It would be tempting to increase our stock allocation as some indicators still appear to be supportive of the stock market rally since mid-February such as the tightening in corporate spreads, historically low initial jobless claims and commodity prices showing signs of recovery. However, at the start of April, we noted that some sentiment indicators were approaching extreme positivism and that market conditions pointed to a less favourable environment for equity investors in the near-term. Our concerns for a potential market pullback then underpinned our neutral stance on equity vs. fixed income. We have the same concern entering into the month of May. Even if we remain positive about stock market perspectives longer terms and still expect equities to hit new record highs in 2016, we again advise investors to proceed with caution in the near-term and keep a neutral stance for now.
Indeed our dashboard of financial and economic indicators to gauge continues to point to a worrying set of signals. High equity-market valuations, the topping in the NYSE cumulative advance/decline line, the recent rise in the CBOE Options Equity Put/Call ratio and the current underperformance of cyclical against defensive sectors are all raising warning flags for equity investors. Moreover, we see little room for equity multiple expansion from here as the Fed started tightening monetary policy in December and still indicates that it expects two rate hikes by the end of this year. The bond market also seems to be pricing that these rate hikes have a very low probability of occurring. Yet, if the U.S. economy was to improve faster than currently anticipated, rates could rise and affect equity valuation. Corporate profit margins also appear to be peaking on higher labor costs, U.S. economic surprise indices are on the decline and we remain in waiting mode for signs of stabilization or improvement in credit conditions before increasing our equity allocation.
For instance, the April 2016 Senior Loan Officer Opinion Survey on Bank Lending Practices continued to provide a negative indication on the short-term outlook for earnings growth and economic activity. The survey showed that a net 11.6% of banks reported tightening standards for commercial and industrial (C&I) loans to large and middle-market firms over the first quarter, while a net 5.8% of respondents reported tightening standards for small business lending. A large percentage of respondents who tightened either standards or terms on C&I loans over the first 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. As illustrated below, credit conditions historically tend to lead earnings growth by six to twelve months.
However, we remain positive about stock market perspectives longer terms and still 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 (see the table below). In other words, we believe that once again, the equity market was wrong in predicting a recession. It would not be the first time: As the Nobel Prize-winning economist Paul Samuelson famously quipped in 1966: ``The stock market has forecast nine of the last five recessions``.
Our regional allocation is slightly changed this month. U.S. equities remain our top overweight as we are still 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. We also continue to recommend that clients underweight Canadian equities as we remain cautious on the short-term outlook for the energy sector. Indeed, the global crude oil market remains well oversupplied with OPEC’s oil output rising to 32.6 million bpd in April despite supply disruptions in Kuwait, Nigeria and Venezuela. Production increases in Iran and Iraq more than offset oil supply outages. As a result, global crude inventories should continue to pile up far into 2016 with the pace of global stock builds accelerating during the second quarter of 2016. On the other hand, non-OPEC output growth is expected to turn negative in 2016 and with world oil demand again expected to increase 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. 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 are slightly increasing our underweight exposure to Other Developed Markets as the significantly stronger euro and yen are raising downside potential to exporters’ profits. Conversely we are increasing our overweight exposure to Emerging Markets as upward earnings revisions relative to the rest of the world are on the rise and the weaker U.S. dollar is improving sentiment.
As for our recommended sector allocation in Canada, we still recommend that clients overweight the Consumer Staples, Financials and Information Technology sectors. However, we are replacing Telecommunication Services from our list of top overweights with the Materials sector. We had recommended investors to overweight Telecommunication Services since the beginning of 2016 and this proved to be a profitable call with the sector outperforming the S&P/TSX Composite index by 1.5% YTD on a total return basis. However, upward earnings revisions relative to the S&P/TSX Composite index are on the decline, which historically coincided with underperformance for the Telecommunication Services sector. On the other hand, our expectations for a coming pick-up in asset price volatility and that monetary policymakers will remain cautious could support gold prices and ETF inflows into the precious metal in the near-term, with the greatest weighting within the Materials sector being gold and silver stocks. The recent rebound in China floor space of buildings under construction and new yuan loans could also support base metal prices (see the chart below).
In the U.S., we still advise clients to overweight the Consumer Discretionary, Industrials, Telecommunication Services and Information Technology sectors. However, we are replacing Consumer Staples from our list of top overweights with the Materials sector. We had recommended investors to overweight Consumer Staples stocks since the beginning of 2016 and this proved to be a profitable call with the sector outperforming the S&P 500 index by 3.6% YTD on a total return basis. The Consumer Staples sector appear expensive based on its relative 12-month forward PEG ratio – the 12-month forward PE divided by the 5-yr forward consensus expected EPS growth, which is trading close to a more than 15-year high. Moreover, the current tightening of high-yield credit spreads represents a major headwind to the relative performance of Consumer Staples as the sector historically tends to underperform when the risk-taking tone in the credit market turns more constructive. We also continue to expect investor demand for high-yielding instruments to increase in the context of historically low yields across developed market government bonds, which should lead to further tightening in corporate spreads. As for the Materials sector, the improving economic outlook for China and emerging markets represents a major positive for raw materials demand and upward earnings revisions relative to the S&P 500 index are on the rise, which historically coincided with outperformance for Materials stocks.
Canadian Bond Allocation
Currently our model has an overweight exposure to fixed income securities of corporate issuers vs. Canadian government. We remain constructive on corporate bonds on the back of attractive valuations and all-in yields. The Canadian economy should continue to benefit from the strengthening U.S. economy, past CAD depreciation, accommodative monetary policy and the recently announced Liberal stimulus package, which should keep defaults low outside of the metals and energy sectors and remain supportive for credit. Investor demand for high-yielding instruments should also increase in the context of historically low yields across developed market government bonds. Also, we continue to forecast a coming pick-up in the second half of the year for the S&P/TSX Composite earnings growth rate, which historically coincided with relative outperformance for corporate bonds. However, we remain cautious on the short-term outlook for the energy sector and a further decline in commodity prices could result in another round of underperformance for corporate debt. As a result, we advise clients to remain prudent and selective from an issuer and sector-exposure perspective.
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