The news that a majority of British voters decided to leave the European Union on June 23rd caught most market participants by surprise and initially triggered sharp losses in global risk assets by causing political, economic and market uncertainty in Europe. This surprise decision also buoyed safe-haven assets, accentuating the outperformance of bonds relative to equities since the beginning of the year. At the end of 2015, we turned neutral on equities and advised investors to proceed with caution in the near-term as our dashboard of financial and economic indicators pointed to a worrying set of signals. Our recommendation to cut allocation to stocks and remain neutral proved valuable so far. The recent sell-off in global risk assets prompted some of our clients to ask for our view on near-term perspectives for markets. For the first time since the beginning of the year, we are recommending clients to overweight equities as we are of the view that the current environment represents a buying opportunity, especially in light of the recent Brexit pullback, which we felt was overdone.
First, the immediate repercussions of the Brexit vote for the global economy are likely to be limited as the U.K. economy currently makes up only 4% of global GDP and terms of the new relationship between the U.K. and the European Union will only be redefined following a long period of negotiations; a process which will only start when triggered by article 50 of the Lisbon Treaty. Moreover, there are still some chances, although slim in our view, for an eventual reversal of U.K.’s decision to leave the EU in a general election or second referendum. In addition, global central banks are expected to take any measures needed to support the proper functioning of financial markets in the wake of the Brexit vote. British banks are also more resilient than during the Financial Crisis, thanks to significant improvements in their capital structures. The near-term outlook for the European economy remains as promising as it has been for years, in our view. Domestic demand, especially private consumption, remains the main growth driver, thanks to cheap oil and improvements in hiring. Credit standards are very accommodative and credit demand is also improving. In other words, indiscriminate selling of risk assets following last week’s Brexit vote may well translate into buying opportunities.
Second, market sentiment turned extremely bearish in a very short period of time with key sentiment indicators reaching levels similar to those achieved during past recessions and financial crises. With the economic backdrop more positive today than in 2008 for instance, we are of the view that global equities probably hit a bottom early this week. For example, many of our favorite sentiment indicators such as the S&P 500 forward 12-month P/E ratio divided by the CBOE VIX Index, the CBOE Equity Put/Call ratio, and the VIX-to-VXV ratio all hit levels in the wake of the Brexit vote that historically tended to coincide with near market bottoms. The extremely bearish sentiment among fund managers also reinforces the case for further gains in equity prices from a contrarian perspective. According to the latest BofA Merrill Lynch Fund Manager Survey, the majority of fund managers remain underweight equities and the average cash balance jumped up to 5.7% in June, which is the highest level in nearly fifteen years.
Third, the recent jump in U.S. consumers’ expectations of future conditions to a new high since last January bodes well for the relative performance of equities against bonds. Indeed, historical changes in this indicator tracked well the relative performance of equities. In addition to that, both initial jobless claims and the number of available people per job opening remain historically low and small business hiring plans recently hit a new high since last December, which still signals a healthy labor market. Also, the year-over-year change in initial claims remains in negative territory, which bodes well for equities. Historically, large and sustained declines in equity prices tend to occur when the year-over-year change in initial claims turns positive. Another indicator signaling that the global economy continues to move in the right direction is the current upward trend in the CRB Raw Industrials-to-Initial jobless claims ratio. Strength in this indicator historically tends to coincide with rising equity prices.
Moreover, the ISM Manufacturing index has been back above the key 50-threshold since March, following five consecutive months in contractionary territory. The rebound in the ISM Manufacturing index bodes well for the U.S. economy and a second-quarter GDP rebound. Indeed, the Atlanta Fed GDPNow model forecast for real GDP growth in the second quarter of 2016 has been creeping higher over the past few weeks and reached 2.7% on June 29, up from 1.8% at the end of April. The upward revision to the percent change in real GDP primarily reflects upward revisions to personal consumption expenditures, residential investment and net exports. The current rise in the ISM New Orders-to-Inventories ratio also appears to suggest that further improvements in manufacturing sentiment might be in the cards as this ratio historically tracked well changes in the ISM Manufacturing index.
We also expect equities to hit new record highs in 2016 as global economic growth should pick up, interest rates will remain low for an extended period and corporate profits should gain traction with a strong rebound in energy prices during the second half of 2016. If we are correct with our long-held view that the U.S. economy is nowhere near a recession in 2016, this would be the first time in more than fifty years that equities peaked more than twelve months prior to the start of a recession. We are also confident about our decision to underweight bonds. The bond market performed very well since the beginning of the year but probably over extended itself, especially if the global economy continues to improve, even if only slightly.
As for our regional allocation, we still recommend that investors overweight Canadian equities. The significant increase in OPEC crude oil production appears to be behind us with production roughly unchanged since the third quarter of 2015. Non-OPEC output growth will turn negative in 2016 and with world oil demand again expected to increase by more than 1 mb/d this year, 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. Our year-end 2016 target for WTI crude oil prices remains $68/bbl.
As for our sector allocation in Canada, we continue to recommend that clients overweight the Consumer Staples and Materials sectors. However, we are replacing Industrials, Information Technology and Financials from our list of top overweights with the Energy and Telecommunication Services sectors. In the U.S., we still advise clients to overweight the Consumer Discretionary, Telecommunication Services and Materials sectors. However, we are adding the Energy and Consumer Staples sectors and removing Financials, Industrials and Information Technology from our list of top overweights.
Canadian Bond Allocation
We maintain our overweight exposure to fixed income securities of corporate issuers vs. Canadian government. We remain constructive on corporate bonds as the Canadian economy should continue to benefit from the strengthening U.S. economy, past CAD depreciation and accommodative monetary policy. Investor demand for high-yielding instruments should also continue to increase in the context of historically low interest rates. Moreover, according to our Recession Model, the odds of an imminent U.S. recession remain low at the moment, which is supportive for credit and underlines our view that defaults should stay low outside of the metals and energy sectors, in spite of eroding credit metrics. We will closely monitor changes in our Recession Model over the next few months to see how our investment recommendations need to be adjusted to take it into account. Also, we continue to expect the rebound in the S&P/TSX Composite earnings growth to gain steam over the next few months, thanks to rising commodity prices. The S&P/TSX 12-month forward earnings growth is currently estimated at close to 10%, up 3.0% from levels reached at the end of March. Rising earnings growth historically coincided with relative outperformance for corporate bonds. On the other hand, we still advise clients to remain prudent and selective from an issuer and sector-exposure perspective.
