FinLight Research | www.finlightresearch.com
EQUITY
Bottom line :
De-risking should continue. A higher allocation to cash is sensible in this late-stage stock bull.
We adjust our positioning rules on the S&P 500 as follows:
We remain Neutral above 2106
To switch to OW again, we need a material break higher than 2170 - 2190
We will switch to UW as soon as the 2100-2106 range is materially broken to the downside.
Any clean break below the ‘09 trend would make us move massively UW
We like the low US beta. We remain Neutral Japan and UW Europe vs. US.
We remain UW in US small caps vs large caps.
We stay OW defensive vs. cyclical and value stocks vs growth stocks.
In our previous report, we’ve turned Neutral on high dividend stocks. As expected, utilities, and
dividend focused stocks have experienced selling pressure. Our view is that low vol/min vol
stocks are increasingly vulnerable.
EM has been one of the main beneficiaries from the risk appetite revival following the Brexit vote.
Nevertheless, we feel cautious about how resilient EM assets would be in the face of rising US
rates. We remain UW EMs vs DMs.
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FinLight Research | www.finlightresearch.com
US Earnings
The S&P500 stands within an earnings
recession.
For Q3 2016, the estimated earnings
decline is -2.1% YoY (+1.3% if energy is
excluded), marking the first time the
index has seen 6 consecutive quarters
of YoY declines in earnings since
2008/2009
For all of 2016, the estimated S&P 500
growth rate is now projected at -0.1%
for earnings and +2.1% for revenues.
For Q3-2016, 80 companies have
issued negative EPS guidance and 34
companies have issued positive EPS
guidance
The forward 12-month P/E ratio is now
16.7, which is well above the 5-year
(14.9) and 10-year (14.3) averages.
Analysts still expect earnings growth
to return in Q4 2016
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FinLight Research | www.finlightresearch.com
US Earnings
For each quarter since
2014, EPS estimates
have been revised down
If the trend of earnings
revisions continues,
earnings growth for all of
2016 would hardly be
positive
It’s worth noting that the
picture is much better if
you exclude energy
We also notice that
earnings estimate fall
before the season begins,
but the final growth rate
tends to beat estimates
20
FinLight Research | www.finlightresearch.com
End of Earnings Recession?
According to Factset data,
actual earnings have always
beaten analyst's estimates
since 2014
Given the usually positive
difference between actual
and estimated earnings
growth, we may expect that
the final reports for Q3-
2016 will break the streak
of lower earnings
21
FinLight Research | www.finlightresearch.com
S&P500 – A Long-Term Perspective
S&P 500 to be valued pretty
aggressively relative to
historical valuations:
Equity markets still appear at
lofty valuations, whatever the
valuation metric we use.
All the indicators we use
suggest a cautious long-term
outlook and weak long-term
return expectations These
measures are consistent with
flat (0%) 12 year S&P 500
nominal total returns
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FinLight Research | www.finlightresearch.com
S&P500 – Market Breadth
Since July, the index has
been diverging from its
50d-MA breadth.
Divergence is substantial
and surely will not last.
Re-convergence could be
done either with the
S&P500 breaking out the
symmetrical triangle to the
downside, or with the
breadth breaking to the
upside
The market continues to
hesitate (the consolidation
triangle is getting tighter)
and will likely break on one
side or the other, very
soon.
This break will be followed
by an impulsive movement
in the same direction.
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FinLight Research | www.finlightresearch.com
S&P500 – A Medium-Term Perspective
Since Q3-2015, the VIX
moving range widened and
corrective actions in the index
became more painful.
Convergence of support and
resistance is creating a
tightening range around
current levels. A break out
seems imminent.
Given the current low level of
the VIX, a break to the
downside looks more
probable.
24
FinLight Research | www.finlightresearch.com
S&P 500 – A Short-Term Perspective
Over the short-term, the
next level to watch is
2106. Any clean break
below it will open the door
to a more impulsive
decline towards 2060 and
even 2000.
On the topside, we need
to go through the 100-
dma at 2140 to feel more
confident about the end of
the correction.
But only a material break
above the trend across
the highs since Aug. ‘16
(~2170) would make the
setup constructive
enough to consider a
bullish stance.
25
FinLight Research | www.finlightresearch.com
S&P500 – A Short-Term Perspective
Our prop. Short-Term trading model has been flat since mid-August.
3 systems are targeting a break above 2189.
3 others are targeting a break below 2083
Bottom line: There is no conviction there!
26
FinLight Research | www.finlightresearch.com
S&P500 – Implied Vol
S&P 500 implied volatility
still appears somewhat low
when compared with the
potential move (as measured
by 1-year beta to the MSCI
World) in a risk-off scenario
More generally, DM vols
appear more attractive than
EM vols.
On a risk-return basis, we
continue to prefer DM to
Ems equities.
27
FIXED INCOME & CREDIT
GOVIES & INFLATION-LINKED
Recent data suggests that the US economic recovery is gathering momentum The Fed seems on track
to raise rates in December
The rumor that the ECB may taper its bond purchases in advance of the scheduled end date impacted
negatively stocks and bonds. The induced volatility in markets should be seen as a warning signal of
what is to come when interest rates ultimately start to go up.
Low interest rates are causing significant damage to financial institutions (banks, pension funds,
insurance companies). The amplitude of this damage will become evident in the next recession
The sell-off in Govies should continue as bond valuations are still stretched and Central Banks
outlook appears less supportive for duration. ECB/BoJ QE programs may be replaced by fiscal
policies.
G3 government yields are inconsistent with fundamentals. Eurozone (like Japanese) yields appear too
low when compared to nominal GDP growth. In our view, this is a bubble inflated by investors who
think that central banks will support such prices indefinitely.
The endgame will be disastrous given the extreme levels reached by valuation and market
positioning in FI.
We are Neutral on 10y-USTs and will remain so as long as the 1.85 resistance isn’t breached.
The U.S. curve looks likely to steepen from here, especially if the 10y-UST yield goes above 1.85. We
prefer to get out of our long flatteners positions on the UST curve.
FinLight Research | www.finlightresearch.com
28
FIXED INCOME & CREDIT
INFLATION-LINKED
Inflation isn't on anyone's radar right now. Inflation expectations haven't moved up yet. Any
surprise on the inflation front would make a lot of damage on the market.
Inflationary signs should be watched closely as they will foreshadow a steepening decline in
Govies.
We remain Neutral HICP Inflation as we see breakevens trading sideways
We move to OW 10y-TIPS. The US labor market is late in the cycle and should drive wage inflation.
Moreover, and from a tech perspective, the US 10y-breakeven has broken its downtrend since ’13
(~1.60) to the upside and seems to target 1.75 and even 1.85.
FinLight Research | www.finlightresearch.com
29
FIXED INCOME & CREDIT
CORPORATE CREDIT
Credit is expensive relative to the fundamentals . fundamentals continue to deteriorate, with EBITDA
growth continuing to decline and net leverage rising further (especially in the US). But central
bank QE from Europe and Japan remains a support.
We still see significant interest in USD credit given the low level of Euro HG credit yields. But we
expect demand for USD credit will slow because of the rising cost of FX risk hedging
Concerns around European banks, combined with a hard Brexit stance from the UK made European
credit markets underperform their US counterparties.
We remain overweight US vs EUR credit (more on IG than HY) because of our fundamentally
bearish view on European credit, the relative yield disadvantage and the fact that the re-leveraging
cycle looks more mature in the US.
In high yield, bonds rallied sharply after OPEC Algiers meeting. We keep, nevertheless, our bias
towards higher quality. Any unpriced rate hike (and/or dollar strengthening) would weigh on low quality
bonds (High Yield and EM debt). We remain UW on HY and Neutral on IG.
FinLight Research | www.finlightresearch.com
30
FIXED INCOME & CREDIT
EM DEBT
The dollar strengthening we still expect would weigh on EM debt
We remain Neutral on EM bonds, because of all the macro challenges facing the EM economies at a
time when the Fed is likely to be more hawkish
Bottom line : Neutral Govies, UW US vs Eurozone Govies, get out of our long flatteners on the US
yield curve, but remain short duration in 2y USTs, UW credit mainly through HY and Neutral on IG
(duration hedged), UW Eurozone vs US in IG & HY credit, OW 10y-TIPS breakevens and Neutral HICP
Inflation, UW High Yield vs High Grade, Neutral on EM sovereigns with a little preference for hard
currencies bonds.
FinLight Research | www.finlightresearch.com
31
US Govies – 10y UST
The divergence between US
bond yields and the global
PMI seems too wide to last.
Convergence can come from
either side. But, given the
global context (CB actions,
monetary policies…), it is more
probable to see it coming from
higher yields.
Closing the gap needs a
catalyst that may come from
ECB/BoJ ineluctable tapering
(or just rumors of).
We feel more cautious on all
yield sensitive assets: Govies,
HY credit, EM debt…
FinLight Research | www.finlightresearch.com
32
US Govies – 10y UST
Our positioning rules remain
unchanged:
OW below 1.65
Neutral above 1.65 and
remain so as long as the
1.80 level is preserved.
Move to Neutral around
1.25-1.28
Above 1.80, move to UW.
In September, and according
to these rules, we’ve moved
from OW to Neutral, then to
OW again before turning
Neutral above 1.65 on Oct.
6th.
We remain Neutral as long
as the 1.85 resistance isn’t
breached.
Breaking above 1.85 seems
unlikely, at least for now.
FinLight Research | www.finlightresearch.com
33
Credit Fundamentals
We continue to feel cautious
about US corporate leverage
and its disconnection from credit
spreads.
Corporate indebtedness is back
to its previous peak, when
measured as a percentage of
net revenues.
The picture is made more
bearable by low interest rates
and low debt servicing. This
will remain true as far as
corporations are able to
refinance maturing debt easily.
The ultimate risk for such an
instable equilibrium: liquidity
vanishing under a severe risk-
off scenario.
FinLight Research | www.finlightresearch.com
34
Credit Fundamentals
Upgrade-to-downgrade ratio and default rate have has reached levels last seen in H2-2008.
And this not just an oil/energy story.
This is again a sign that we are in the late stage of the credit cycle.
FinLight Research | www.finlightresearch.com
35
US Credit – Relative Positioning
We have been OW US vs European credit since Jul. ‘16 on HY and since Apr ‘15 on IG.
In September, we made money on this position as European indices have underperformed US
indices, mainly driven by worries about European banks
We maintain our current relative positioning
FinLight Research | www.finlightresearch.com
36
US Credit – Is Active Hedging On?
At around 11.5%, CDX.IG pull-
call skew is close to its 3 month
highs
OTM CDX put options are quite
expensive relative to call
options. This is probably the
sign of active credit risk
hedging.
FinLight Research | www.finlightresearch.com
37
EXCHANGE RATES
Central banks remain the key driver of foreign exchange, We remain structural Dollar bulls
As expected, the dollar is now supported by the Fed’s hawkish rhetoric and bets on a rate hike in Dec
‘16.
The technical picture for the EUR-USD remains rangy and messy. The U.S./German 10-year
spread is starting to widen, which is normally bearish for EUR-USD
We remain UW for the moment. We will move to Neutral above 1.14, and to OW if the spot breaks
above the 1.156 resistance to target 1.18
Our positioning rules remain unchanged:
Move to Neutral within the 1.14 - 1.156 range
Move to OW if the spot breaks above the 1.156 resistance to target 1.18
Remain UW below 1.14.
Over the medium-term (Q4-2016 and H1-2017), we maintain our downside projections towards
1.07-1.04-parity. For that, we need a clean break through the strong support area at 1.0910-1.0950
area, then through 1.06 (the floor of the triangle pattern).
Hard Brexit has become a meaningful risk. The value of the British pound has plummeted since the
referendum vote and seems to be saying that the British (tough) strategy to deal with Brexit is not the
good one.
FinLight Research | www.finlightresearch.com
38
EXCHANGE RATES
The downtrend since January has been broken and we’ve moved from Neutral to OW around
104 on Oct. 11. Next targets to watch: 104.8 and 108.
We adjust our positioning rules on USD-JPY as follows:
Remain OW as far as the downtrend from Jan. ‘16 isn’t reintegrated.
Move to Neutral below
Only a break below of 99.50 and bearish momentum, would make us move to UW
EM currencies have weakened since the middle of August as Fed risks have been repriced.
We anticipate that pressure on EM currencies will resume and continue until we see a more
constructive / fundamental improvement for global growth and commodities supply/demand
imbalances.
We remain UW EM and Commodity FX
FinLight Research | www.finlightresearch.com
39
EUR-USD
The U.S./German 10-year spread
is starting to widen, which is
normally bearish for EURUSD.
The technical picture for EUR-
USD remains rangy and messy.
We remain UW for the moment.
We will move to Neutral above
1.14, and to OW if the spot
breaks above the 1.156
resistance (the ceil of the triangle
pattern formed since Mar. ‘15) to
target 1.18
Over the medium-term (Q4-2016
and H1-2017), we maintain our
downside projections towards
1.07-1.04-parity. For that, we
need a clean break through the
strong support area at 1.0910-
1.0950 area, then through 1.06
(the floor of the triangle pattern).
FinLight Research | www.finlightresearch.com
40
USD-JPY
In our previous report, we said: “The
important area to watch stands
around the trendline formed across
the highs since January ~103.94”
The downtrend since January has
been broken and we’ve moved
from Neutral to OW around 104
on Oct. 11. Next targets to watch:
104.8 and 108.
We adjust our positioning rules on
USD-JPY as follows:
Remain OW as far as the
downtrend from Jan. ‘16 isn’t
reintegrated.
Move to Neutral below
Only a break below of 99.50
and bearish momentum, would
make us move to UW
FinLight Research | www.finlightresearch.com
41
COMMODITY
We continue to view upward moves since Jan. ‘16 more as technical adjustments than as a
fundamentally-driven ones.
We don’t see any sustainable recovery without a pick-up in global growth or a material
tightening on the supply side. It is likely that supply destruction (due to pull-back in capital
investment) will be the main catalyst for the next sustainable recovery in prices.
We also expect a considerable volatility along the way
We remain UW commodities over 3-6 months as we believe the recent rally might be short-lived
The supply side has adjusted but still has a way to go in many commodities before erasing
current imbalances. In order to get more cuts in supply, we think there needs another leg
down in prices to force capitulation
US dollar strengthening should resume. Dollar will dictate both direction and velocity in
commos. We expect the stronger dollar to put downward pressure on commodities despite
supportive fundamentals for some of them
The downtrend in commodities looks about to bottom out. We see one last leg down in energy
and metals.
FinLight Research | www.finlightresearch.com
42
COMMODITY
Bottom Line :
Energy:
OPEC agreement in Algiers has supported markets. OPEC surprised markets by agreeing to cut
production (to a range of 32.5-33.0 mbd at some point after the November meeting) for the first time in
eight years. However, much uncertainty remains around a finalized OPEC deal.
Another good news for oil: Inventories showed an unexpected decline.
Ample supply remains the major problem plaguing the oil market. US shale production continues to
weigh on price.
Despite the recent decline in inventories, crude oil stockpiles are still above levels they were at this time
last year and much higher than the average levels of the last ten years or going all the way back to 1984
We think that the bottom is in for oil, but we don’t expect a significant rally from here. Any growing
evidence that the downtrend in U.S. crude production is ending, would induce another sharp drop in
prices.
$40-$50 per barrel is the range for WTI over the short-term. Only an unexpected exogenous event
could cause oil to break out of it, on one side or the other..
We actually expect the spot to test again the 25-30 area before putting in a permanent rebound. At this
stage, we watch a few key levels ($40, $36, $31, $25). We need to see how the price behaves around
these levels to make our projections.
FinLight Research | www.finlightresearch.com
43
COMMODITY
According to our positioning rules, we turned to Neutral on WTI as the spot broke above $50 (Oct 11)
Our bearish bias is still intact. Only a material break above 52.5 would open scope for a rally.
Our tactical rules are adjusted as follows:
Remain Neutral above $50
Move to UW below $49.8-$50
Move to OW above $52.5 (to target 60 – 65) or below $29 (to play the rebound).
FinLight Research | www.finlightresearch.com
44
COMMODITY
Precious Metals:
Outlook for precious metals continues to be dominated by Fed rhetoric, macroeconomic and political
uncertainties and the subsequent impact on US dollar, real yields and sovereign credit.
As expected in our previous report, price weakness has shown up again in the gold market. The losses
were sudden and severe on Oct. 4th. A number of explanations were proffered for the sell-off. Most of
them turned around the rally in the US dollar and the reversal in US long-term yields.
Applying our positioning rules (please have a look to our Sep. Report), we’ve moved from OW to
Neutral on Gold as the spot broke below 1295 (on Oct. 4th)
Our positioning rules are adjusted as follows:
Remain Neutral between 1210 and 1300
Go OW above 1300, targeting 1380 and even 1430
Turn UW if the spot breaks below 1210 and go OW again below 1070
Over the medium term, we think that gold / silver are still due for a final leg down. Our ultimate
target was raised to 1000 – 1040 on gold and 12.5-13 on silver. The main risk to our scenario is the
resurgence of DM sovereign risk (starting with UK?).
FinLight Research | www.finlightresearch.com
45
COMMODITY
Base Metals: .
Despite the macro-driven rally started in Jan ‘16, we remain UW on base metals on continuing excess
supply, weak prospects for demand and cost deflation.
Industrial metals have remained range bounded since July. We believe that lower prices are still
needed to induce more supply adjustments.
From a longer-term point of view, we believe that metals prices are headed for multi-year declines
as the current China-driven super-cycle appears to have peaked
Agriculture:
The S&P GSCI Agri TR Index posted a decent gain (+4.5%) in September.
Last week, wheat and corn futures soared, amid talks of hedge funds struggling to close short positions,
with good US export sales data, and talk of Chinese demand for wheat
For grains, a bullish shift in sentiment from here, would require a significantly larger-than-expected cut to
US yields.
We choose to remain Neutral on Agris, as we have no conviction at this stage and given big
uncertainties around forecasts for 2016-17
FinLight Research | www.finlightresearch.com
46
Crude – A Fundamental Perspective
In Algiers meeting, OPEC oil ministers agreed in principle to cut production to a cap of 32.5-33.0
mbd. At this stage, the agreement is nothing more than the formation of a study group to consider
how to enact such a reduction in November meeting..
In the meanwhile, OPEC output rose to a record 33.75 million in September
The targeted cap remains some 10% higher than OPEC production when oil first reached the
$60 level.
FinLight Research | www.finlightresearch.com
47
Crude – A Medium-Term Perspective
The downtrend is still intact.
Moreover, oil prices are now at extreme overbought levels, which may provide a long-term sell signal
with $30-35/bbl as a target.
As long as the spot remains below the downtrend line, the pressure remains to the downside.
FinLight Research | www.finlightresearch.com
48
Crude – Tech. Perspective
According to our positioning
rules, we turned to Neutral on
WTI as the spot broke above
$50 (Oct 11)
Our bearish bias is still intact.
Only a material break above
52.5 would open scope for a
rally.
Our tactical rules are adjusted
as follows:
Remain Neutral above $50
Move to UW below $49.8-
$50
Move to OW above $52.5
(to target 60 – 65) or below
$29 (to play the rebound).
FinLight Research | www.finlightresearch.com
49
Gold – Tech. Perspective
The move on Oct. 4th was sudden and severe. Gold fell to the lowest in almost 4 months and
breached the key technical level of 200-dma.
A material break below the 200dma may mean that the current uptrend is over.
FinLight Research | www.finlightresearch.com
50
Gold – Tech. Perspective
Applying our positioning rules
(please have a look to our Sep.
Report), we’ve moved from
OW to Neutral on Gold as the
spot broke below 1295 (on Oct.
4th)
The next level to watch is 1249.
A break through will open the
door to a test of 1210.
Only a move above 1300 would
signal a recovery.
Our positioning rules are
adjusted as follows:
Remain Neutral between
1210 and 1300
Go OW above 1300,
targeting 1380 and even
1430
Turn UW if the spot breaks
below 1210 and go OW
again below 1070
FinLight Research | www.finlightresearch.com
51
Copper – Tech. Perspective
Within the industrial metals
complex, we’ve UW Copper for
a while now. From a
fundamental point of view,
Copper is still one of the most
oversupplied markets.
But, from a technical
perspective, we think the metal
will soon find a near-term
support around 4620 (the floor of
the current triangle pattern)
We switch to Neutral with a
bullish bias, for now.
We’ll move to OW if the spot
breaks up (above 4950, target
~5400 where we’ll move
massively UW) and to UW again
if it breaks down (below 4620)
FinLight Research | www.finlightresearch.com
52
ALTERNATIVE STRATEGIES
The HFRI Fund Weighted Composite Index posted gains of 0.6% in September (+3.0% QoQ and
4.2% YoY). Gains were led by Equity Hedge (+1.1% MoM) and Relative Value (+0.9% MoM, with RV :
Volatility Arbitrage making 1.6% MoM) strategies.
Both CTA and Discretionary Macro strategies showed mixed performance in September, with -0.7%
on HFRI Systematic Diversified Index and a meager +0.1% on HFRI Macro: Discretionary Thematic
Index
Global Macro managers have largely benefitted from recent market movements, as they
continue to play the growth divergence thesis between the US and the rest of the world. Thus, they
posted substantial gains since Oct. 1st, benefitting from their long USD positions, the sharp decline of
the GBP/USD and their short duration trades in fixed income. These views have finally proved
profitable as markets increasingly price in a Fed rate hike by December.
CTAs accentuated their losses in October, as a result of their long fixed income and mixed
performance in the commodity bucket, and despite their short positioning in Pound.
We believe that diversifying portfolios with an increased allocation to alternatives is particularly
attractive at this stage of the cycle, given the current macroeconomic and interest rate uncertainties.
Within the hedge fund universe, we continue to prefer strategies with moderate market
directionality (“risk diversifiers” type) such as L/S Equity Market Neutral, Global Macro and CTAs.
The reason behind that is that we continue to consider traditional asset classes as richly valued.
FinLight Research | www.finlightresearch.com
53
ALTERNATIVE STRATEGIES
We maintain our OW rating on :
Equity Market Neutral, a strategy we think to be well positioned for a spike of volatility by the fall.
CTAs: Despite their recent losses, we keep a clear OW stance on CTAs as a diversifier in
portfolios and a hedge against future stress. Furthermore, we expect new trends to emerge
soon… either from a firmer expansion or more likely from a recession!
Global Macro: We like this strategy as a diversifier and tail hedge. We have a slight preference
for macro funds with a focus on Forex and Fixed-income…
Vol. Arb strategy and prefer funds that trade volatility globally (all assets / all regions).
FinLight Research | www.finlightresearch.com
54
Hedge Fund Alpha Generation
The hedge fund industry has been
producing a negative overall alpha
since end-2015
This underperformance has been driven
by several factors: crowded trades,
uncertainties about growth and rate
policy, lower dispersion…
FinLight Research | www.finlightresearch.com
Bottom Line: Global Asset Allocation
Markets are relatively too calm, but appear to be at a crucial point.
Equity market is still locked in a tight range, but breakout seems
imminent
Equity volatility is unlikely to stay this low. We expect it to increase
through the US election due to the global uncertainties (Brexit, next US
rate hike…)
EM has been one of the main beneficiaries from the risk appetite
revival following the Brexit vote. Nevertheless, we feel cautious about
how resilient EM assets would be in the face of rising US rates.
Looking ahead, fundamentals appear to have improved.. That has
renewed speculation that the Fed could raise rates as early as
December
With elevated valuations and crowded long positioning in equities
and bonds, the market appears vulnerable to shocks over the
near term.
Said another way, current market conditions imply small potential
returns and big latent risks across almost all asset classes. Thus, we
remain defensive in our asset allocation.
The moral of the story? Be prepared for anything…
We summarize our views as follows
55
FinLight Research | www.finlightresearch.com
56
Disclaimer
FinLight Research | www.finlightresearch.com
This writing is for informational purposes only and does not constitute an
offer to sell, a solicitation to buy, or a recommendation regarding any
securities transaction, or as an offer to provide advisory or other services
by FinLight Research in any jurisdiction in which such offer, solicitation,
purchase or sale would be unlawful under the securities laws of such
jurisdiction. The information contained in this writing should not be
construed as financial or investment advice on any subject matter.
FinLight Research expressly disclaims all liability in respect to actions
taken based on any or all of the information on this writing.
About Us…
FinLight Research is a research-centric company focused on Asset Allocation from a top-down
perspective, on Portfolio Construction, and all related quantitative aspects and risk management issues.
Our expertise expands along 3 axes:
Asset Allocation with risk control and/or risk budgeting techniques
Allocation to alternative investments : Hedge funds, rule-based strategies (momentum, value,
carry, volatility), real assets (real estate, infrastructure, farmland, timberland and natural resources).
Private equity and venture capital should be the next step…
Allocation with a factorial approach built on the understanding (profiling) of the risk/return drivers of
the different asset classes
FinLight Research is an innovation-oriented company. We target to fill the gap between the
academic research and the investment community, especially on real assets and alternatives. We survey
on a continuous basis the academic literature for interesting published and working papers related to
quantitative investing, non-linear profiling, asset allocation, real assets...
57
FinLight Research | www.finlightresearch.com
Our Standard Offer
Provide tailor-
made quantitative
analysis of your
portfolios in terms
of asset allocation,
risk profiling and
risk contribution
Provide tailor-
made quantitative
analysis of your
portfolios in terms
of asset allocation,
risk profiling and
risk contribution
•Risk Profiling
Offer a turnkey 3-
step factor-based
process in GAA
with factor
selection, risk
budgeting and
dynamic portfolio
protection
Offer a turnkey 3-
step factor-based
process in GAA
with factor
selection, risk
budgeting and
dynamic portfolio
protection
•Factor-based GAA Process
Provide assistance
with alternative
investments
(including real
assets) in terms of
profiling, and
integration in a
GAA
Provide assistance
with alternative
investments
(including real
assets) in terms of
profiling, and
integration in a
GAA
•Alternative Investments
Provide assistance
with asset
allocation and
related risk control
and/or risk
budgeting
techniques
Provide assistance
with asset
allocation and
related risk control
and/or risk
budgeting
techniques
•Global Asset Allocation
(GAA)
58
FinLight Research | www.finlightresearch.com

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Finlight Research - Market Perspectives - Oct 2016

  • 1. Market Perspectives October 2016 Oct. 14th, 2016 www.finlightresearch.com What the wise do early, a fool does in the end
  • 2. “Since 1947, every time profits fell this much, or for this long, a recession was either underway or about to begin. […] The only exception was the middle of 1986 to early 1987. The argument can be made that corporate profits fell in 1986/1987 because a collapse in crude oil prices crushed energy profits. This is similar to the current fall in profits… Despite this collapse in profits in 1986/1987, stock prices marched to new all- time highs. The same is happening now. However, by the fall of 1987 the market became overvalued by most measures and crashed, reversing all the gains over the previous 18 months. ” – Jim Bianco (Bianco Research) 2 FinLight Research | www.finlightresearch.com
  • 3. Executive Summary: Global Asset Allocation Markets are relatively too calm, but appear to be at a crucial point. Equity market is still locked in a tight range, but breakout seems imminent Equity volatility is unlikely to stay this low. We expect it to increase through the US election due to the global uncertainties (Brexit, next US rate hike…) EM has been one of the main beneficiaries from the risk appetite revival following the Brexit vote. Nevertheless, we feel cautious about how resilient EM assets would be in the face of rising US rates. Looking ahead, fundamentals appear to have improved.. That has renewed speculation that the Fed could raise rates as early as December With elevated valuations and crowded long positioning in equities and bonds, the market appears vulnerable to shocks over the near term. Said another way, current market conditions imply small potential returns and big latent risks across almost all asset classes. Thus, we remain defensive in our asset allocation. The moral of the story? Be prepared for anything… We summarize our views as follows 3 FinLight Research | www.finlightresearch.com
  • 4. MACRO VIEW The Good Jobless claims in the U.S. dropped to the second-lowest level since 1973. With September data release, the global manufacturing PMI seems to be breaking its downtrend The ISM Non Manufacturing report was excellent We are probably at an inflection point on equity earnings The Bad The Atlanta Fed model projects Q3 GDP growth at just 2.1%, down from 2.8% expected a few days ago. Two months ago, GDPNow was predicting Q3 GDP growth nearly 1% higher US Commercial real estate (CRE) suffers. The Dodge Momentum Index (a leading indicator for new non-residential CRE investment) fell 4.3% in September to 129.0 (vs 134.8 in August) The Ugly Main systemic risk resides in China: China is not recovering but rather just re-leveraging. Chinese debt bomb is ticking. Debt is used to create the illusion of growth. The Chinese banking sector is going to end up needing a bailout. A Hard Brexit has become a meaningful risk Something huge is probably gathering in Japan: Abenomics has failed! Contrary to every economic theory, debt accumulation, debt monetization and record amounts of currency creation have resulted in a rising yen and falling prices. 4 FinLight Research | www.finlightresearch.com
  • 5. 5 FinLight Research | www.finlightresearch.com The Big Four Economic Indicators The current picture is characterized by relatively strong Employment and Income, a weak Industrial Production (probably in recovery mode since its Mar ‘16 lows) and Real Retail Sales hovering around a flat line. The average of these indicators has been trending lower since Nov. ‘14, suggesting that the economy is still moving sideways. Industrial Production has been the weakest link in the economic recovery since the GFC. But the picture has been getting mildly better since June.
  • 6. 6 FinLight Research | www.finlightresearch.com The Big Four Economic Indicators Looking at an aggregate of the four indicators, we see that: Things have gotten much better since the end of the last recession. But we are still far from catching up with the secular trend. The gap to that secular trend is even getting wider.
  • 7. 7 FinLight Research | www.finlightresearch.com ISM Manufacturing & Services ☺ Both ISM manufacturing and services indices are now in expansion territories The manufacturing index rebounded to 51.5 in September, up from 49.4 in August. Its new orders component rebounded to 55.1 in September from 49.1 in August. The ISM Non Manufacturing report was excellent. The services index jumped to 57.1 from 51.4 in August. Its new orders component soared to 60 (up from 51.4)
  • 8. 8 FinLight Research | www.finlightresearch.com Global Manufacturing PMI The global PMI is also getting much better. The JPM Global Manufacturing PMI has been in a continuous downtrend since 2013, and clearly pointing to a global recession. With the last monthly moves (50.8 in Aug and 51.0 in Sep), the downtrend seems broken, and global recession avoided for the moment. Is that a sign of an improved global growth? Just wait and see...
  • 9. 9 FinLight Research | www.finlightresearch.com US Employment – U6 Unemployment Rate vs Wage Growth Since the end of the GFC, the U6 unemployment rate (including unemployed + underemployed, such as involuntary part-time workers) has decreased from 17% to around 10%. However, Current levels remain too high (near the peak of the previous cycle). Wage increases (at a meager 2.6% YoY in nominal terms) remain pathetic
  • 10. 10 FinLight Research | www.finlightresearch.com US Employment – Adjusted for Population Growth Labor market improvement cannot go forever… When adjusted for population growth, nonfarm Employment data tend to show a similar trend to that of the seventies. Given where we stand within the business cycle, the current level may constitute a new interim peak.
  • 11. 11 FinLight Research | www.finlightresearch.com US Capex US capex picture remains bleak with nonresidential fixed investment continuing its long slip down.
  • 12. 12 FinLight Research | www.finlightresearch.com US Capacity Utilization One of the main factors weighing on inflation and growth is excess capacity. Overcapacity is more and more obvious in the global economy. Capacity utilization has been trending lower and stands now at a level that has been historically indicative of recession. Source: St. Louis Federal Reserve Capacity Utliization
  • 13. 13 FinLight Research | www.finlightresearch.com GS – Global Leading Indicator (GLI) The September Final GLI came in at 2.8%yoy. Its MoM momentum came at 0.31% (up from its last month’s 0.27%) The September GLI reading now signals economic expansion after a brief summer excursion in the slowdown quadrant. Seven of the ten underlying components of the GLI improved in August. We continue to think that the acceleration we’ve been witnessing since Jan. ‘15 is quite modest for a typical expansion phase
  • 14. 14 FinLight Research | www.finlightresearch.com EQUITY Our equity outlook remains cautious. We see the market more vulnerable than ever to growth, earnings and policy disappointments. Stocks have flirted with making a move above the recent highs but conviction seems missing. The US equity valuation picture has hardly changed since last quarter. Whatever metrics we consider, US stocks look expensive, making the pressure to deliver a positive earnings growth very substantial Relative to alternatives, though, valuations are a lot more reasonable than what many perceive. The S&P 500 earnings yield is nearly twice the yield on the 10 year treasury. Its dividend yield is 0.5% points higher than the 10 year UST. In order for valuations to cause problems, there has to be a catalyst (a rate hike, a recession, disappointing earnings, a geopolitical event…) to get it started. Market volatility remains very subdued. We still expect an increase in VIX futures over the next couple of months and through the U.S. presidential election. Given the current congestion in indices, due to a convergence of supports and resistances, a break out of the tightening range is likely coming, but the direction is uncertain at this time. The trigger for that movement could be the Q3 earnings season. Given the current VIX level, we think it is less likely a significant rally will occur from here. A stronger dollar will induce another headwind to already weak earnings Capital spending continues to contract and to be replaced by stock buybacks and other forms of financial engineering.
  • 15. 15 FinLight Research | www.finlightresearch.com EQUITY We remain Neutral on S&P 500 but with a bearish bias as we see increasing political uncertainty into the US elections and some headwinds from the resumption of the Fed rate hike cycle and a strong Dollar. We remain UW Europe into year-end because of elevated political uncertainty (from Brexit and the Italian referendum) and uncertainty on ECB policy We still think that key fundamental data will eventually matter… in a BIG BIG way. For now, investors are buying the rumor of better future earnings. One day, they will be selling the news of bad effective earnings.
  • 16. 16 FinLight Research | www.finlightresearch.com EQUITY Our scenarios are unchanged. Our main scenario from here (70% chance) : A massive top forming around 2170-2190 Equities remain expensive, earnings growth poor and profit margins are showing increasing evidence of peaking. On Price/Sales metric, equities are trading at the top of the historical range. A resumption of earnings growth going into 2016 will be necessary for equities to move higher. Our alternative scenario (30% chance) : The S&P500 breaks the 2170-2190 resistance, opening the way to 2225 - 2300. Such a breakout would need a new round of stimulus and/or a new impulse to macro fundamentals A pull back below 2060 is needed in order to confirm our primary scenario! Above 2200-2225, we’ll be obliged to recognize the alternative scenario is in.
  • 17. 17 FinLight Research | www.finlightresearch.com EQUITY Bottom line : De-risking should continue. A higher allocation to cash is sensible in this late-stage stock bull. We adjust our positioning rules on the S&P 500 as follows: We remain Neutral above 2106 To switch to OW again, we need a material break higher than 2170 - 2190 We will switch to UW as soon as the 2100-2106 range is materially broken to the downside. Any clean break below the ‘09 trend would make us move massively UW We like the low US beta. We remain Neutral Japan and UW Europe vs. US. We remain UW in US small caps vs large caps. We stay OW defensive vs. cyclical and value stocks vs growth stocks. In our previous report, we’ve turned Neutral on high dividend stocks. As expected, utilities, and dividend focused stocks have experienced selling pressure. Our view is that low vol/min vol stocks are increasingly vulnerable. EM has been one of the main beneficiaries from the risk appetite revival following the Brexit vote. Nevertheless, we feel cautious about how resilient EM assets would be in the face of rising US rates. We remain UW EMs vs DMs.
  • 18. 18 FinLight Research | www.finlightresearch.com US Earnings The S&P500 stands within an earnings recession. For Q3 2016, the estimated earnings decline is -2.1% YoY (+1.3% if energy is excluded), marking the first time the index has seen 6 consecutive quarters of YoY declines in earnings since 2008/2009 For all of 2016, the estimated S&P 500 growth rate is now projected at -0.1% for earnings and +2.1% for revenues. For Q3-2016, 80 companies have issued negative EPS guidance and 34 companies have issued positive EPS guidance The forward 12-month P/E ratio is now 16.7, which is well above the 5-year (14.9) and 10-year (14.3) averages. Analysts still expect earnings growth to return in Q4 2016
  • 19. 19 FinLight Research | www.finlightresearch.com US Earnings For each quarter since 2014, EPS estimates have been revised down If the trend of earnings revisions continues, earnings growth for all of 2016 would hardly be positive It’s worth noting that the picture is much better if you exclude energy We also notice that earnings estimate fall before the season begins, but the final growth rate tends to beat estimates
  • 20. 20 FinLight Research | www.finlightresearch.com End of Earnings Recession? According to Factset data, actual earnings have always beaten analyst's estimates since 2014 Given the usually positive difference between actual and estimated earnings growth, we may expect that the final reports for Q3- 2016 will break the streak of lower earnings
  • 21. 21 FinLight Research | www.finlightresearch.com S&P500 – A Long-Term Perspective S&P 500 to be valued pretty aggressively relative to historical valuations: Equity markets still appear at lofty valuations, whatever the valuation metric we use. All the indicators we use suggest a cautious long-term outlook and weak long-term return expectations These measures are consistent with flat (0%) 12 year S&P 500 nominal total returns
  • 22. 22 FinLight Research | www.finlightresearch.com S&P500 – Market Breadth Since July, the index has been diverging from its 50d-MA breadth. Divergence is substantial and surely will not last. Re-convergence could be done either with the S&P500 breaking out the symmetrical triangle to the downside, or with the breadth breaking to the upside The market continues to hesitate (the consolidation triangle is getting tighter) and will likely break on one side or the other, very soon. This break will be followed by an impulsive movement in the same direction.
  • 23. 23 FinLight Research | www.finlightresearch.com S&P500 – A Medium-Term Perspective Since Q3-2015, the VIX moving range widened and corrective actions in the index became more painful. Convergence of support and resistance is creating a tightening range around current levels. A break out seems imminent. Given the current low level of the VIX, a break to the downside looks more probable.
  • 24. 24 FinLight Research | www.finlightresearch.com S&P 500 – A Short-Term Perspective Over the short-term, the next level to watch is 2106. Any clean break below it will open the door to a more impulsive decline towards 2060 and even 2000. On the topside, we need to go through the 100- dma at 2140 to feel more confident about the end of the correction. But only a material break above the trend across the highs since Aug. ‘16 (~2170) would make the setup constructive enough to consider a bullish stance.
  • 25. 25 FinLight Research | www.finlightresearch.com S&P500 – A Short-Term Perspective Our prop. Short-Term trading model has been flat since mid-August. 3 systems are targeting a break above 2189. 3 others are targeting a break below 2083 Bottom line: There is no conviction there!
  • 26. 26 FinLight Research | www.finlightresearch.com S&P500 – Implied Vol S&P 500 implied volatility still appears somewhat low when compared with the potential move (as measured by 1-year beta to the MSCI World) in a risk-off scenario More generally, DM vols appear more attractive than EM vols. On a risk-return basis, we continue to prefer DM to Ems equities.
  • 27. 27 FIXED INCOME & CREDIT GOVIES & INFLATION-LINKED Recent data suggests that the US economic recovery is gathering momentum The Fed seems on track to raise rates in December The rumor that the ECB may taper its bond purchases in advance of the scheduled end date impacted negatively stocks and bonds. The induced volatility in markets should be seen as a warning signal of what is to come when interest rates ultimately start to go up. Low interest rates are causing significant damage to financial institutions (banks, pension funds, insurance companies). The amplitude of this damage will become evident in the next recession The sell-off in Govies should continue as bond valuations are still stretched and Central Banks outlook appears less supportive for duration. ECB/BoJ QE programs may be replaced by fiscal policies. G3 government yields are inconsistent with fundamentals. Eurozone (like Japanese) yields appear too low when compared to nominal GDP growth. In our view, this is a bubble inflated by investors who think that central banks will support such prices indefinitely. The endgame will be disastrous given the extreme levels reached by valuation and market positioning in FI. We are Neutral on 10y-USTs and will remain so as long as the 1.85 resistance isn’t breached. The U.S. curve looks likely to steepen from here, especially if the 10y-UST yield goes above 1.85. We prefer to get out of our long flatteners positions on the UST curve. FinLight Research | www.finlightresearch.com
  • 28. 28 FIXED INCOME & CREDIT INFLATION-LINKED Inflation isn't on anyone's radar right now. Inflation expectations haven't moved up yet. Any surprise on the inflation front would make a lot of damage on the market. Inflationary signs should be watched closely as they will foreshadow a steepening decline in Govies. We remain Neutral HICP Inflation as we see breakevens trading sideways We move to OW 10y-TIPS. The US labor market is late in the cycle and should drive wage inflation. Moreover, and from a tech perspective, the US 10y-breakeven has broken its downtrend since ’13 (~1.60) to the upside and seems to target 1.75 and even 1.85. FinLight Research | www.finlightresearch.com
  • 29. 29 FIXED INCOME & CREDIT CORPORATE CREDIT Credit is expensive relative to the fundamentals . fundamentals continue to deteriorate, with EBITDA growth continuing to decline and net leverage rising further (especially in the US). But central bank QE from Europe and Japan remains a support. We still see significant interest in USD credit given the low level of Euro HG credit yields. But we expect demand for USD credit will slow because of the rising cost of FX risk hedging Concerns around European banks, combined with a hard Brexit stance from the UK made European credit markets underperform their US counterparties. We remain overweight US vs EUR credit (more on IG than HY) because of our fundamentally bearish view on European credit, the relative yield disadvantage and the fact that the re-leveraging cycle looks more mature in the US. In high yield, bonds rallied sharply after OPEC Algiers meeting. We keep, nevertheless, our bias towards higher quality. Any unpriced rate hike (and/or dollar strengthening) would weigh on low quality bonds (High Yield and EM debt). We remain UW on HY and Neutral on IG. FinLight Research | www.finlightresearch.com
  • 30. 30 FIXED INCOME & CREDIT EM DEBT The dollar strengthening we still expect would weigh on EM debt We remain Neutral on EM bonds, because of all the macro challenges facing the EM economies at a time when the Fed is likely to be more hawkish Bottom line : Neutral Govies, UW US vs Eurozone Govies, get out of our long flatteners on the US yield curve, but remain short duration in 2y USTs, UW credit mainly through HY and Neutral on IG (duration hedged), UW Eurozone vs US in IG & HY credit, OW 10y-TIPS breakevens and Neutral HICP Inflation, UW High Yield vs High Grade, Neutral on EM sovereigns with a little preference for hard currencies bonds. FinLight Research | www.finlightresearch.com
  • 31. 31 US Govies – 10y UST The divergence between US bond yields and the global PMI seems too wide to last. Convergence can come from either side. But, given the global context (CB actions, monetary policies…), it is more probable to see it coming from higher yields. Closing the gap needs a catalyst that may come from ECB/BoJ ineluctable tapering (or just rumors of). We feel more cautious on all yield sensitive assets: Govies, HY credit, EM debt… FinLight Research | www.finlightresearch.com
  • 32. 32 US Govies – 10y UST Our positioning rules remain unchanged: OW below 1.65 Neutral above 1.65 and remain so as long as the 1.80 level is preserved. Move to Neutral around 1.25-1.28 Above 1.80, move to UW. In September, and according to these rules, we’ve moved from OW to Neutral, then to OW again before turning Neutral above 1.65 on Oct. 6th. We remain Neutral as long as the 1.85 resistance isn’t breached. Breaking above 1.85 seems unlikely, at least for now. FinLight Research | www.finlightresearch.com
  • 33. 33 Credit Fundamentals We continue to feel cautious about US corporate leverage and its disconnection from credit spreads. Corporate indebtedness is back to its previous peak, when measured as a percentage of net revenues. The picture is made more bearable by low interest rates and low debt servicing. This will remain true as far as corporations are able to refinance maturing debt easily. The ultimate risk for such an instable equilibrium: liquidity vanishing under a severe risk- off scenario. FinLight Research | www.finlightresearch.com
  • 34. 34 Credit Fundamentals Upgrade-to-downgrade ratio and default rate have has reached levels last seen in H2-2008. And this not just an oil/energy story. This is again a sign that we are in the late stage of the credit cycle. FinLight Research | www.finlightresearch.com
  • 35. 35 US Credit – Relative Positioning We have been OW US vs European credit since Jul. ‘16 on HY and since Apr ‘15 on IG. In September, we made money on this position as European indices have underperformed US indices, mainly driven by worries about European banks We maintain our current relative positioning FinLight Research | www.finlightresearch.com
  • 36. 36 US Credit – Is Active Hedging On? At around 11.5%, CDX.IG pull- call skew is close to its 3 month highs OTM CDX put options are quite expensive relative to call options. This is probably the sign of active credit risk hedging. FinLight Research | www.finlightresearch.com
  • 37. 37 EXCHANGE RATES Central banks remain the key driver of foreign exchange, We remain structural Dollar bulls As expected, the dollar is now supported by the Fed’s hawkish rhetoric and bets on a rate hike in Dec ‘16. The technical picture for the EUR-USD remains rangy and messy. The U.S./German 10-year spread is starting to widen, which is normally bearish for EUR-USD We remain UW for the moment. We will move to Neutral above 1.14, and to OW if the spot breaks above the 1.156 resistance to target 1.18 Our positioning rules remain unchanged: Move to Neutral within the 1.14 - 1.156 range Move to OW if the spot breaks above the 1.156 resistance to target 1.18 Remain UW below 1.14. Over the medium-term (Q4-2016 and H1-2017), we maintain our downside projections towards 1.07-1.04-parity. For that, we need a clean break through the strong support area at 1.0910-1.0950 area, then through 1.06 (the floor of the triangle pattern). Hard Brexit has become a meaningful risk. The value of the British pound has plummeted since the referendum vote and seems to be saying that the British (tough) strategy to deal with Brexit is not the good one. FinLight Research | www.finlightresearch.com
  • 38. 38 EXCHANGE RATES The downtrend since January has been broken and we’ve moved from Neutral to OW around 104 on Oct. 11. Next targets to watch: 104.8 and 108. We adjust our positioning rules on USD-JPY as follows: Remain OW as far as the downtrend from Jan. ‘16 isn’t reintegrated. Move to Neutral below Only a break below of 99.50 and bearish momentum, would make us move to UW EM currencies have weakened since the middle of August as Fed risks have been repriced. We anticipate that pressure on EM currencies will resume and continue until we see a more constructive / fundamental improvement for global growth and commodities supply/demand imbalances. We remain UW EM and Commodity FX FinLight Research | www.finlightresearch.com
  • 39. 39 EUR-USD The U.S./German 10-year spread is starting to widen, which is normally bearish for EURUSD. The technical picture for EUR- USD remains rangy and messy. We remain UW for the moment. We will move to Neutral above 1.14, and to OW if the spot breaks above the 1.156 resistance (the ceil of the triangle pattern formed since Mar. ‘15) to target 1.18 Over the medium-term (Q4-2016 and H1-2017), we maintain our downside projections towards 1.07-1.04-parity. For that, we need a clean break through the strong support area at 1.0910- 1.0950 area, then through 1.06 (the floor of the triangle pattern). FinLight Research | www.finlightresearch.com
  • 40. 40 USD-JPY In our previous report, we said: “The important area to watch stands around the trendline formed across the highs since January ~103.94” The downtrend since January has been broken and we’ve moved from Neutral to OW around 104 on Oct. 11. Next targets to watch: 104.8 and 108. We adjust our positioning rules on USD-JPY as follows: Remain OW as far as the downtrend from Jan. ‘16 isn’t reintegrated. Move to Neutral below Only a break below of 99.50 and bearish momentum, would make us move to UW FinLight Research | www.finlightresearch.com
  • 41. 41 COMMODITY We continue to view upward moves since Jan. ‘16 more as technical adjustments than as a fundamentally-driven ones. We don’t see any sustainable recovery without a pick-up in global growth or a material tightening on the supply side. It is likely that supply destruction (due to pull-back in capital investment) will be the main catalyst for the next sustainable recovery in prices. We also expect a considerable volatility along the way We remain UW commodities over 3-6 months as we believe the recent rally might be short-lived The supply side has adjusted but still has a way to go in many commodities before erasing current imbalances. In order to get more cuts in supply, we think there needs another leg down in prices to force capitulation US dollar strengthening should resume. Dollar will dictate both direction and velocity in commos. We expect the stronger dollar to put downward pressure on commodities despite supportive fundamentals for some of them The downtrend in commodities looks about to bottom out. We see one last leg down in energy and metals. FinLight Research | www.finlightresearch.com
  • 42. 42 COMMODITY Bottom Line : Energy: OPEC agreement in Algiers has supported markets. OPEC surprised markets by agreeing to cut production (to a range of 32.5-33.0 mbd at some point after the November meeting) for the first time in eight years. However, much uncertainty remains around a finalized OPEC deal. Another good news for oil: Inventories showed an unexpected decline. Ample supply remains the major problem plaguing the oil market. US shale production continues to weigh on price. Despite the recent decline in inventories, crude oil stockpiles are still above levels they were at this time last year and much higher than the average levels of the last ten years or going all the way back to 1984 We think that the bottom is in for oil, but we don’t expect a significant rally from here. Any growing evidence that the downtrend in U.S. crude production is ending, would induce another sharp drop in prices. $40-$50 per barrel is the range for WTI over the short-term. Only an unexpected exogenous event could cause oil to break out of it, on one side or the other.. We actually expect the spot to test again the 25-30 area before putting in a permanent rebound. At this stage, we watch a few key levels ($40, $36, $31, $25). We need to see how the price behaves around these levels to make our projections. FinLight Research | www.finlightresearch.com
  • 43. 43 COMMODITY According to our positioning rules, we turned to Neutral on WTI as the spot broke above $50 (Oct 11) Our bearish bias is still intact. Only a material break above 52.5 would open scope for a rally. Our tactical rules are adjusted as follows: Remain Neutral above $50 Move to UW below $49.8-$50 Move to OW above $52.5 (to target 60 – 65) or below $29 (to play the rebound). FinLight Research | www.finlightresearch.com
  • 44. 44 COMMODITY Precious Metals: Outlook for precious metals continues to be dominated by Fed rhetoric, macroeconomic and political uncertainties and the subsequent impact on US dollar, real yields and sovereign credit. As expected in our previous report, price weakness has shown up again in the gold market. The losses were sudden and severe on Oct. 4th. A number of explanations were proffered for the sell-off. Most of them turned around the rally in the US dollar and the reversal in US long-term yields. Applying our positioning rules (please have a look to our Sep. Report), we’ve moved from OW to Neutral on Gold as the spot broke below 1295 (on Oct. 4th) Our positioning rules are adjusted as follows: Remain Neutral between 1210 and 1300 Go OW above 1300, targeting 1380 and even 1430 Turn UW if the spot breaks below 1210 and go OW again below 1070 Over the medium term, we think that gold / silver are still due for a final leg down. Our ultimate target was raised to 1000 – 1040 on gold and 12.5-13 on silver. The main risk to our scenario is the resurgence of DM sovereign risk (starting with UK?). FinLight Research | www.finlightresearch.com
  • 45. 45 COMMODITY Base Metals: . Despite the macro-driven rally started in Jan ‘16, we remain UW on base metals on continuing excess supply, weak prospects for demand and cost deflation. Industrial metals have remained range bounded since July. We believe that lower prices are still needed to induce more supply adjustments. From a longer-term point of view, we believe that metals prices are headed for multi-year declines as the current China-driven super-cycle appears to have peaked Agriculture: The S&P GSCI Agri TR Index posted a decent gain (+4.5%) in September. Last week, wheat and corn futures soared, amid talks of hedge funds struggling to close short positions, with good US export sales data, and talk of Chinese demand for wheat For grains, a bullish shift in sentiment from here, would require a significantly larger-than-expected cut to US yields. We choose to remain Neutral on Agris, as we have no conviction at this stage and given big uncertainties around forecasts for 2016-17 FinLight Research | www.finlightresearch.com
  • 46. 46 Crude – A Fundamental Perspective In Algiers meeting, OPEC oil ministers agreed in principle to cut production to a cap of 32.5-33.0 mbd. At this stage, the agreement is nothing more than the formation of a study group to consider how to enact such a reduction in November meeting.. In the meanwhile, OPEC output rose to a record 33.75 million in September The targeted cap remains some 10% higher than OPEC production when oil first reached the $60 level. FinLight Research | www.finlightresearch.com
  • 47. 47 Crude – A Medium-Term Perspective The downtrend is still intact. Moreover, oil prices are now at extreme overbought levels, which may provide a long-term sell signal with $30-35/bbl as a target. As long as the spot remains below the downtrend line, the pressure remains to the downside. FinLight Research | www.finlightresearch.com
  • 48. 48 Crude – Tech. Perspective According to our positioning rules, we turned to Neutral on WTI as the spot broke above $50 (Oct 11) Our bearish bias is still intact. Only a material break above 52.5 would open scope for a rally. Our tactical rules are adjusted as follows: Remain Neutral above $50 Move to UW below $49.8- $50 Move to OW above $52.5 (to target 60 – 65) or below $29 (to play the rebound). FinLight Research | www.finlightresearch.com
  • 49. 49 Gold – Tech. Perspective The move on Oct. 4th was sudden and severe. Gold fell to the lowest in almost 4 months and breached the key technical level of 200-dma. A material break below the 200dma may mean that the current uptrend is over. FinLight Research | www.finlightresearch.com
  • 50. 50 Gold – Tech. Perspective Applying our positioning rules (please have a look to our Sep. Report), we’ve moved from OW to Neutral on Gold as the spot broke below 1295 (on Oct. 4th) The next level to watch is 1249. A break through will open the door to a test of 1210. Only a move above 1300 would signal a recovery. Our positioning rules are adjusted as follows: Remain Neutral between 1210 and 1300 Go OW above 1300, targeting 1380 and even 1430 Turn UW if the spot breaks below 1210 and go OW again below 1070 FinLight Research | www.finlightresearch.com
  • 51. 51 Copper – Tech. Perspective Within the industrial metals complex, we’ve UW Copper for a while now. From a fundamental point of view, Copper is still one of the most oversupplied markets. But, from a technical perspective, we think the metal will soon find a near-term support around 4620 (the floor of the current triangle pattern) We switch to Neutral with a bullish bias, for now. We’ll move to OW if the spot breaks up (above 4950, target ~5400 where we’ll move massively UW) and to UW again if it breaks down (below 4620) FinLight Research | www.finlightresearch.com
  • 52. 52 ALTERNATIVE STRATEGIES The HFRI Fund Weighted Composite Index posted gains of 0.6% in September (+3.0% QoQ and 4.2% YoY). Gains were led by Equity Hedge (+1.1% MoM) and Relative Value (+0.9% MoM, with RV : Volatility Arbitrage making 1.6% MoM) strategies. Both CTA and Discretionary Macro strategies showed mixed performance in September, with -0.7% on HFRI Systematic Diversified Index and a meager +0.1% on HFRI Macro: Discretionary Thematic Index Global Macro managers have largely benefitted from recent market movements, as they continue to play the growth divergence thesis between the US and the rest of the world. Thus, they posted substantial gains since Oct. 1st, benefitting from their long USD positions, the sharp decline of the GBP/USD and their short duration trades in fixed income. These views have finally proved profitable as markets increasingly price in a Fed rate hike by December. CTAs accentuated their losses in October, as a result of their long fixed income and mixed performance in the commodity bucket, and despite their short positioning in Pound. We believe that diversifying portfolios with an increased allocation to alternatives is particularly attractive at this stage of the cycle, given the current macroeconomic and interest rate uncertainties. Within the hedge fund universe, we continue to prefer strategies with moderate market directionality (“risk diversifiers” type) such as L/S Equity Market Neutral, Global Macro and CTAs. The reason behind that is that we continue to consider traditional asset classes as richly valued. FinLight Research | www.finlightresearch.com
  • 53. 53 ALTERNATIVE STRATEGIES We maintain our OW rating on : Equity Market Neutral, a strategy we think to be well positioned for a spike of volatility by the fall. CTAs: Despite their recent losses, we keep a clear OW stance on CTAs as a diversifier in portfolios and a hedge against future stress. Furthermore, we expect new trends to emerge soon… either from a firmer expansion or more likely from a recession! Global Macro: We like this strategy as a diversifier and tail hedge. We have a slight preference for macro funds with a focus on Forex and Fixed-income… Vol. Arb strategy and prefer funds that trade volatility globally (all assets / all regions). FinLight Research | www.finlightresearch.com
  • 54. 54 Hedge Fund Alpha Generation The hedge fund industry has been producing a negative overall alpha since end-2015 This underperformance has been driven by several factors: crowded trades, uncertainties about growth and rate policy, lower dispersion… FinLight Research | www.finlightresearch.com
  • 55. Bottom Line: Global Asset Allocation Markets are relatively too calm, but appear to be at a crucial point. Equity market is still locked in a tight range, but breakout seems imminent Equity volatility is unlikely to stay this low. We expect it to increase through the US election due to the global uncertainties (Brexit, next US rate hike…) EM has been one of the main beneficiaries from the risk appetite revival following the Brexit vote. Nevertheless, we feel cautious about how resilient EM assets would be in the face of rising US rates. Looking ahead, fundamentals appear to have improved.. That has renewed speculation that the Fed could raise rates as early as December With elevated valuations and crowded long positioning in equities and bonds, the market appears vulnerable to shocks over the near term. Said another way, current market conditions imply small potential returns and big latent risks across almost all asset classes. Thus, we remain defensive in our asset allocation. The moral of the story? Be prepared for anything… We summarize our views as follows 55 FinLight Research | www.finlightresearch.com
  • 56. 56 Disclaimer FinLight Research | www.finlightresearch.com This writing is for informational purposes only and does not constitute an offer to sell, a solicitation to buy, or a recommendation regarding any securities transaction, or as an offer to provide advisory or other services by FinLight Research in any jurisdiction in which such offer, solicitation, purchase or sale would be unlawful under the securities laws of such jurisdiction. The information contained in this writing should not be construed as financial or investment advice on any subject matter. FinLight Research expressly disclaims all liability in respect to actions taken based on any or all of the information on this writing.
  • 57. About Us… FinLight Research is a research-centric company focused on Asset Allocation from a top-down perspective, on Portfolio Construction, and all related quantitative aspects and risk management issues. Our expertise expands along 3 axes: Asset Allocation with risk control and/or risk budgeting techniques Allocation to alternative investments : Hedge funds, rule-based strategies (momentum, value, carry, volatility), real assets (real estate, infrastructure, farmland, timberland and natural resources). Private equity and venture capital should be the next step… Allocation with a factorial approach built on the understanding (profiling) of the risk/return drivers of the different asset classes FinLight Research is an innovation-oriented company. We target to fill the gap between the academic research and the investment community, especially on real assets and alternatives. We survey on a continuous basis the academic literature for interesting published and working papers related to quantitative investing, non-linear profiling, asset allocation, real assets... 57 FinLight Research | www.finlightresearch.com
  • 58. Our Standard Offer Provide tailor- made quantitative analysis of your portfolios in terms of asset allocation, risk profiling and risk contribution Provide tailor- made quantitative analysis of your portfolios in terms of asset allocation, risk profiling and risk contribution •Risk Profiling Offer a turnkey 3- step factor-based process in GAA with factor selection, risk budgeting and dynamic portfolio protection Offer a turnkey 3- step factor-based process in GAA with factor selection, risk budgeting and dynamic portfolio protection •Factor-based GAA Process Provide assistance with alternative investments (including real assets) in terms of profiling, and integration in a GAA Provide assistance with alternative investments (including real assets) in terms of profiling, and integration in a GAA •Alternative Investments Provide assistance with asset allocation and related risk control and/or risk budgeting techniques Provide assistance with asset allocation and related risk control and/or risk budgeting techniques •Global Asset Allocation (GAA) 58 FinLight Research | www.finlightresearch.com