A key reason why we turned overweight equities at the end of June was that we expected corporate profits to gain traction during the second half of the year on the back of accelerating global economic growth and improvements in the profit margin outlook. This re-acceleration in earnings growth, combined with the extremely bearish market sentiment at the time, in our view, made equity valuations attractive on a relative basis. With Q3 corporate earnings season well underway, companies in the S&P 500 are now expected to report a positive year-over-year EPS growth rate for the first time since early 2015, basically ending the profits recession that lasted for five consecutive quarters. Interestingly, eight of the 11 sectors are reporting positive year-over-year earnings growth so far in Q3. In addition to that, the 12-month forward EPS growth rate for S&P 500 constituents remains on the rise, suggesting that earnings growth should continue to accelerate in the quarters ahead (see the chart below). As mentioned in previous publications, accelerating earnings growth historically tends to coincide with rising equity prices.
The recent news that the U.S. economy grew at its fastest pace in two years in the third quarter also reinforced our thesis. Indeed, U.S. real GDP came in at an annualized 2.9% pace in Q3, rebounding sharply from its slow pace in the first half of the year. However, the stronger-than-expected GDP headline masked weak details. First, most of the positive surprise was due to a $22.1B inventory contribution. With already high inventory-to-sales ratios, inventory investment should contribute less to U.S. growth over the coming quarters. Second, consumer spending only rose by 2.1%, below market expectations of a 2.6% increase. Third, residential investment was weak during the quarter.
This weakness is also supported by the quarter-over-quarter change in the Duncan Leading indicator, which measures the real growth of cyclical components of GDP in relation to overall real economic growth. This indicator pursued its decline during Q3, meaning that the cyclical components of the economy continued to weaken relative to overall demand. As shown below, this signals that we are late in the cycle as past peaks in the Duncan Leading index tended to lead downturns in the business cycle by about four to eight quarters.
Still, we remain optimistic about near-term economic prospects as the four-week average of jobless claims remains near its lowest point since 1973, the year-over-year rate of change in revolving credit continues to accelerate and the real growth rate in total labor income remains historically high. All of these indicators point to healthy consumer spending, which should support economic activity in the quarters ahead. In addition to that, the recent rise in the annual growth rate of new home sales, combined with tight inventories and a still buoyant labor market, imply an upcoming rebound in residential investment. The outlook for capital projects is also improving with the net percentage of U.S. small business owners planning capital outlays in the next 3 to 6 months still on the rise and close to its highest reading in the recovery.
In its October 2016 World Economic Outlook, the IMF also expects growth in emerging market and developing economies to accelerate in 2016 for the first time in six years. For 2017, emerging economies are again expected to post accelerating growth of 4.6%, largely contributing to the expected recovery in global growth. Stronger global growth should represent a tailwind for earnings growth.
Our view for corporate profits and global economic activity to continue improving largely explains our decision to maintain our +5% overweight equities. In addition to that, our expectations for Hillary Clinton to win the 2016 U.S. presidential election should lead to a significant decline in election-related uncertainties and improve risk sentiment. Cash balances remain elevated with the latest BofA Merrill Lynch Global Fund Manager Survey showing the average cash balance rising from 5.5% in September to 5.8% in October, a new high since November 2001. Market internals also remain positive with transportation, semiconductor and investment banking stocks still outperforming, a performance far from the typical market behavior prior to severe market pullbacks. However, the recent underperformance of B-rated bonds relative to BB-rated bonds remains a source of concern and future changes should be monitored very carefully. Moreover, renewed strength in the U.S. dollar could negatively impact U.S. economic activity and the earnings outlook. Finally, it should be clear that this outcome is contingent on a Clinton victory on November 8th as a Trump presidency is likely to be very detrimental to equities.
In terms of regional allocation, we are reducing our exposure to Canadian equities and Developed Markets in favor of U.S. equities. The large rebound in the long-to-short ratio for non-commercial contracts of crude oil futures to a new high since July 2014 could act as a potential headwind to oil prices from a contrarian perspective (see the chart below). Also, the ECB Q3 Bank Lending Survey pointed to a tightening of lending standards in the next three months for European firms. Tightening credit conditions could represent a significant headwind to European economic growth in the coming quarters.
As for sector allocation in Canada, we still recommend that clients overweight the Energy, Materials, Telecommunication Services, Information Technology and Industrials sectors. However, we are removing Utilities from our list of top overweights with relative forward earnings showing signs of peaking. In the U.S., we still recommend that clients overweight the Energy, Materials, Information Technology and Industrials sectors. However, we are replacing Telecommunication Services and Utilities from our list of top overweight sectors with the Consumer Discretionary and Financials sectors as our expectations for a re-acceleration in economic growth should benefit cyclical sectors.
Canadian Bond Allocation
We continue to recommend an overweight exposure to fixed income securities of corporate issuers vs. Canadian government. Investor demand for high-yielding instruments should continue to increase in the context of historically low interest rates. Moreover, we continue to expect the rebound in the S&P/TSX Composite earnings growth to gain steam over the next few months. Rising earnings growth historically coincided with relative outperformance for corporate bonds.
