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Market Perspectives
September 2016
Sep. 9th, 2016
www.finlightresearch.com
Inflation is the dog that hasn’t barked yet
“You are once again creating complacency
with your words. You are creating one of the
greatest misallocations of capital in history as
performance chasing investors plow into
passive market-cap weighted indices because
of your policies which have destroyed the
normal functioning of markets through volatility
suppression. The more you talk, the more you
create one class of investors who take extra
risk, and another which sees the market’s
response to your words and then themselves
decide to not even participate.”
– Michael A. Gayed (Pension Partners),
talking to the Fed
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FinLight Research | www.finlightresearch.com
Executive Summary: Global Asset Allocation
Markets remain in “Goldilocks” situation. Data are bad enough to lower
the chance of an imminent Fed rate hike, but not ugly enough to suggest a
recession is imminent.
The summer was so quiet. September is expected to be more stressful as
there is quite a lot of uncertainties about growth and Central Banks
meetings.
The growing divergence between earnings and market prices is dangerous
More signs seem to reflect secular stagnation: implied long-term
dividend growth, payout rates for US equities, 5y-5y forward rates, 10y real
rates, lack of growth in productivity…
A key concern at this stage remains the lack of diversification as most
safe assets appear too stretched
Central banks continue their irrational game, with the hope to levitate
financial asset prices long enough to allow fundamentals to catch up. The
inevitable result in our opinion is that inflation will take off, and do so
with a vengeance.
We make minor adjustments to our asset allocation this month, except on
stocks where we’ve moved from OW to Neutral..
We summarize our views as follows
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FinLight Research | www.finlightresearch.com
MACRO VIEW
The Good
Durable goods new orders rebounded 4.4% reversing the recent weakness, but still moving
sideways
Sentiment remains bullish
New home sales increased 12.4% MoM,. But US Housing news was globally mixed,with existing
home sales at -3.2% MoM
The Bad
Everything from monthly job creation to wages, hours worked and ISM non-manufacturing has
missed targets.
The pace of growth has been slowing from a peak of 5% in Q3-2014. US GDP rose only 1.1% in
Q2 according to the revised calculations, with very strong consumer spending still (+4.4%), but
very weak investment (-9.7%). Weak productivity is the “usual suspect”.
We feel cautious about commercial real estate where prices have soared 95% from their lows.
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.
There is a real risk of China joining in with the currency wars, in the context of collapsing
growth and deteriorating world trade.
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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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 better since June.
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Durable Goods New Orders ☺
Durable goods new orders rebounded 4.4% reversing the recent weakness.
Excluding transportation, new orders increased 1.5%.
Excluding defense, new orders increased 3.8%.
But, the data series has been rangy since 2013
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Macro is not Rosy yet…
US potential GDP continues its slide Inflation is persistently defying all Fed
Projections…
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FinLight Research | www.finlightresearch.com
Blame the Slowdown in Productivity!
Productivity growth has been plunging in all
DM economies over the past decade.
Productivity slowdown is clearly weighing on
GDP.
Two possible explanations for that:
Fischer’s theory that weak productivity
growth is the fault of a lack of
innovation, an issue that monetary
policy is not well equipped to address
Mismeasurement of effective
productivity due to the increased
difficulty to assess value in the
information and communications
technology (mainly software, digital
products, and specialized technology
equipment) sector.
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FinLight Research | www.finlightresearch.com
Cautious on Commercial Real Estate
We keep a cautious eye on US
Commercial real estate. Prices
have soared an impressive 95%
from their lows, well above the
previous real estate bubble.
But the tide seems to be turning,
as more banks (31.4% in Q3, vs
24.6% in Q2) are tightening
standards on Commercial Real
Estate loans.
Percentage of banks tightening standards on CRE loans
10
US Rates: Signs of Secular Stagnation?
5y-5yr forward rates are well below 2008
levels in main DM markets
This is consistent with “secular
stagnation” theories.
FinLight Research | www.finlightresearch.com
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FinLight Research | www.finlightresearch.com
Chinese Economy
Chinese economic
growth has disappointed
over the last years.
But the picture appears
substantially worse
when the GDP is seen
in US dollar terms.
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FinLight Research | www.finlightresearch.com
GS – Global Leading Indicator (GLI)
The August Final GLI came in
at 2.5%yoy. Its MoM
momentum came at 0.27%
(down from its last month’s
0.28%)
GLI is back in “Slowdown”
territories
Only three 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
13
FinLight Research | www.finlightresearch.com
EQUITY
Our equity outlook remains cautious. We see the market more vulnerable than ever to growth and
policy disappointments.
Despite the fact that we’re running into 6 straight quarters of earnings contraction, the S&P500 made new
all-time highs. Its trend remains up on the daily, weekly and monthly time frames.
Globally, stocks are trading at historical high valuations in terms of earnings and sales
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.
Tactically, we moved from OW (a position we’ve kept since Mar. ‘16) to Neutral on stocks, as the
S&P500 broke below 2055, last Friday (Sep 9).
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 2080 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 moved from OW to Neutral as the index broke below 2155 on Friday Sep 9.
To switch to OW again, we need a break higher than 2185 – 2200
We will switch to UW as soon as the 2000 – 2010 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 remain OW defensive vs. cyclical and value stocks vs growth stocks. We turn Neutral on high
dividend stocks.
We remain UW EMs vs DMs despite the recent EM outperformance and robust flows going into
EM Equities (since the start of July).
An “on hold” Fed and a range bounded US dollar is positive for EM sentiment
But, we see risks to the downside. We expect another (last) leg of USD strengthening.
Negative spillovers from China will also likely have a strong impact on other EMs.
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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 -2.0% YoY (+1.2% 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 -0.2%
for earnings and +2.1% for revenues.
For Q3-2016, 78 companies have
issued negative EPS guidance and 35
companies have issued positive EPS
guidance
The forward 12-month P/E ratio is now
17.0, which is well above the 5-year
(14.8) 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
Our feeling is that reported
earnings should be interpreted
with more and more cautious
The gap between operating
earnings and GAAP
(standard accounting rules)
earnings is getting wider
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FinLight Research | www.finlightresearch.com
US Revenues
The good news is that growth of S&P 500 revenues has turned positive in Q2-2016. A modest, but
encouraging move.
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FinLight Research | www.finlightresearch.com
European Earnings
EPS estimates for European
stocks have been falling each
year since 2012.
Thus, equity performance
was mainly driven by
increasing multiples.
Source: IBES
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FinLight Research | www.finlightresearch.com
European Earnings
Indeed, equity valuations for European stocks
are near their historical highs.
Furthermore, European equities don’t look
fundamentally cheaper than US equities,
when financials are excluded .
We keep our UW bias on European stocks vs US
stocks.
12-month Fwd P/E Ratio
Source: Goldman Sachs
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FinLight Research | www.finlightresearch.com
Earnings Sentiment
Global earnings sentiment has been improving, recently.
The move on CY16 global earnings has been the most optimistic in recent years
Source: IBES, Goldman Sachs
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Payout Ratios
Payout ratios are back to their
historical highs
This seems consistent with low
growth expectations
This is probably another sign
of secular stagnation
Percentage of European companies with dividend
yields exceeding corporate bond yields
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FinLight Research | www.finlightresearch.com
Dividend Growth
Long-term dividend growth (as
implied by dividend swaps) is still
heading south.
Currently, it stands at its 2008
lows.
Dividend growth slide has closely
followed the (mis-)evaluation of
10yr USTs.
This is one of the signs we see
for secular stagnation
The picture is worse for European
stocks Another reason to remain
UW Europe vs US.
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FinLight Research | www.finlightresearch.com
High DY Stocks
High dividend yield stocks
outperformed in line with
government yield shrinkage
High DY stocks have clearly
benefited from yield scarcity
We have been OW High DY
stocks for a while, now.
We choose to switch to
neutral on High DY stocks
given the poor dividend growth
perspectives.
Source: Goldman Sachs
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FinLight Research | www.finlightresearch.com
S&P500 – BBM Squeeze
The S&P 500's daily Bollinger Band Width
(BBW) has never been lower since1982.
This is probably a sign that a big move is
imminent in stocks
Such a “squeeze” in BBW is usually
followed by a band break and the start
of a new move in one direction or the
other.
S&P500 Bollinger BandWidth
Source: Bloomberg
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FinLight Research | www.finlightresearch.com
S&P500 – Market Breadth
Market breadth has deteriorated a lot during the summer: 50-dma breadth (% of SPX companies
trading above their 50 day moving average) fall to its lowest level since the Brexit surprise in end of Jun’
16.
There are zero stocks above their 50-DMAs in both the Utilities and Telecom sectors, the best
performers YTD
Furthermore, the breadth chart shows a bearish divergence configuration which may be interpreted as
another warning signal.
Source: Bloomberg data
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FinLight Research | www.finlightresearch.com
S&P500 - Market Sentiment
Current levels of implied volatility and correlation (on stocks in US and Europe) also seem to indicate that
we’re close to a substantial move on stocks.
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FinLight Research | www.finlightresearch.com
US Equities – Market Positioning
Commodity Futures Trading Commission's COT report shows that hedge funds hold an extremely
long position in Dow futures
Source: CFTC Commitments of Traders
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FinLight Research | www.finlightresearch.com
US Equities – Market Positioning
Hedge funds are massively net short VIX futures.
This is a bearish signal as crowded short positioning usually lead to an explosive move in the
opposite direction.
Source: CFTC Commitments of Traders
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FinLight Research | www.finlightresearch.com
S&P500 – A Long-Term Perspective
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&P 500 – A Medium-Term Perspective
Our target of 2170 on the
S&P500 was reached and
exceeded.
In our previous report, we
said: “We remain OW as
long as the 2155 level is
preserved. “
Given Friday’s move
(close at 2127), we
decided to turn Neutral,
according to our
positioning rules.
We will switch to UW as
soon as the 2000 – 2010
range is materially broken
to the downside.
To switch to OW again,
we need a break higher
than 2185 – 2200.
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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!
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FIXED INCOME & CREDIT
GOVIES & INFLATION-LINKED
Over the last weeks, the Fed has been signaling its willingness to move ahead with a second rate hike.
A rate hike by year end now seems in the bag. Recent comments from Fed officials have also
opened the door for a rate hike as soon as in September 21st
As a consequence, the US rate curve flattened with its front end underperforming and long end
remaining stable.
After this quiet summer, rate volatility seems far too low. Thus, any sign of reluctance by Central
Bank to ease further would result in a substantial correction in global rates .
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.
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 10y-TIPS and HICP Inflation as we expect breakevens to trade sideways from
here
FinLight Research | www.finlightresearch.com
34
FIXED INCOME & CREDIT
CORPORATE CREDIT
A quiet summer and a depressed volatility have been supportive for the credit markets.
Corporate credit spreads inched tighter on both sides of the Atlantic with HY outperforming IG.
Euro HY continued to tighten with investors exodus out of CSPP-eligible bonds (with tighter spreads)
and moving down the rating spectrum.
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 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.
We keep 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.
We remain, however, concerned about the outlook for the US HY market, where default rates
continue to move up and balance sheets are deteriorating. Renewed weakness in oil prices will bring
this issue under the spotlights again
We expect the focus on liquidity to remain. As said in previous reports, we feel concerned about the
credit market liquidity as the rate of turnover in corporate bonds has steadily declined since 2009,
despite the huge inflows
FinLight Research | www.finlightresearch.com
35
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 : We change nothing to our views : OW Govies, UW US vs Eurozone Govies, remain
long flatteners on the US yield curve and short duration in 2y USTs, UW credit mainly through HY and
Neutral on IG (duration hedged), UW Eurozone vs US in IG & HY credit, Neutral 10y-TIPS and Neutral
HICP Inflation, UW High Yield vs High Grade, Neutral on EM sovereigns with a little preference for local
bonds
FinLight Research | www.finlightresearch.com
36
US Rates – TED Spread at Crisis Levels
The Libor rate continues to rise when most interest rates are falling. The 3-month rate hit a 7-year high,
at the end of August, driving TED spread to crisis levels.
Many analysts express the view that this atypical move is caused by the new money market mutual
fund reform that prompts institutional investors to shift a large amount of their holdings out of prime and
municipal funds and into government funds
This new 2a7 regulation was adopted in October 2014 with a two-year transition period., meaning it
will become effective next month.
FinLight Research | www.finlightresearch.com
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US Rates – Towards a Systemic Deficiency?
Among the expected changes
due to this new regulation is an
exodus out of eurodollar
deposits, Repo agreements, and
commercial papers into
government portfolios (T-bills
and agencies short papers)
A way to verify this dominant
hypothesis is to look at the
outstanding amount of CPs.
CPs outstanding notional has
been declining over the last
months, but the move seems
similar to those experienced
since mid-2013. At this stage, it
doesn’t appear significant
enough to validate the “MMF
reform theory”.
FinLight Research | www.finlightresearch.com
38
US Rates – A Dollar Funding Crunch?
Since end of 2015, the move on 3-month US Libor has come with a similar widening in OIS rates
and Libor-OIS spreads
As a consequence, the short-term funding gap relative to Japan has increased in a substantial way.
FinLight Research | www.finlightresearch.com
39
US Rates – Higher Hedging Costs
This “rarefication” of short-
term dollar funding has
became visible through
USD-JPY basis swaps.
From a Japanese investor’s
point of view, the widening
of USD-JPY basis swaps
has pushed the cost of
dollar hedging to a level
(around an additional 100bp
over the past year) that
simply eliminates any
yield pick-up for him.
FinLight Research | www.finlightresearch.com
40
US Govies – No longer attractive for Foreign Investors
The yield pick-up that a foreign investor can
obtain by buying 10y UST (instead of his
local-currency sovereign bonds) and
hedging the FX risk has literally vanished.
As an example, JPY-hedged 10y US
Treasury yields plunged around 200bps over
the last year, moving into negative
territories.
The perpetual search for (positive) yield
would probably drive foreign investors out of
10y USTs, into longer maturities, agencies,
and down the rating spectrum (MBS, EM
sovereigns, DM corporates)
FinLight Research | www.finlightresearch.com
41
US Real Rates
Long-term real interest rates
have trended south since the
end of 2015, but seem to be
stabilizing over the last few
months.
Central Banks have failed to
ignite inflation via QE. Fiscal
stimulus is probably their net try.
We start to see signs of a
reversal in LT US real interest
rates
FinLight Research | www.finlightresearch.com
Source: Bloomberg data
42
US Govies – 10y UST
Technically speaking, the risk
of an impulsive decline has
diminished on the 10y UST
yield
In June, we moved to OW as
the 10y yield broke below
1.65.
Since July, yields have been
evolving within a tight triangle
consolidation pattern
Our positioning rules are
adjusted:
We’ll turn Neutral again
above 1.65 and we’ll
remain so as long as the
1.80 level is preserved.
We’ll move also Neutral
around 1.25-1.28
Above 1.80, we’ll move to
UW.
FinLight Research | www.finlightresearch.com
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EUR Govies – 10y Bund
The bund seem to have
found a support at -0.13%
for the moment.
We remain OW but will
consider bearish
exposure if the 10y-yield
move through -0.02%.
Target ~0.11%
FinLight Research | www.finlightresearch.com
44
US Credit – HY vs IG
US HY has been outperforming IG since
March.
We keep however our bias towards IG
for a better risk-return tradeoff.
We believe investors are too
complacent with credit risk.
Investors are uncomfortable with current
valuations, but still stick to their ‘buy-the-
dip' mentality’: They have cash to put to
work, and are just looking for better entry
levels.
Major risks, at this stage, are:
A resurgence of idiosyncratic risk.
A rate shock induced by Central
Banks reluctance to ease more.
FinLight Research | www.finlightresearch.com
45
US Credit – Rating Drift Rate
Upgrade-to-downgrade ratio is
another indicator showing that
we are in the late stage of the
credit cycle.
FinLight Research | www.finlightresearch.com
46
EXCHANGE RATES
Central banks remain the key driver of foreign exchange, We remain structural Dollar bulls
The dollar is now likely to bounce as the Fed ramps up its hawkish rhetoric.
The technical picture for the 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 1.16 resistance to target 1.18
Our positioning rules remain unchanged:
Move to Neutral within the 1.14 - 1.165 range
Move to OW if the spot breaks above the 1.165 resistance to target 1.18
Remain UW below 1.14. Target = 1.08 and then 1.04 to parity over 2H
Over the medium-term (2H-2016), we expect the pre-2015 downtrend to resume, eventually.
we maintain our downside projections towards 1.07-1.04-parity. For that, we need a clean break
through the 1.0910-1.0981 area, then through 1.06 support.
We remain Neutral on the USD-JPY.
But we see the risk of continued losses in USD-JPY ahead of the next BoJ meeting end of Sep. ’16
Our positioning rules on USD-JPY are adjusted:
Remain Neutral below 105.5
Move to OW above 105.5
Only a break below of 99.50 and bearish momentum, would make us move to UW
FinLight Research | www.finlightresearch.com
47
EXCHANGE RATES
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
48
EUR-USD
3 months ago, we moved to UW
on the EUR-USD after the clean
break below 1.13.
The technical picture 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 1.16 resistance
to target 1.18
Over the medium-term (2H-
2016), we maintain our downside
projections towards 1.07-1.04-
parity. For that, we need a clean
break through the 1.0910-
1.0981 area, then through 1.06
support.
FinLight Research | www.finlightresearch.com
49
USD-JPY
The important area to watch stands
around the trendline formed across
the highs since January ~103.94
For now, we remain Neutral.
We adjust however our positioning
rules on USD-JPY as follows:
Remain Neutral below 105.5
(Jan. trendline)
Move to OW above 105.5
Only a break below of 99.50
and bearish momentum, would
make us move to UW
FinLight Research | www.finlightresearch.com
50
COMMODITY
The summer sell-off hasn’t occurred in commos.
Nevertheless, and as expected, commodity prices moved lower in response to the Fed's most recent
hawkish rhetoric.
We continue to view upward moves 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
51
COMMODITY
Bottom Line :
Energy:
Hopes of a producer deal have supported markets, but now are fading. OPEC freeze appears more
like a bluff. Prospects of a deal in Algiers become less and less plausible.
Ample supply and growing inventories remain the major problem plaguing the oil market. US shale
production continues to weigh on price.
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.
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.
We keep our UW bias as long as the spot remains below $50/barrel
Our tactical rules are unchanged:
Remain UW below $50 to target $37
Move to Neutral above $50
Move to OW above the channel (drawn from Jan. ‘16) ceil or below $29.
FinLight Research | www.finlightresearch.com
52
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.
Price weakness is expected to show up again in the gold market, as investors reassess the probability
and timing of the Fed’s next rate hike. September rate hike is, now, a real possibility (not yet priced by
the market) and so gold could come under pressure again soon.
We see more signs pointing towards a reversal in long-term US real interest rates. Such a move will
threaten Gold’s bullishness.
According to our positioning rules, we remain OW on Gold as it stays above 1295.
We feel, however, cautious about the sustainability of the recent rally as long positioning becomes
very crowded: According to the latest CFTC‘s COT report. Gold futures' net speculative positions
remains close to multi-year highs.
At this stage, 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?).
Our positioning rules are adjusted as follows:
Remain OW above 1295, targeting 1367 and even 1428
Go Neutral again between 1260 and 1295
Turn UW if the spot breaks below 1260 and go OW again below 1070
FinLight Research | www.finlightresearch.com
53
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 over the summer. 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
In base metals, we see limited further upside potential for copper, as it appears to be one of the most
oversupplied markets.
Agriculture:
The S&P GSCI Agri TR Index posted another loss in Aug. Excess supply worldwide continues to weigh
on prices.
For grains, a bullish shift in sentiment from here, would require a significantly larger-than-expected cut to
US yields. We notice that hedge funds have returned to cutting bullish positioning on agricultural
commodities.
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
54
Gold – Tech. Perspective
We remain OW Gold.
Our positioning rules are
adjusted as follows:
Remain OW above 1295,
targeting 1367 and even
1428
Go Neutral again between
1260 and 1295
Turn UW if the spot breaks
below 1260 and go OW
again below 1070
FinLight Research | www.finlightresearch.com
55
Precious Metals: Gold Stocks vs Physical Gold
Gold miner rally is living
on borrowed time.
Since the beginning of the
current gold bull cycle in
2002, precious metals
stocks have been
underperforming gold.
PM stocks have
outperformed only during 4
short periods of 6 to 12
months.
We are currently in the 4th
period that started in Jan
’16, statistically close to its
end.
Thus we expect gold to
rebound soon relative to
PM stocks.
FinLight Research | www.finlightresearch.com
56
Crude – Tech. Perspective
According to our positioning
rules (please see our previous
reports), we remain UW crude.
We believe that the downside
risk has significantly increased
Our tactical rules are adjusted
as follows:
Remain UW below $50 to
target $37
Move to Neutral above $50
Move to OW above the
channel (drawn from Jan.
‘16) ceil or below $29.
FinLight Research | www.finlightresearch.com
57
ALTERNATIVE STRATEGIES
The HFRI Fund Weighted Composite Index posted gains of 0.4% in August. Gains were led by
Event-Driven (+1.8% MoM) and Equity Hedge (+1.3% MoM) strategies.
CTAs experienced losses of 2.9% over the month, as a result of their long fixed income and short USD
positions, and despite some gains generated from commodities through short exposure on agricultural
Global Macro managers continue to play the growth divergence thesis between the US and the rest of
the world. They posted a gain of +0.4% in August, benefitting from their long USD positions and shorts
in FI.
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
58
ALTERNATIVE STRATEGIES
We maintain our OW rating on :
Equity Market Neutrals both for their “intelligent” beta and their alpha contribution.
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 from
here…
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 (HFRI RV: Volatility Index: +0.4% MoM, +2.5% Ytd) and prefer funds that trade
volatility globally (all assets / all regions).
FinLight Research | www.finlightresearch.com
59
Hedge Fund Liquidity
Using the universe of equity HF on their platform (~1200 managers), Novus calculate the “30-day
Liquidity” metric: the portion of a given portfolio the manager can liquidate over 30
consecutive trading days, assuming that managers can sell 20% or less of the 90-day trailing
average trading volume for each security without adversely affecting price
According to this metric, in 2015, the average manager has been able to liquidate 92% of his equity
holdings over 30 trading days without impacting prices.
The “30-day Liquidity” metric has been stable over the last 6 years.
FinLight Research | www.finlightresearch.com
Source: Novus
60
Hedge Fund Liquidity
However, calculating liquidity using strictly the “30-day Liquidity” metric may be misleading.
This metric is based on each fund’s holdings, and doesn’t capture the concentration /
crowdedness risk due to the increased tendency of HFs (with growing AUMs) to chase the same
ideas. Novus calculate another 30-Day Liquidity indicator based on an aggregated view of all the
portfolios they manage on their platform.
According to this measure, liquidity has receded to record lows. It stands at half its value in 2009!
FinLight Research | www.finlightresearch.com
Source: Novus
61
Hedge Fund Liquidity
Crowdedness appears as a
real risk for HF managers, a
risk for which they receive no
compensation at all.
Actually, liquidity and
alpha have been
decreasing in lock-step
since
2009.
Crowding is eating an ever-
growing portions out of
returns.
FinLight Research | www.finlightresearch.com
Bottom Line: Global Asset Allocation
Markets remain in “Goldilocks” situation. Data are bad enough to lower
the chance of an imminent Fed rate hike, but not ugly enough to suggest a
recession is imminent.
The summer was so quiet. September is expected to be more stressful as
there is quite a lot of uncertainties about growth and Central Banks
meetings.
The growing divergence between earnings and market prices is dangerous
More signs seem to reflect secular stagnation: implied long-term
dividend growth, payout rates for US equities, 5y-5y forward rates, 10y real
rates, lack of growth in productivity…
A key concern at this stage remains the lack of diversification as most
safe assets appear too stretched
Central banks continue their irrational game, with the hope to levitate
financial asset prices long enough to allow fundamentals to catch up. The
inevitable result in our opinion is that inflation will take off, and do so
with a vengeance.
We make minor adjustments to our asset allocation this month, except on
stocks where we’ve moved from OW to Neutral..
We summarize our views as follows
62
FinLight Research | www.finlightresearch.com
63
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...
64
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)
65
FinLight Research | www.finlightresearch.com

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Finlight Research - Market Perspectives - Sep 2016

  • 1. Market Perspectives September 2016 Sep. 9th, 2016 www.finlightresearch.com Inflation is the dog that hasn’t barked yet
  • 2. “You are once again creating complacency with your words. You are creating one of the greatest misallocations of capital in history as performance chasing investors plow into passive market-cap weighted indices because of your policies which have destroyed the normal functioning of markets through volatility suppression. The more you talk, the more you create one class of investors who take extra risk, and another which sees the market’s response to your words and then themselves decide to not even participate.” – Michael A. Gayed (Pension Partners), talking to the Fed 2 FinLight Research | www.finlightresearch.com
  • 3. Executive Summary: Global Asset Allocation Markets remain in “Goldilocks” situation. Data are bad enough to lower the chance of an imminent Fed rate hike, but not ugly enough to suggest a recession is imminent. The summer was so quiet. September is expected to be more stressful as there is quite a lot of uncertainties about growth and Central Banks meetings. The growing divergence between earnings and market prices is dangerous More signs seem to reflect secular stagnation: implied long-term dividend growth, payout rates for US equities, 5y-5y forward rates, 10y real rates, lack of growth in productivity… A key concern at this stage remains the lack of diversification as most safe assets appear too stretched Central banks continue their irrational game, with the hope to levitate financial asset prices long enough to allow fundamentals to catch up. The inevitable result in our opinion is that inflation will take off, and do so with a vengeance. We make minor adjustments to our asset allocation this month, except on stocks where we’ve moved from OW to Neutral.. We summarize our views as follows 3 FinLight Research | www.finlightresearch.com
  • 4. MACRO VIEW The Good Durable goods new orders rebounded 4.4% reversing the recent weakness, but still moving sideways Sentiment remains bullish New home sales increased 12.4% MoM,. But US Housing news was globally mixed,with existing home sales at -3.2% MoM The Bad Everything from monthly job creation to wages, hours worked and ISM non-manufacturing has missed targets. The pace of growth has been slowing from a peak of 5% in Q3-2014. US GDP rose only 1.1% in Q2 according to the revised calculations, with very strong consumer spending still (+4.4%), but very weak investment (-9.7%). Weak productivity is the “usual suspect”. We feel cautious about commercial real estate where prices have soared 95% from their lows. 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. There is a real risk of China joining in with the currency wars, in the context of collapsing growth and deteriorating world trade. 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 better since June.
  • 6. 6 FinLight Research | www.finlightresearch.com Durable Goods New Orders ☺ Durable goods new orders rebounded 4.4% reversing the recent weakness. Excluding transportation, new orders increased 1.5%. Excluding defense, new orders increased 3.8%. But, the data series has been rangy since 2013
  • 7. 7 FinLight Research | www.finlightresearch.com Macro is not Rosy yet… US potential GDP continues its slide Inflation is persistently defying all Fed Projections…
  • 8. 8 FinLight Research | www.finlightresearch.com Blame the Slowdown in Productivity! Productivity growth has been plunging in all DM economies over the past decade. Productivity slowdown is clearly weighing on GDP. Two possible explanations for that: Fischer’s theory that weak productivity growth is the fault of a lack of innovation, an issue that monetary policy is not well equipped to address Mismeasurement of effective productivity due to the increased difficulty to assess value in the information and communications technology (mainly software, digital products, and specialized technology equipment) sector.
  • 9. 9 FinLight Research | www.finlightresearch.com Cautious on Commercial Real Estate We keep a cautious eye on US Commercial real estate. Prices have soared an impressive 95% from their lows, well above the previous real estate bubble. But the tide seems to be turning, as more banks (31.4% in Q3, vs 24.6% in Q2) are tightening standards on Commercial Real Estate loans. Percentage of banks tightening standards on CRE loans
  • 10. 10 US Rates: Signs of Secular Stagnation? 5y-5yr forward rates are well below 2008 levels in main DM markets This is consistent with “secular stagnation” theories. FinLight Research | www.finlightresearch.com
  • 11. 11 FinLight Research | www.finlightresearch.com Chinese Economy Chinese economic growth has disappointed over the last years. But the picture appears substantially worse when the GDP is seen in US dollar terms.
  • 12. 12 FinLight Research | www.finlightresearch.com GS – Global Leading Indicator (GLI) The August Final GLI came in at 2.5%yoy. Its MoM momentum came at 0.27% (down from its last month’s 0.28%) GLI is back in “Slowdown” territories Only three 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
  • 13. 13 FinLight Research | www.finlightresearch.com EQUITY Our equity outlook remains cautious. We see the market more vulnerable than ever to growth and policy disappointments. Despite the fact that we’re running into 6 straight quarters of earnings contraction, the S&P500 made new all-time highs. Its trend remains up on the daily, weekly and monthly time frames. Globally, stocks are trading at historical high valuations in terms of earnings and sales 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. Tactically, we moved from OW (a position we’ve kept since Mar. ‘16) to Neutral on stocks, as the S&P500 broke below 2055, last Friday (Sep 9). 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.
  • 14. 14 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 2080 is needed in order to confirm our primary scenario! Above 2200-2225, we’ll be obliged to recognize the alternative scenario is in.
  • 15. 15 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 moved from OW to Neutral as the index broke below 2155 on Friday Sep 9. To switch to OW again, we need a break higher than 2185 – 2200 We will switch to UW as soon as the 2000 – 2010 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 remain OW defensive vs. cyclical and value stocks vs growth stocks. We turn Neutral on high dividend stocks. We remain UW EMs vs DMs despite the recent EM outperformance and robust flows going into EM Equities (since the start of July). An “on hold” Fed and a range bounded US dollar is positive for EM sentiment But, we see risks to the downside. We expect another (last) leg of USD strengthening. Negative spillovers from China will also likely have a strong impact on other EMs.
  • 16. 16 FinLight Research | www.finlightresearch.com US Earnings The S&P500 stands within an earnings recession. For Q3 2016, the estimated earnings decline is -2.0% YoY (+1.2% 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 -0.2% for earnings and +2.1% for revenues. For Q3-2016, 78 companies have issued negative EPS guidance and 35 companies have issued positive EPS guidance The forward 12-month P/E ratio is now 17.0, which is well above the 5-year (14.8) and 10-year (14.3) averages. Analysts still expect earnings growth to return in Q4 2016
  • 17. 17 FinLight Research | www.finlightresearch.com US Earnings Our feeling is that reported earnings should be interpreted with more and more cautious The gap between operating earnings and GAAP (standard accounting rules) earnings is getting wider
  • 18. 18 FinLight Research | www.finlightresearch.com US Revenues The good news is that growth of S&P 500 revenues has turned positive in Q2-2016. A modest, but encouraging move.
  • 19. 19 FinLight Research | www.finlightresearch.com European Earnings EPS estimates for European stocks have been falling each year since 2012. Thus, equity performance was mainly driven by increasing multiples. Source: IBES
  • 20. 20 FinLight Research | www.finlightresearch.com European Earnings Indeed, equity valuations for European stocks are near their historical highs. Furthermore, European equities don’t look fundamentally cheaper than US equities, when financials are excluded . We keep our UW bias on European stocks vs US stocks. 12-month Fwd P/E Ratio Source: Goldman Sachs
  • 21. 21 FinLight Research | www.finlightresearch.com Earnings Sentiment Global earnings sentiment has been improving, recently. The move on CY16 global earnings has been the most optimistic in recent years Source: IBES, Goldman Sachs
  • 22. 22 FinLight Research | www.finlightresearch.com Payout Ratios Payout ratios are back to their historical highs This seems consistent with low growth expectations This is probably another sign of secular stagnation Percentage of European companies with dividend yields exceeding corporate bond yields
  • 23. 23 FinLight Research | www.finlightresearch.com Dividend Growth Long-term dividend growth (as implied by dividend swaps) is still heading south. Currently, it stands at its 2008 lows. Dividend growth slide has closely followed the (mis-)evaluation of 10yr USTs. This is one of the signs we see for secular stagnation The picture is worse for European stocks Another reason to remain UW Europe vs US.
  • 24. 24 FinLight Research | www.finlightresearch.com High DY Stocks High dividend yield stocks outperformed in line with government yield shrinkage High DY stocks have clearly benefited from yield scarcity We have been OW High DY stocks for a while, now. We choose to switch to neutral on High DY stocks given the poor dividend growth perspectives. Source: Goldman Sachs
  • 25. 25 FinLight Research | www.finlightresearch.com S&P500 – BBM Squeeze The S&P 500's daily Bollinger Band Width (BBW) has never been lower since1982. This is probably a sign that a big move is imminent in stocks Such a “squeeze” in BBW is usually followed by a band break and the start of a new move in one direction or the other. S&P500 Bollinger BandWidth Source: Bloomberg
  • 26. 26 FinLight Research | www.finlightresearch.com S&P500 – Market Breadth Market breadth has deteriorated a lot during the summer: 50-dma breadth (% of SPX companies trading above their 50 day moving average) fall to its lowest level since the Brexit surprise in end of Jun’ 16. There are zero stocks above their 50-DMAs in both the Utilities and Telecom sectors, the best performers YTD Furthermore, the breadth chart shows a bearish divergence configuration which may be interpreted as another warning signal. Source: Bloomberg data
  • 27. 27 FinLight Research | www.finlightresearch.com S&P500 - Market Sentiment Current levels of implied volatility and correlation (on stocks in US and Europe) also seem to indicate that we’re close to a substantial move on stocks.
  • 28. 28 FinLight Research | www.finlightresearch.com US Equities – Market Positioning Commodity Futures Trading Commission's COT report shows that hedge funds hold an extremely long position in Dow futures Source: CFTC Commitments of Traders
  • 29. 29 FinLight Research | www.finlightresearch.com US Equities – Market Positioning Hedge funds are massively net short VIX futures. This is a bearish signal as crowded short positioning usually lead to an explosive move in the opposite direction. Source: CFTC Commitments of Traders
  • 30. 30 FinLight Research | www.finlightresearch.com S&P500 – A Long-Term Perspective 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
  • 31. 31 FinLight Research | www.finlightresearch.com S&P 500 – A Medium-Term Perspective Our target of 2170 on the S&P500 was reached and exceeded. In our previous report, we said: “We remain OW as long as the 2155 level is preserved. “ Given Friday’s move (close at 2127), we decided to turn Neutral, according to our positioning rules. We will switch to UW as soon as the 2000 – 2010 range is materially broken to the downside. To switch to OW again, we need a break higher than 2185 – 2200.
  • 32. 32 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!
  • 33. 33 FIXED INCOME & CREDIT GOVIES & INFLATION-LINKED Over the last weeks, the Fed has been signaling its willingness to move ahead with a second rate hike. A rate hike by year end now seems in the bag. Recent comments from Fed officials have also opened the door for a rate hike as soon as in September 21st As a consequence, the US rate curve flattened with its front end underperforming and long end remaining stable. After this quiet summer, rate volatility seems far too low. Thus, any sign of reluctance by Central Bank to ease further would result in a substantial correction in global rates . 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. 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 10y-TIPS and HICP Inflation as we expect breakevens to trade sideways from here FinLight Research | www.finlightresearch.com
  • 34. 34 FIXED INCOME & CREDIT CORPORATE CREDIT A quiet summer and a depressed volatility have been supportive for the credit markets. Corporate credit spreads inched tighter on both sides of the Atlantic with HY outperforming IG. Euro HY continued to tighten with investors exodus out of CSPP-eligible bonds (with tighter spreads) and moving down the rating spectrum. 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 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. We keep 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. We remain, however, concerned about the outlook for the US HY market, where default rates continue to move up and balance sheets are deteriorating. Renewed weakness in oil prices will bring this issue under the spotlights again We expect the focus on liquidity to remain. As said in previous reports, we feel concerned about the credit market liquidity as the rate of turnover in corporate bonds has steadily declined since 2009, despite the huge inflows FinLight Research | www.finlightresearch.com
  • 35. 35 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 : We change nothing to our views : OW Govies, UW US vs Eurozone Govies, remain long flatteners on the US yield curve and short duration in 2y USTs, UW credit mainly through HY and Neutral on IG (duration hedged), UW Eurozone vs US in IG & HY credit, Neutral 10y-TIPS and Neutral HICP Inflation, UW High Yield vs High Grade, Neutral on EM sovereigns with a little preference for local bonds FinLight Research | www.finlightresearch.com
  • 36. 36 US Rates – TED Spread at Crisis Levels The Libor rate continues to rise when most interest rates are falling. The 3-month rate hit a 7-year high, at the end of August, driving TED spread to crisis levels. Many analysts express the view that this atypical move is caused by the new money market mutual fund reform that prompts institutional investors to shift a large amount of their holdings out of prime and municipal funds and into government funds This new 2a7 regulation was adopted in October 2014 with a two-year transition period., meaning it will become effective next month. FinLight Research | www.finlightresearch.com
  • 37. 37 US Rates – Towards a Systemic Deficiency? Among the expected changes due to this new regulation is an exodus out of eurodollar deposits, Repo agreements, and commercial papers into government portfolios (T-bills and agencies short papers) A way to verify this dominant hypothesis is to look at the outstanding amount of CPs. CPs outstanding notional has been declining over the last months, but the move seems similar to those experienced since mid-2013. At this stage, it doesn’t appear significant enough to validate the “MMF reform theory”. FinLight Research | www.finlightresearch.com
  • 38. 38 US Rates – A Dollar Funding Crunch? Since end of 2015, the move on 3-month US Libor has come with a similar widening in OIS rates and Libor-OIS spreads As a consequence, the short-term funding gap relative to Japan has increased in a substantial way. FinLight Research | www.finlightresearch.com
  • 39. 39 US Rates – Higher Hedging Costs This “rarefication” of short- term dollar funding has became visible through USD-JPY basis swaps. From a Japanese investor’s point of view, the widening of USD-JPY basis swaps has pushed the cost of dollar hedging to a level (around an additional 100bp over the past year) that simply eliminates any yield pick-up for him. FinLight Research | www.finlightresearch.com
  • 40. 40 US Govies – No longer attractive for Foreign Investors The yield pick-up that a foreign investor can obtain by buying 10y UST (instead of his local-currency sovereign bonds) and hedging the FX risk has literally vanished. As an example, JPY-hedged 10y US Treasury yields plunged around 200bps over the last year, moving into negative territories. The perpetual search for (positive) yield would probably drive foreign investors out of 10y USTs, into longer maturities, agencies, and down the rating spectrum (MBS, EM sovereigns, DM corporates) FinLight Research | www.finlightresearch.com
  • 41. 41 US Real Rates Long-term real interest rates have trended south since the end of 2015, but seem to be stabilizing over the last few months. Central Banks have failed to ignite inflation via QE. Fiscal stimulus is probably their net try. We start to see signs of a reversal in LT US real interest rates FinLight Research | www.finlightresearch.com Source: Bloomberg data
  • 42. 42 US Govies – 10y UST Technically speaking, the risk of an impulsive decline has diminished on the 10y UST yield In June, we moved to OW as the 10y yield broke below 1.65. Since July, yields have been evolving within a tight triangle consolidation pattern Our positioning rules are adjusted: We’ll turn Neutral again above 1.65 and we’ll remain so as long as the 1.80 level is preserved. We’ll move also Neutral around 1.25-1.28 Above 1.80, we’ll move to UW. FinLight Research | www.finlightresearch.com
  • 43. 43 EUR Govies – 10y Bund The bund seem to have found a support at -0.13% for the moment. We remain OW but will consider bearish exposure if the 10y-yield move through -0.02%. Target ~0.11% FinLight Research | www.finlightresearch.com
  • 44. 44 US Credit – HY vs IG US HY has been outperforming IG since March. We keep however our bias towards IG for a better risk-return tradeoff. We believe investors are too complacent with credit risk. Investors are uncomfortable with current valuations, but still stick to their ‘buy-the- dip' mentality’: They have cash to put to work, and are just looking for better entry levels. Major risks, at this stage, are: A resurgence of idiosyncratic risk. A rate shock induced by Central Banks reluctance to ease more. FinLight Research | www.finlightresearch.com
  • 45. 45 US Credit – Rating Drift Rate Upgrade-to-downgrade ratio is another indicator showing that we are in the late stage of the credit cycle. FinLight Research | www.finlightresearch.com
  • 46. 46 EXCHANGE RATES Central banks remain the key driver of foreign exchange, We remain structural Dollar bulls The dollar is now likely to bounce as the Fed ramps up its hawkish rhetoric. The technical picture for the 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 1.16 resistance to target 1.18 Our positioning rules remain unchanged: Move to Neutral within the 1.14 - 1.165 range Move to OW if the spot breaks above the 1.165 resistance to target 1.18 Remain UW below 1.14. Target = 1.08 and then 1.04 to parity over 2H Over the medium-term (2H-2016), we expect the pre-2015 downtrend to resume, eventually. we maintain our downside projections towards 1.07-1.04-parity. For that, we need a clean break through the 1.0910-1.0981 area, then through 1.06 support. We remain Neutral on the USD-JPY. But we see the risk of continued losses in USD-JPY ahead of the next BoJ meeting end of Sep. ’16 Our positioning rules on USD-JPY are adjusted: Remain Neutral below 105.5 Move to OW above 105.5 Only a break below of 99.50 and bearish momentum, would make us move to UW FinLight Research | www.finlightresearch.com
  • 47. 47 EXCHANGE RATES 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
  • 48. 48 EUR-USD 3 months ago, we moved to UW on the EUR-USD after the clean break below 1.13. The technical picture 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 1.16 resistance to target 1.18 Over the medium-term (2H- 2016), we maintain our downside projections towards 1.07-1.04- parity. For that, we need a clean break through the 1.0910- 1.0981 area, then through 1.06 support. FinLight Research | www.finlightresearch.com
  • 49. 49 USD-JPY The important area to watch stands around the trendline formed across the highs since January ~103.94 For now, we remain Neutral. We adjust however our positioning rules on USD-JPY as follows: Remain Neutral below 105.5 (Jan. trendline) Move to OW above 105.5 Only a break below of 99.50 and bearish momentum, would make us move to UW FinLight Research | www.finlightresearch.com
  • 50. 50 COMMODITY The summer sell-off hasn’t occurred in commos. Nevertheless, and as expected, commodity prices moved lower in response to the Fed's most recent hawkish rhetoric. We continue to view upward moves 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
  • 51. 51 COMMODITY Bottom Line : Energy: Hopes of a producer deal have supported markets, but now are fading. OPEC freeze appears more like a bluff. Prospects of a deal in Algiers become less and less plausible. Ample supply and growing inventories remain the major problem plaguing the oil market. US shale production continues to weigh on price. 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. 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. We keep our UW bias as long as the spot remains below $50/barrel Our tactical rules are unchanged: Remain UW below $50 to target $37 Move to Neutral above $50 Move to OW above the channel (drawn from Jan. ‘16) ceil or below $29. FinLight Research | www.finlightresearch.com
  • 52. 52 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. Price weakness is expected to show up again in the gold market, as investors reassess the probability and timing of the Fed’s next rate hike. September rate hike is, now, a real possibility (not yet priced by the market) and so gold could come under pressure again soon. We see more signs pointing towards a reversal in long-term US real interest rates. Such a move will threaten Gold’s bullishness. According to our positioning rules, we remain OW on Gold as it stays above 1295. We feel, however, cautious about the sustainability of the recent rally as long positioning becomes very crowded: According to the latest CFTC‘s COT report. Gold futures' net speculative positions remains close to multi-year highs. At this stage, 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?). Our positioning rules are adjusted as follows: Remain OW above 1295, targeting 1367 and even 1428 Go Neutral again between 1260 and 1295 Turn UW if the spot breaks below 1260 and go OW again below 1070 FinLight Research | www.finlightresearch.com
  • 53. 53 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 over the summer. 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 In base metals, we see limited further upside potential for copper, as it appears to be one of the most oversupplied markets. Agriculture: The S&P GSCI Agri TR Index posted another loss in Aug. Excess supply worldwide continues to weigh on prices. For grains, a bullish shift in sentiment from here, would require a significantly larger-than-expected cut to US yields. We notice that hedge funds have returned to cutting bullish positioning on agricultural commodities. 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
  • 54. 54 Gold – Tech. Perspective We remain OW Gold. Our positioning rules are adjusted as follows: Remain OW above 1295, targeting 1367 and even 1428 Go Neutral again between 1260 and 1295 Turn UW if the spot breaks below 1260 and go OW again below 1070 FinLight Research | www.finlightresearch.com
  • 55. 55 Precious Metals: Gold Stocks vs Physical Gold Gold miner rally is living on borrowed time. Since the beginning of the current gold bull cycle in 2002, precious metals stocks have been underperforming gold. PM stocks have outperformed only during 4 short periods of 6 to 12 months. We are currently in the 4th period that started in Jan ’16, statistically close to its end. Thus we expect gold to rebound soon relative to PM stocks. FinLight Research | www.finlightresearch.com
  • 56. 56 Crude – Tech. Perspective According to our positioning rules (please see our previous reports), we remain UW crude. We believe that the downside risk has significantly increased Our tactical rules are adjusted as follows: Remain UW below $50 to target $37 Move to Neutral above $50 Move to OW above the channel (drawn from Jan. ‘16) ceil or below $29. FinLight Research | www.finlightresearch.com
  • 57. 57 ALTERNATIVE STRATEGIES The HFRI Fund Weighted Composite Index posted gains of 0.4% in August. Gains were led by Event-Driven (+1.8% MoM) and Equity Hedge (+1.3% MoM) strategies. CTAs experienced losses of 2.9% over the month, as a result of their long fixed income and short USD positions, and despite some gains generated from commodities through short exposure on agricultural Global Macro managers continue to play the growth divergence thesis between the US and the rest of the world. They posted a gain of +0.4% in August, benefitting from their long USD positions and shorts in FI. 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
  • 58. 58 ALTERNATIVE STRATEGIES We maintain our OW rating on : Equity Market Neutrals both for their “intelligent” beta and their alpha contribution. 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 from here… 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 (HFRI RV: Volatility Index: +0.4% MoM, +2.5% Ytd) and prefer funds that trade volatility globally (all assets / all regions). FinLight Research | www.finlightresearch.com
  • 59. 59 Hedge Fund Liquidity Using the universe of equity HF on their platform (~1200 managers), Novus calculate the “30-day Liquidity” metric: the portion of a given portfolio the manager can liquidate over 30 consecutive trading days, assuming that managers can sell 20% or less of the 90-day trailing average trading volume for each security without adversely affecting price According to this metric, in 2015, the average manager has been able to liquidate 92% of his equity holdings over 30 trading days without impacting prices. The “30-day Liquidity” metric has been stable over the last 6 years. FinLight Research | www.finlightresearch.com Source: Novus
  • 60. 60 Hedge Fund Liquidity However, calculating liquidity using strictly the “30-day Liquidity” metric may be misleading. This metric is based on each fund’s holdings, and doesn’t capture the concentration / crowdedness risk due to the increased tendency of HFs (with growing AUMs) to chase the same ideas. Novus calculate another 30-Day Liquidity indicator based on an aggregated view of all the portfolios they manage on their platform. According to this measure, liquidity has receded to record lows. It stands at half its value in 2009! FinLight Research | www.finlightresearch.com Source: Novus
  • 61. 61 Hedge Fund Liquidity Crowdedness appears as a real risk for HF managers, a risk for which they receive no compensation at all. Actually, liquidity and alpha have been decreasing in lock-step since 2009. Crowding is eating an ever- growing portions out of returns. FinLight Research | www.finlightresearch.com
  • 62. Bottom Line: Global Asset Allocation Markets remain in “Goldilocks” situation. Data are bad enough to lower the chance of an imminent Fed rate hike, but not ugly enough to suggest a recession is imminent. The summer was so quiet. September is expected to be more stressful as there is quite a lot of uncertainties about growth and Central Banks meetings. The growing divergence between earnings and market prices is dangerous More signs seem to reflect secular stagnation: implied long-term dividend growth, payout rates for US equities, 5y-5y forward rates, 10y real rates, lack of growth in productivity… A key concern at this stage remains the lack of diversification as most safe assets appear too stretched Central banks continue their irrational game, with the hope to levitate financial asset prices long enough to allow fundamentals to catch up. The inevitable result in our opinion is that inflation will take off, and do so with a vengeance. We make minor adjustments to our asset allocation this month, except on stocks where we’ve moved from OW to Neutral.. We summarize our views as follows 62 FinLight Research | www.finlightresearch.com
  • 63. 63 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.
  • 64. 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... 64 FinLight Research | www.finlightresearch.com
  • 65. 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) 65 FinLight Research | www.finlightresearch.com