Global equities continue to flirt with all-time highs, but investors remain wary. According to the latest BofA Merrill Lynch Global Fund Manager Survey that canvasses the views of more than 300 institutional, retail and hedge fund managers around the world, the average cash balance rose from 5.4% in August to 5.5% in September, close to the highest level in nearly fifteen years.
Moreover, despite the stock market rally since mid-February, the net percentage of fund managers saying they were overweight global equities was just +1%, which is only slightly above levels seen during previous economic and financial shocks in mid-2011 and mid-2012. This negative outlook was also reflected in Citigroup’s latest poll of pension, mutual and hedge fund investors where the median cash figure as a percent of assets under management jumped to 7.5% in 3Q16, matching the highest level seen over the past seven years. The AAII Investor Sentiment Survey also pictured this lack of optimism with the percentage of individual investors expecting stock prices to rise over the next six months down to 24.0% for the week ending on September 28th, which is a new low since June 22nd, 2016.
Why are investors casting such a wary eye on global equities? Elevated valuations, political and Fed policy uncertainties, poor corporate earnings trends, risks of an inventory correction, eroding credit metrics and the current stage of the economic cycle are all common reasons for explaining the current anxiety level. We still do not share this lack of enthusiasm and we continue to recommend an overweight in stocks and an underweight in bonds, a preference that we have held since the end of last June (see the chart below). Our quantitative models even recommend a larger overweight allocation to equities but uncertainties surrounding the upcoming U.S. presidential election lead us to maintain our +5% overweight equities.
Our preference for equities can largely be explained by our expectations for a pickup in corporate profits during the second half of 2016 as global economic growth should accelerate. First, the return of the ISM Manufacturing index to expansionary territory in September, combined with the strong rebound in the ISM New Orders component represent a positive sign for the U.S. economic outlook. The large bounce in the ISM Non-Manufacturing survey in September to 57.1 also reinforces this view, especially considering that the details were upbeat with the Business Activity and New Orders components substantially higher from the August readings. Second, as illustrated below, the increasing percentage of U.S. small businesses planning to raise their average selling prices should continue to support the current rise in the S&P 500 12-month forward profit margin, again contributing positively to earnings growth.
Third, the S&P 500 positive-to-negative preannouncement ratio is on the rise and at a new high since 2011. Finally, the current outperformance of S&P 500 high operating leverage stocks suggests that revenue growth per share should continue to accelerate, which represents another positive signal for the earnings outlook (see the chart below). As mentioned in previous publications, a re-acceleration in earnings growth could well improve risk sentiment and support equity prices during the remainder of the year. When earnings growth accelerates, equity prices historically tend to rise. Our base-case scenario also remains for a December rate hike by the Federal Reserve, which could lead to downward pressure on bond prices. However, the upside potential in yields for the rest of the year now appears limited from current levels, in our view.
Although we agree that stock valuations are elevated, equities still appear historically cheap relative to government and corporate bonds. Indeed, the spread between the S&P 500 dividend yield and the U.S. 10-year bond yield remains close to its widest level in more than 40 years. Also, the historically elevated spread between the S&P 500 forward earnings yield and the effective yield on U.S. high-yield companies should support price multiples in the near-term as long as Donald Trump does not win the 2016 presidential election and we are not about to enter a recession. In such a case, all bets would be off and price multiples would move on a downward trend. Although the race is tight, the current probability of a Trump victory remains lower than 30%. Moreover, according to our Recession Model, the odds of an imminent recession remain low at the moment (see the chart below). This model performed well in predicting recessions over the last 50 years and rarely produced a false signal.
Moreover, several indicators continue to suggest that the stock market rally since mid-February is not over yet. First, high-yield corporate spreads remain into tightening mode. Also, within the high-yield space, CCC-rated or below bonds continue to outperform BB-rated bonds, which is far from the typical market behavior prior to severe market pullbacks. Indeed, past equity market pullbacks tended to be preceded by an underperformance of weaker borrowers (see the chart below). Moreover, the year-over-year change in unemployment claims remains in negative territory. Historically, large and sustained declines in equity prices tend to occur when the year-over-year change in initial claims turns positive.
In addition to that, both the semiconductor and capital market industries continue to outperform the S&P 500, which is again far from the typical market behavior prior to severe equity pullbacks. The small-cap outperformance represents another indicator that is not displaying warning signs. Although some market sentiment indicators are pointing to high investor complacency, we remain of the view that any near-term pullback should be shallow and be viewed as an opportunity for investors to deploy capital into equities.
Our regional allocation is unchanged this month. We still recommend that clients overweight Canadian equities on the back of our expectations for rising energy prices. As for our sector allocation in Canada, we still recommend that clients overweight the Energy, Materials, Telecommunication Services and Utilities sectors. However, we are replacing Consumer Staples from our list of top overweights with the Information Technology and Industrials sectors as our expectations for a re-acceleration in economic growth should benefit cyclical sectors. In the U.S., we still recommend that clients overweight the Energy, Materials, Telecommunication Services and Utilities sectors. However, we are replacing Consumer Staples and Consumer Discretionary from our list of top overweight sectors with the Information Technology and Industrials 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, according to our Recession Model, the odds of an imminent U.S. recession remain low at the moment, which is supportive for credit, in spite of eroding credit metrics. We also continue to expect the rebound in the S&P/TSX Composite earnings growth to gain steam over the next few months, thanks to rising energy prices. Rising earnings growth historically coincided with relative outperformance for corporate bonds.
