At the end of December, we turned neutral on equities on the back of a combination of the following factors: the indefatigable widening of credit spreads in the corporate bond market, the persistent decline in both the ISM Manufacturing index and the number of upward earnings revisions, and the increasing pressure on corporate profit margins. This recommendation proved profitable as global equities largely underperformed bonds so far in 2016 as rising speculation of a possible U.S. recession, a deterioration in global economic prospects and market volatility all weighted on investors’ outlook. On the other hand, we noted in early February that market sentiment had turned extremely bearish with key indicators reaching levels similar to those achieved during past recessions and financial crises. With the economic backdrop more positive today than in 2008-09 for instance and our view that the risk of a U.S. recession is relatively low (see the chart below), we then argued that the worst of the correction may be behind us. Still we maintained our neutral stance on equity vs. fixed income as defensive sectors and strong balance sheet stocks continued to outperform cyclicals and weak balance sheet stocks, respectively, indicating no turning point yet in risk appetite by investors. We also advised clients to wait for year-over-year gains in the U.S. dollar to start to flatten before increasing exposure to equities due to the strong USD’s effect on corporate profits.
The good news is cyclical sectors and weak balance sheet stocks have been outperforming since mid-February, indicating a potential turning point in risk appetite by investors (see the charts below). Another positive indicator is the recent decline in the four-week moving average of initial jobless claims to the 270,000 level in February following an unexpected increase in January, suggesting that U.S. labor market momentum remains solid. In addition to that, the bullish turn in market breadth, as exhibited by the recent rise in the New York Stock Exchange Advance/Decline line, combined with the pick-up in U.S. economic surprise indices, tightening in credit spreads and depressed sentiment make a sustained bounce increasingly likely, in our view.
Another positive indicator is the current flattening in the year-over-year gains of the USD, which signals that headwinds from the strong dollar on both corporate profits and the manufacturing sector should start fading (see the charts below).
However, there are reasons to remain careful. For example, the January 2016 Senior Loan Officer Opinion Survey on Bank Lending Practices gave a negative indication on the short-term outlook for the U.S. economy and earnings growth. The survey showed that a net 8.2% of banks reported tightening standards for commercial and industrial (C&I) loans to large and middle-market firms over the fourth quarter, while a net 4.2% of respondents reported tightening standards for small business lending. A majority of respondents that tightened either standards or terms on C&I loans over the fourth quarter cited a less favorable or more uncertain economic outlook, a worsening of industry-specific problems and reduced tolerance for risk as reasons for the change. Credit conditions historically tend to lead economic activity and earnings growth by six to twelve months (see the charts below).
U.S. consumers' expectations of future conditions also continue to deteriorate, which historically coincided with equity underperformance (see the chart below).
In addition to that, the 6-month change in the Conference Board index of leading economic indicators is on the decline and approaching the key threshold of 0. Recessions typically occur following a fall in this indicator below the 0 level (see the chart below).
The bottom line is that signs of improvement in key economic and financial indicators mentioned above make a sustained rebound in equities increasingly likely, in our view. However, we prefer to maintain our neutral stance on equity vs. fixed income for now as we are of the view that further strength is required in these indicators to reinforce the odds of a reversal. Also, we remain in waiting mode for signs of stabilization or improvement in credit conditions, consumer confidence and leading economic indicators before increasing our equity allocation. We will closely monitor coming developments for an attractive re-entry point for stock investors.
As for our regional equity allocation, our top overweight remains U.S. equities. We remain of the view that the U.S. is a relative bright spot for economic growth versus the rest of the world in the near-term. Low energy prices, an improving labor market and strong household formation boosting housing demand should continue to stimulate the U.S. economy. U.S. stocks are also reasonably valued against global equities with the relative 12-mth forward price-to-earnings ratio for the S&P 500 close to its 10-yr average. In addition to that, S&P 500 earnings estimates relative to the rest of the world remain on the rise, which historically coincided with relative outperformance for U.S. equities (see the charts below).
We continue to recommend that clients underweight Canadian equities as we remain cautious on the short-term outlook for the natural resources sector. The global crude oil market remains well oversupplied and global crude inventories should continue to pile up far into 2016. The pace of global stock builds will even accelerate in the second quarter of 2016. On the other hand, according to the International Energy Agency (IEA), non-OPEC output growth is expected to turn negative in 2016. With world oil demand expected to increase by 1.3% in 2016, the pace of global stock accumulation should significantly weaken in the second half of 2016, which in turn should act as a positive catalyst to energy prices. We will closely monitor the situation over the next few months to see how the global oil balance will evolve and how our investment recommendations need to be adjusted to take it into account. For now, we remain underweight Canadian equities.
We reduced our exposure to Other Developed Markets from Neutral/Overweight to Underweight as the tightening in global financial conditions could lead Eurozone bank lending standards to tighten and negatively impact non-residential investment and economic growth. There are already some worrying signs with German businesses turning more pessimistic regarding future business developments. Indeed, the IFO Expectations index declined in February to its lowest level since December 2012 (see the chart below). This indicator historically tends to lead turning points in economic growth.
The current increase in the year-over-year percent change in the EUR/USD also represents a headwind to Euro area exports and the relative performance of European equities. As illustrated below, a rise in the year-over-year change in the euro FX rate historically coincided with underperformance in European equities.
We also continue to recommend an overweight exposure to Emerging Markets as upward earnings revisions relative to the rest of the world are on the rise. However, risks of currency devaluation and volatility could justify remaining neutral.
Our sector allocation for both Canadian and U.S. equities is unchanged this month. In Canada, we still recommend that clients overweight the Telecommunication Services, Consumer Staples, Information Technology and Financials sectors. In the U.S., we still advise clients to overweight the Consumer Staples, Consumer Discretionary, Information Technology and Health Care sectors.
