FinLight Research - Market Perspectives May 2014

Market PerspectivesMay 2014

May 3rd, 2014

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Sell in May and go away?

“The Fed has lost any semblance, any wispy remnant of humility,introspection, caution and historical perspective. It is all cameras andapplause […]The Fed (along with other central banks) is fully immersed in fiscalpolicy, arrogating more and more responsibility for the functioning ofthe global economy, picking winners and losers in purchasing financialassets, directing the allocation of credit and making ever-bolderpredictions ever-further into the unknowable future. […]In effect, it is achieving total political power in a political vacuum,without the accountability of being elected. […]If you open a faucet in the winter and only a trickle comes out,what do you do? Easy! Open it wider. In fact, open ALL thefaucets! Brilliant! Now they are all trickling. But when the pipeblockage comes unstuck or the ice melts, you will have a flood ”

Hedge-fund manager Paul Singer

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Executive Summary: Global Asset Allocation

� Low volatility is no panacea: the fall in volatility in bond, equity, and commodity markets is eliminating caution, favoring excess risk taking and leverage. Our view is that volatility rarely stays this low for long

� We are muddled by the divergent signals we see in the market(High beta stocks ugly performance, outperformance in Goviesand weakness in US$ despite good economic news, equity / FX / rate vols drifting towards all-time lows)

� Is something more fundamental is going wrong in the world economy ?

� Is the market signaling concern about the economy i n a post QE world?

� Many signs point to a global slowdown: China's sudden decline in exports, downward revision to their economy's growth rate, stalling of Europe's recovery and risk of deflation

� We continue to see the main systemic risk coming fr om China .

� We summarize our views as follows �


MACRO VIEW

� The Good� Economic data have been trending positively� The 0.4% decline in the US unemployment rate from 6.7% to 6.3% is a good point, even if it’s mainly

explained by the decline in the Labor Force Participation rate� Expected earnings growth remains strong� Michigan Consumer Sentiment final number for April was the second highest reading in almost

seven years.� Chicago PMI and ISM Manufacturing report both came in stronger than expected. Leading economic

indicators were also strong (up 0.8%)� April flash PMI for Eurozone surprised on the upside. German IFO for April was also surprisingly

strong, in particular the expectations component.

� The Bad� Q1 GDP growth was near zero. Is that a weather exception?� Eurozone is probably just one adverse shock away from going into deflation.� Treasuries are rallying despite Fed tapering, signaling something is wrong with the global picture� China's growth remains disappointing.� The collapse in the price‐to‐book ratio of Chinese banks emphasizes the China's bad non-performing

loan picture. � Geopolitical risks are high, but actual effects on markets have been small, so far.

� The Ugly � A sustained slowdown in Chinese growth below 7% YoY.



Big Four Economic Indicators

� The global picture is always that of a slow but consistent recovery. � The data for Feb and Mar. are back to green� Among the 4 indicators, two (Real Retail Sales and Industrial Production) have already reached their all-

time highs. Nonfarm Employment remains on a positive trend. Only Real Personal Income is still struggling.


Personal Income

� At 0.54%, the Personal Income March MoM is the largest since Dec. ‘12 spike (explained by income strategies in anticipation of tax increases)

� The March MoM decreases to 0.34% when we adjust for inflation and Transfer Payments. � On a YoY basis, Real Personal Income less Transfer runs at the hardly exciting level of 2.15%


Employment

� Nonfarm Employment for April was up by 288K, the largest increase since January 2012. � On a YoY basis, Nonfarm Employment increased at 1.74%, a level that appears low for a typical mid-

cycle recovery� The 0.4% decline in the unemployment rate from 6.7% to 6.3% is a good point, even if it’s mainly

explained by the decline in the Labor Force Participation rate


Employment – An Unbalanced Recovery

� According to a recent report from the National Employment Law Project, the employment growth during the recovery appears to be concentrated in lower-wage industries

� The report shows that job losses and gains have been skewed: “Higher-wage industries shed 3.6 million positions during the recession and have added only 2.6 million positions during the recovery. But lower-wage industries lost two million jobs, then added 3.8 million.”


Retail Sales

� The Advance retail sales (headline and core) came in better than expected in March� Is that a sign that the winter slump was weather related?

� When adjusted for both population growth and inflation, retail sales are now back to March 2004 level


Retail Sales vs PCE

� Real retail sales fell to near recessionary levels before rebounding in March

� A similar pattern was observed on durable goods spending

� This is fully in line with the flat GDP report.


GS – Global Leading Indicator (GLI)

� According to the GLI, global growthis no longer decelerating, but thereis no significant positiveacceleration.

� After 6 months of continuous slowing, the GLI continues to locate the global industrial cycle on the frontier of the expansion phase (defined by positive and increasing momentum)

� 5 of the 10 underlying componentsimproved in April

� We note the extreme difficulty the GLI has to move more decisively into expansion.


US Real GDP

� The recovery out of the last recession looks disappointing compared to earlier recoveries� This is the slowest recovery over the U.S. post-World War II period� This is mainly due to the weakness in consumption in services and non-durables.


Eurozone Recovery

� At 54, the April flash PMI for Eurozone is now at a 3 year high and at a level consistent with 2% GDP growth.

� But at this stage, Eurozone Industrial Production is everything but spectacular…

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Eurozone Inflation

� Eurozone inflation continues to raise concern, as it systematically undershoots the ECB’s forecasts

� Draghi’s rhetoric “inflation expectations remain well anchored” is simply no longer true.

� Eurozone is probably just one adverse shock away from going into deflation.

� This should prompt ECB to further monetary easing, and probably to implement a QE program over the near term

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15

US Inflation

� Inflation continues to surprise to the downside.

� Consensus inflation forecasts have been falling as real growth forecasts have been rising. Volatility of inflation is also going down.

� This is probably one of the reasons for the sideways range in government yields



Consumer Sentiment

� The University of Michigan Consumer Sentiment final number for April came in at 84.6� This is the second highest reading in almost seven years.� This is still below non-recessionary average level of 87.4


Housing

� The private residential investment's share of GDP has bottomed.� Case-Shiller home prices were up almost 13% YoY, softening question marks on other recent home

sales data.

� As goes housing, so goes the economy.

Source: Bespoke Invest.


China’s Growth

� China's growth remains disappointing. � The Manufacturing PMI has been in the contraction range for the last 3 months. � The PPI inflation rate has been negative on a YoY basis for the past 26 months through March, probably

due to excess capacity � According to Ed Yardini, China’s crude oil flat demand suggests that “growth may be slowing even faster

than suggested by GDP and production indicators”.


China NPL Problem Matters…

� Non-performing loans have increased dramatically since 2008 (exceeding one trillion dollars) as a result of the massive expansion of credit to the non‐financial and household sectors

� The collapse in the price‐to‐book ratio of Chinese banks emphasizes the China's bad NPL picture. � The biggest challenge for Chinese authorities is to contain the NPL problem and avoid contagion to one

of the Big 4 banks


EQUITY

� On the S&P500, we witness a certain exhaustion of the trend at its highs. But we need clearer signals to expect a deeper consolidation. The first real sign of momentum loss would be given by a break below Nov 2012 uptrend.

� On the Nasdaq and Russell2000, odds are increasing for a downside resolution

� The large divergence between the S&P500 on one hand and small caps / high beta stocks on the other hand, is painting a strange defensive-oriented picture.

� We continue to think that any further upside on the S&P 500 should be driven by earnings growth rather than P/E expansion

� Bottom line :� We remain Neutral equities. Breaking through the 1833 pivot on the S&P500 would likely be the

signal we wait for to go short stocks

� We keep our UW on (deflationary) Europe and EM vs. US. We reverse our view on Japan from OW (as we were proven badly wrong!) to Neutral/UW

� We might switch more constructive on Europe if the ECB QE materializes. This would be bullish for equities, especially financials, cyclicals and periphery.

� We keep our bias to defensive high-yielding stocks. A severe unwind seems to be underway in high-beta areas like Biotech and Social Media.


Earnings

� The forward 4-quarter estimate for the SP 500 has increased to $123.19, implying a YoY growth rate of 8.21% (the highest since Jan ‘12)

� However, earnings estimates were lowered in all key regions.� The consensus MSCI Eurozone EPS growth expectations Ytd are on a negative trend similar to that

experienced during each of the last 3 years.

MSCI Eurozone


Earnings

� Current levels in equity markets cannot be sustainable without a substantial growth in global earnings

� Any further upside in equities should be driven by earnings growth rather than P/E expansion


Earnings / Revenue Estimates

� While the earnings estimates beat rate (62%) has been normal so far this season, the revenue estimates beat rate (50%) has been clearly weak .

Source: Bespoke Invest.


Small Caps Divergence

� A large disconnect is happening in the market currently. � As the Dow is testing new all-time highs, the Russell 2000 seems to be heading to its major support at

100!


Small Caps & High-Beta Stocks Blood Bath

� Small caps and high-beta stocks are getting hammered as a logical result of the reversal of the Fed's zero interest rate policy

� The performance of high beta stocks relative to defensive stocks points to a deterioration of market's tolerance for risk since Mar.14

� Both underperformances are painting a defensive-ori ented picture.


Market Sentiment

� Treasuries are rallying despite Fed tapering… � The behavior of long USTs relative to intermediate duration can point to coming risk-off periods and

higher volatility for stocks


Sell In May…

� The seasonal effect is real… at least on average.


Sell In May? Just wait for clearer signals…

� On the S&P500, we witness a certain exhaustion of the trend at its highs. But we need clearer signals to expect a deeper consolidation.

� The most notable support from here stands at the uptrend from Nov. 2012 (1,833)

� Breaking through this pivot would likely be a concerning signal.

� An other concerning signal is already here: The Russell2000 has already broken its Nov. 2012 uptrend

� Russell2000 weakness would be confirmed by a clean break of 1114 support (200 daily MA)


Trading Model – S&P500

� Our prop. Short-Term trading model is now neutral to slightly short on May. 2nd at 1881 on the index� The model targets 1847 – 1756 and increases its shor ts above 1885


Japanese Equities

� The latest BoJ outlook report seems to indicate that QE is put “on hold” for the moment, leaving Nikkei and USD-JPY vulnerable.

� Another move higher in stocks needs more policy stimulus

� We cut Japan to Neutral / UW from OW. A correction seems underway et may last several moths with a target 1000 Ptslower.


EM Equities

� During April and after a substantial improvement against DM, EM resumes its underperformance as:� EM GDP growth continues to be

revised to the downside� EM EPS are also revised down

� We remain UW EM stocks against DM stocks.

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Risk Aversion vs Equities

� At -0.32, the RAI remains in neutral territories. The correction is not significant. Equity 6m-momentum is too high (and completely disconnected from risk aversion) to be sustainable.

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FIXED INCOME & CREDIT

� In our central scenario we continue to see higher i ntermediate-duration yields, lead by a rise in the US and UK, and marginally tighter peripheral sp reads vs. Germany.

� Government yields continue to trade in a narrow range, with low volatility encouraged by low inflation and disappointing data. Stable yields and low volatility help periphery, EM sovereigns and credit.

� Nevertheless, we keep our short positioning on UST and expect 10-year yields to reach 2.90%-3.20% by mid-year

� We continue to OW Eurozone vs. US and UK given disinflationary risks in Europe.

� Within the Eurozone, we stay neutral Peripheral vs Core as we see lasting spread compression to be very limited if any.

� We stay neutral on TIPS breakeven but remain short 5yx5y Eurozone inflation as a hedge against the risk of Eurozone deflation.

� As a tail hedge, we keep our 10y bund swap spread receiver swap


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FIXED INCOME & CREDIT

� In corporate credit, investors appear to be seeking out risk on the margin, moving down in quality in search for yield.

� The search-for-yield is likely to remain strong and may push spreads a bit tighter over the rest of the year. But, the risk of a liquidity shock is significant.

� Issuance quality has started to deteriorate

� Expected ECB potential QE should be supportive to credit but less than Fed QE.

� Given the rising government bond yields, we choose to stay Neutral (but may move to UW very soon) on credit overall . We are clearly less constructive over the medium-term.

� Regionally, we are Neutral between the US and Europ e. European credit has a much stronger potential for returns but this is mainly due to its much higher exposure to banks and peripheral credit.

� On a risk-adjusted basis, we continue to prefer IG over HY. We were proven correct specially in the US credit.

� Bottom line : Still UW Govies, Neutral credit, neutral TIPS, UW High Yield vs High Grade


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US Treasuries

� In contrast to our strong expectations for higher yields, we’ve rather seen sideways move in Govies, so far in 2014.

� Concerns over Ukraine more than outweighed the strong employment report, pushing Treasury yields down and flattening the curve

� UST yield continues to trade in a narrow 20bp range, as it did over the last 3 months

� We stay near term bearish and think that the range low will hold given the tapering move

� But the repeated failure to close above 2.80% presents a risk to our view.

� The major question remains: Is the market signaling concern about the economy in a post QE world?


36

Implied Inflation - Eurozone

� 1y and 5y implied inflation continue their slide down… The inflation curve is steepening� Shorting 5yx5y Eurozone inflation seems a good hedge against the risk of Eurozone deflation.


37

Implied Inflation - US

� We remain neutral on TIPS breakeven


38

Issuance Quality

� In European HY space, issuance quality has started to deteriorate with only 18% of April issuance being BB-rated, 54% used for releveraging and 14% of issuance in CCC

� Among the 32 bonds issued in April, 27 were rated single-B or less.


GCP: General Corporate Purposes

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Market Inflows

� We see a global context of slowing inflows into HY bonds and leveraged loans� European high yield retail inflows had started to moderate. � US leveraged loan inflows turned negative for the first time in two years , while US high yield bond

inflows are near zero.


40

Credit – HY vs IG

� Spreads for both the European and US indices have tightened in line, with HY underperforming IG, specially in the US.

� The US HY/IG spread ratio has not been this high since November 2012


41

EXCHANGE RATES

� We keep our view for a stronger USD index in 2014 b ased on higher US rates and non-US fundamental weakness

� Investors have already capitulated on the long USD view (but not us !) initiated with the beginning of tapering. This should support the dollar as far as the US economy does not disappoint.

� As expected, the EUR-USD traded sideways so far in Q2. We remain Neutral and wait for a clean break below 1.3675 to become UW and target 1.31 - 1.28.

� We may see 1.40 soon, but the exhaustion pattern is already here. In order for our EUR bearish view to realize, the spot should hold below the trend across the highs since Feb. 2012

� The latest BoJ outlook report seems to indicate that QE is put “on hold” for the moment, leaving USD-JPY (like the Nikkei ) vulnerable.

� On the USD-JPY, a corrective phase seems underway, with a reasonable target around 99.50. The uptrend should resume from there. we become UW and use the area 103.93-104.34 as a stop loss.



EUR-USD

� Contrary to our past expectation, April performance has probably materialized a clean break above the 2008 downtrend.

� But we still see an exhaustion pattern developing, coupled with a lack of momentum� The 1.3833 and 1.40 levels should be watched very closely. In order for our EUR bearish view to

realize, the spot should hold below the trend across the highs since Feb. 2012


EUR-USD

� The strength of the Euro might be explained by large current account surplus and net capital (portfolio and FDI) inflows.


EUR-USD

� Yield differential between US and Germany implies a forex in the 1.20 – 1.25 range� The divergence is the widest since Mar. ‘13


US Dollar Volatility

� The G10 FX 1-month implied volatility has moved very close to its cycle lows from Jun. ‘07 � With weekly oscillators at their extremes, it seems reasonable to argue a base developing in 1-month

implied volatility.


US Dollar Volatility

� G10 FX volatility appears too low when looked at wi thin the business cycle!� Compared to the average performance of 3-month realized volatility across G10 currencies (trade-

weighted dollar) around that last four Fed tightening cycles, the present G10 FX realized volatility shows a shocking pattern, with an astonishing undershoot of the pre-tightening norm

� We are approaching the undershoot we’ve experienced in 2007 pre-Lehman.

� We expect a rise in FX volatility (probably on better than expected US economic news), driving up speculative USD positions from their lowest levels in over a year


Carry Strategies

� Currency managers are again long EM carry trades af ter being short in Q1-2014 � The risk aversion on EMs has vanished

� They are still flat to slightly short on G10 carry

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COMMODITY

� Investors are getting back to commodities as a portfolio diversifier. Flow data showed renewed investor interest in the asset class.

� Last month, we’ve decided to move commodities from OW to UW on the short run. W e keep this view.

� Over the short run , � We remain Neutral on Energy. Crude oil prices could be threatened by a higher US production and

inventories.� We become Neutral to moderately OW on Agriculture, especially crops (Adverse weather, greater

expectations of an El Niño later this year) and remain OW premium coffee and cocoa

� We switch from UW to Neutral on base metals as a certain optimism has returned to these markets in recent weeks.

� We stay UW precious metals (targeting 1180-1150 on gold and 17 and then 12.50 on silver) because of rising real interest rates and strengthening of the dollar.

� Reaching a base will give a buying signal not only on physical gold but also on gold miners.

� Over the MT, we stay UW copper . The downside risk due to increasing supply and a lower Chinese demand is too significant to be ignored. We target 6400 (Q3-2014), and ultimately 6000.



Commodity Flows

� The data for both flows and AUM suggest a rebound in prices after a particularly negative 2013.� According to Citi Research, retail and institutional commodity AUM grew 11% in the first 2 months of

the year to $375 Bln

� Investors are coming back to commodities as a portf olio diversifier : $6bn in new monies flew into the sector over Q1-2014

� Commodities are taking a pole position across macro asset classes for the first time since H1-2008.


Copper

� Pessimistic sentiment towards Chinese growth should drive copper prices to the downside, as China is expected to account for as much as 60% of copper demand growth.

� Refined copper Chinese imports in March were soft

� From our point of view, the fall in LME total stock s of copper does not signal any surge in demand , but rather a simple movement of metal from LME to other repositories : Estimates of Chinese bonded warehouse stocks have risen to a record 825kt

� With copper trading above $6 700, we think the risk is biased to the downside.

:


Gold – Fair Value Price

� Stay Bearish. Medium term technicals remain weak on precisous metals, especially Gold and Silver.

� Like on Silver, the bias seems skewed to the downside. The move up we’ve seen recently is corrective in nature as it remains below the 38.2% retrace of the drop from Oct 2012.

� Our theoretical price (implied by US$, sovereign CD S and Real Rates) stands now at 1180 (as of May 2nd ), versus a market price at 1298. Our fair price should continue its downward movement as soon as the US$ and real rates resume their move to the upside.

52

ALTERNATIVE STRATEGIES

� We are always OW on AI as we expect a 10% return in the coming year versus 5% on a traditional balanced portfolio (stocks + bonds+ cash).

� During April, Equity Market Neutral performed the best . Equity Long / Short and Macro funds performed the worst.

� YTD, the best performers are Equity Market Neutral, Convertible Arbitrage and Event-Driven. The worst are Macro and CTAs

� For several months now, we have been OW :� Equity long-short market-neutral and Convertible arbitrage. And that was a good deal. � But also on CTAs and Macro funds. And we’ve been quite wrong so far, especially on CTAs.

� We keep our OW on Equity Market Neutrals.� We move Neutral on Convertible Arbitrage as most of the performance was due to high yield positions� We are now OW on Event-Driven, as M&A activity is heating up� In spite of their bad (horrible for CTA) performance YTD, we keep our OW on CTA’s and Global Macro as

a diversifier and tail hedge� We still prefer risk diversifiers to return enhancers


53

The case for Trend Followers / CTAs

� Things should improve now with the return of trends and the decrease of correlations among asset classes


� After 2 years of disappointing returns (2011-2012) and a year of mixed fortunes (2013 with high dispersion among CTAs), trend-following strategies are starting 2014 in bad shape.

� This is clearly not enough to declare the end of glory of the strategy. Trend-followers have seen similar difficult times in 2003-04

� During the GFC, trend followers fared well, unlike most other alternative strategies and asset classes.

� Mixed / bad performance of CTAs in 2011-2013 is normal when we consider the difficulty in capturing trends in an environment that remained:� driven by political intervention needed to

stabilize the financial system� Basically composed of a series of risk-on/risk-off

movements� Unfavorable to the detection and capture of

market trends

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The case for Trend Followers / CTAs

� Despite their disappointing performance, we continue to defend CTAs as a strategy with:� competitive advantages over other assets in

the long term.� Proven capability to navigate through

different market regimes� Stable de-correlating virtue �


55

Event-Driven

� M&A activity has surged, naturally (at this point of the cycle) driven by:� High cash balances and healthy corporate balance sheets� The search for external growth (consolidation, expansion, acquisition) as revenues flatten� Easy funding and low credit costs


56

HF Positioning – CFTC Data

� Based on CFTC data, hedge funds / large specs:� covered S&P 500 shorts and increased Russell

2000 shorts � decreased their short positions in 10-year and

2-Year� increased Gold and Silver longs but kept

Copper shorts.� decreased their Crude longs and increased

Natural Gas shorts. � decreased their EUR longs


Bottom Line: Global Asset Allocation

� Low volatility is no panacea: the fall in volatility in bond, equity, and commodity markets is eliminating caution, favoring excess risk taking and leverage. Our view is that volatility rarely stays this low for long

� We are muddled by the divergent signals we see in the market (High beta stocks ugly performance, outperformance in Goviesand weekness in US$ despite good economic news, equity / FX / rate vols drifting towards all-time lows)

� Is something more fundamental is going wrong in the world economy ?

� Is the market signaling concern about the economy i n a post QE world?

� Many signs point to a global slowdown: China's sudden decline in exports, downward revision to their economy's growth rate, stalling of Europe's recovery and risk of deflation

� We continue to see the main systemic risk coming fr om China .

� We summarize our views as follows �


FinLight Research - Market Perspectives May 2014

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Transcript of FinLight Research - Market Perspectives May 2014