At the end of 2015, 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 upward earnings revisions and the increasing pressure on corporate profit margins. In assessing recent changes in these indicators, it must be recognized that the situation has significantly improved over the past few months. First, since touching new highs in mid-February, investment-grade and high-yield corporate spreads are back into tightening mode in response to the improving market sentiment, rebound in commodity prices, easing concerns about China and declining probabilities of an imminent global recession. It is noteworthy to mention that the tightening in credit spreads is even occurring in spite of the significant increase in U.S. high-yield primary market activity and deteriorating corporate balance sheets. This easing in financial conditions is good news for equities as a strong historical relationship exists between financial conditions and equity prices (see the chart below). In other words, easing financial conditions tend to positively impact prospects for economic activity and stock prices. The decline in financial market stress is also confirmed by the St. Louis Fed Financial Stress Index, which currently stands significantly lower than levels reached at the end of 2015 and still below its long-run average.
In addition to that, the ISM Manufacturing index has been back above the key 50-threshold since March, following five consecutive months in contractionary territory. The USD setback played a major role behind the rise in manufacturing sentiment, fueled by the unwinding of crowded long dollar positions and the Fed’s dovish stance up to the release of the April FOMC minutes. 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 2.5% on June 1, up from 1.8% just a month ago. The upward revision to the percent change in real GDP primarily reflects upward revisions to personal consumption expenditures, residential investment and net exports. On the other hand, recent Fedspeak and the release of the April FOMC minutes have increased significantly the probability of a Fed hike in June, which pushed back the greenback higher, reversing a recent trend that had seen the dollar retract from its recent high reached last year. A bullish breakout in the USD could well have a negative effect on future economic activity considering the historical relationship between the USD and manufacturing sentiment (see the chart below).
Moreover, the S&P 500 12-month forward earnings estimate has been on the rise since the beginning of April and upward revisions in earnings expectations are now close to a new high since May 2014. As illustrated below, there has been more upward than downward revisions to earnings over the past month, which bodes well for the earnings outlook. As we discussed in previous reports, earnings growth will be the key contributor to future equity index appreciation as we are now in an environment of rising Fed funds rates. Indeed, each of the last four tightening cycles led to downward pressures on forward price-to-earnings ratios in the twelve months following the first rate hike. Finally, the trend in corporate profit margins has been improving lately with the S&P 500 12-month forward profit margins currently standing at 10.6%, up 0.2% since the beginning of April. The better earnings outlook is good news for equity prices.
It would be tempting to increase our stock allocation as the indicators mentioned above appear to be supportive of the stock market rally observed since mid-February. The still 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 5.5% in May, levels only reached during past economic/financial shocks. In addition to that, initial jobless claims remain historically low, which signals a healthy job market.
However, 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. First, a coming June hike and the accompanying repricing of Fed rate expectations could well lead to a significant tightening in financial conditions and again cause panic and turmoil in financial markets. The resulting dollar strength could also add downward pressures to earnings estimates, negatively affecting the recent improvement in the earnings outlook. Second, 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. According to the NFIB Small Business Economic Trends survey, an increasing number of small businesses expect credit conditions to tighten in the coming months. Indeed, for owners borrowing at least once every three months, a net 6% of respondents are expecting credit conditions to tighten during the next three months, up 2% from a year ago.
Third, the continuation of the Fed hiking cycle combined with global deflationary pressures and historically low long-term yields on German Bunds and Japanese government bonds are resulting in a flattening of the yield curve. This flattening of the curve represents a major headwind to earnings growth with the yield premium investors demand to hold the 10-year Treasury note over the 2-year note at its lowest level since December 2007. This spread historically tends to lead the year-over-year growth in earnings (see the chart below).
Fourth, examining the relationship between the VIX Index and the less familiar longer-dated CBOE 3-month Volatility Index (VXV) can provide investors with useful insights in assessing the current level of investor complacency and forecasting future changes in equity prices. A low reading in the VIX-to-VXV ratio often coincides with high investor complacency where market participants expect much lower volatility over the next thirty days compared to the coming three months. This is often a precursor to bearish equity market action. Interestingly, the current level in the VIX-to-VXV ratio is at the bottom-end of its historical trading range and may signal that the equity market might have become gradually, once again, too complacent over recent weeks (see the chart below). High equity-market valuations combined with the indicators mentioned above are all raising warning flags for equity investors.
As for our regional allocation, we now 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 (see the chart below). Our year-end 2016 target for WTI crude oil prices remains $68/bbl. We are also slightly decreasing our underweight exposure to Other Developed Markets as the weaker euro and yen are raising upside potential to exporters’ profits. Finally, we are decreasing our overweight exposure to Emerging Markets as a stronger USD could hurt sentiment.
As for our sector allocation in Canada, we still recommend that clients overweight the Consumer Staples, Financials, Information Technology and Materials sectors. However, we are adding Industrials to our list of top overweights as upward earnings revisions relative to the S&P/TSX Composite index are now on the rise, which historically coincided with outperformance for the Industrials sector (see the chart below).
In the U.S., we still advise clients to overweight the Consumer Discretionary, Industrials, Telecommunication Services, Materials and Information Technology sectors. However, we are adding Financials to our list of top overweights as relative valuation remains historically cheap and upward earnings revisions are bottoming out.
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, accommodative monetary policy and the Liberal stimulus package. 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 are on the decline and remain low at the moment (see the chart below), 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 8.8%, up 2.0% 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.
