Leumi Investment Service 4Q16 Letter – Calm Before The Storm?VW Staff
Leumi Investment Service letter for the fourth quarter ended September 30, 2016; titled, “Calm Before The Storm?”
In the last couple of years the month of August, typically a quiet period in the markets, proved volatile with significant gyrations due to Chinese growth concerns (2015) and a downward shock to oil and other commodity prices (2014). Vacations were canceled and investors fretted at falling asset prices. This year, in contrast, a normalized late summer marked by an uneventful August eased markets into the latter part of 2016 with surprisingly low volatility. The aftermath of the Brexit vote in the UK was relatively shallow as it became clear that central banks would intervene and keep liquidity in the markets, and US stock indices touched new highs.
We note also that while the last few years have produced tame Atlantic hurricane seasons, this one produced Hurricane Matthew, which battered the Southeast as the most severe storm to hit the US since Sandy in 2012. Turbulent market, calm weather; quiet market, rough weather…. Without implying causality, we want to observe that the US economic expansion is the fourth longest on record at over seven years, and that Fed rate hike cycles often precede recessions. With the Fed now increasingly likely to initiate rate hikes, we think that the high valuations in US equities merit caution, and that a shift toward safer assets may be prudent.
A number of outstanding global risks persist. These include the outcome of the US and several European elections that feature anti-trade candidates; commodity price shocks and associated Chinese and developed market growth fears; and geopolitical threats in North Korea, the South China Sea, and the Middle East. Developments in these and other situations lead us to recommend caution going into the fourth quarter. Below we examine current market conditions, consider European bank stability, and discuss our belief that the Fed will likely begin a new cycle of rate hikes in December, even as European and Japanese rates remain in negative territory. After recommending the deployment of cash in 4Q15 and 1Q16, we now recommend taking profits on certain appreciated positions to free cash for opportunistic purchases.
Leumi Investment Service – High Valuations and Low Yields
We see frothy valuations in US and European stock markets, likely driven by low interest rates: the S&P 500 is up 6% YTD (see table below), while Britain's FTSE is up 10.5% despite Brexit fears (a weak pound, now less than $1.25/£ vs. $1.50/£ at end-2015 due to the fear of bitter negotiations with the EU, can boost exports). While Eurostoxx is down 8% through the third quarter, it has recovered from being down over 15% earlier in the year after the Brexit vote, though its Price-to-Earnings (P/E) ratio remains somewhat high. In emerging markets, a high P/E ratio accompanies expectations for a Brazilian recovery after the expansive industrial cleanup of anti-competitive graft through the Lava Jato (“Car Wash”) investigations.
The P/E in the US, as represented by the S&P 500, exceeds 20x and is now at its highest point since the end of 2009 (due to a stark reduction in corporate earnings at that time).
In the fixed income markets, yields hit historical lows after the Brexit vote as a flight to quality sent investors into safe-haven US Treasury bonds, as well as gold and sovereign bonds in Germany and Japan, where yields have remained negative through the second and third quarters (see table below). US 10-yr. Treasury yields have ranged from about 1.50% to 2.00% throughout this year.
European Banks Causing Concern
Banks often reflect through their financial performance the state of an economy. These are not disastrous times like those of the Great Recession, though the health of banks in Europe's periphery continues to cause concern. Heightened regulation and more stringent capital limits have reduced the systemic risk of the financial system. In 2008 there came a moment when overnight cash lending nearly halted, and almost brought interactions among corporations and banks to a halt. Central banks injected liquidity to keep the gears turning, and the system has corrected itself. Given today's stronger balance sheets at banks (and most major corporations), it is hard to imagine the same scale of disruption.
The most recent bank scare has involved Deutsche Bank (DB) after the US Dept. of Justice announced a proposed $14 billion settlement that is over twice the bank's litigation reserve. Several large DB hedge fund counterparties announced that they were reducing exposure to the bank. Certainly a crisis of confidence could damage a bank, but the question is whether its capital structure is vulnerable to failure due to fleeing counterparties.
Typically, commercial banks lend money based on a core amount of cash withheld to support the loans (regulators dictate minimum capital ratios on how much cash to keep). Most banks attract deposits to establish this “Stable” cash cushion along with long-term borrowing, but some banks rely also on short-term counterparty funding from Wall Street, called “Warehouse” funding, in the form of repo contracts and derivatives. Stable funding is less likely to evaporate quickly (though there could still be a run on retail deposits at the branches as seen in Greece during its financial crisis). Conversely, repos and most derivatives are short-term instruments and require institutional counterparties that can pull their support quickly. Very broadly, banks like Lehman and Bear Stearns that did not endure the financial crisis relied on too much Warehouse funding. Other banks that specialized in mortgages failed because of falling housing prices and non-performing loans.
The most stable banks have changed over time, reducing their reliance on Warehouse funding. We do not intend to imply that all is well with the banks under new regulation. In fact, the higher capital standards, when combined with lower overall interest rates, mean that banks struggle to make profits. They cannot leverage deposits as much as they did before, and the persistence of low overall interest rates compresses the “spread” between interest-earning assets and interest-paying liabilities. This lowers the return on equity and return on assets of a bank, and could even lead it into distress were its loan default rate to spike. The regulators apply stress testing to gauge these risks, and over the next several years it is expected that those risks should mitigate. What we know from history is that regulation is often an imperfect tool, and we should and do expect some volatility to appear in the banking sector, though we may not know what form it will take.
The Fed Increasingly Likely to Begin Rate Hikes
As of September the US economic recovery surpassed seven years and is the fourth longest on record (the average since the Civil War is 27 months). However, it is also the slowest recovery since the Second World War, as the economy has registered an average of just 2.1% annual growth since 2009. Fed talk leading into the end of the year has encouraged the market to predict, through pricing in Fed Funds futures, a 60-plus percent chance of a rate hike by December. Unemployment still hovers about 5.0%, year-over-year growth in average hourly earnings are at the high end of their range since 2009 (September was 2.6% while the range is 1.7%-2.7%), and the labor participation edged up to 62.9%, a six-month high at the end of the third quarter.
Our tracking of Fed statements (see below) suggests that its deliberations are now leading toward a 25 basis point rate hike in December. This view is supported by the futures markets, and also by the fact that at the September meeting three Fed Governors objected to the decision to stand pat and voted to hike rates. This is the first time we have seen that level of dissent in several years.
We believe that central banks in most developed economies will continue to maintain low rates and engage in market friendly support, either through quantitative easing (QE) or, if policy makers begin to sense that they have reached the limits of QE, then by fiscal stimulus. To this end, we note that recent improvements in the US manufacturing PMI have rolled over, while the Euro zone picked up and China continued its gradual improvement from last year (see chart below).
Unemployment levels in the US have hovered around 5% for some time now, but wage pressures have not appeared and while consumer confidence has registered better levels the household savings rate remains high as the “great deleveraging” of the US household continues. Business investment remains muted as US companies do not appear to have the same confidence in the US consumer to keep spending, even as durable goods purchases trend higher.
Market Effects and Portfolio Strategy
The Leumi Investment Service Investment Committee views the rate-driven market complacency as a risk to client portfolios and believes that positioning going into the end of the year should be conservative, to include selling down some equity and, to a lesser degree, high yield debt, to generate cash for a reserve for opportunistic purchases in the event of a shock to the system that sends down asset prices. As of the end of September, the high yield asset class was trading at the lowest yields since the end of 2014 (see table below). The same is true of high yield energy and emerging markets high yield. Investment grade yields have not pushed through the December 2014 levels, which again signals a current high appetite for riskier assets.
Within the theme of heightened risks of turmoil going forward, we view valuations in developed equity markets as high. The two charts below show how price inflation in shares have driven up Price-to-Earnings ratios: in the case of the US, earnings are flat to slightly down while share prices are sharply up; and in Europe a more pronounced divergence is seen in share prices increasing while earnings drop more dramatically (see US and Europe charts below).
Under a situation of turmoil in the markets we expect large cap equities to remain resilient as investors flock to “safe harbor” assets. We have recently seen large caps in Europe serving as fixed income substitutes given the attractiveness of their dividend yields in the face of negative rates. The chart below shows that in times of turmoil the spread between prices of mid-and small capitalization equities in Europe compresses. There is a similar dynamic at play in the US between mid-caps and large-caps, for which we believe it prudent to shift exposure toward large caps within equity allocations. Our expectation of potential market shocks going forward leads us to suggest large, well established companies and indices representing them.
With lofty valuations, low yields and a probable coming cycle of rate hikes by the Fed, we anticipate heightened market sensitivity to shocks and also expect the risk of recession to increase. Accordingly, across asset classes the Leumi Investment Service Investment Committee favors the following in terms of allocation:
- Fixed Income – Choose quality over duration and extend maturities. Take advantage of recent yield tightening in riskier parts of the asset class, including developed market high yield and emerging markets, to reduce exposure there and allocate to cash in the event of a market dislocation that presents opportunities. Move to higher grade credits for safety, and extend out the curve to obtain higher yields. We see relatively low rates continuing into 2017 even if the Fed begins to hike rates later this year. Yields in the US compare well on a relative value basis, particularly given the negative rate environment in other developed markets.
- Equities – We maintain our positive view on equities, but think that very low interest rates have pushed up valuations and this makes them susceptible to shocks and a potential correction. Given geopolitical risks and rate hike effects we favor shifting to large caps that typically provide good dividend income and may weather a downturn better, and see relative value in European equities compared to the US.
- Alternatives – For portfolios large enough to accommodate them, we view the low correlation of alternative assets such as REITs, CTAs, and Long/Short equity funds positively. While we maintain this view in virtually all market environments, the current state of high equity valuations and low yields makes diversification of this type even more important.
- Cash – We favor taking advantage of high valuations to exit selected positions, mainly equities, and reallocate to cash in order to keep dry powder for potential market dislocations.
A final note regarding stormy weather: for all their severity Hurricanes Matthew and Sandy hit the mainland US as Category 1 hurricanes on the Saffir-Simpson scale. No major (Category 3 to 5) hurricane has made landfall in the US mainland in nearly ten years, since Hurricane Wilma in 2005 (the same year as Katrina). This marks the longest break between landfalls since 1851. That long period of relative calm sounds familiar also when we talk about the long economic recovery in the US, which makes us wary of inclement “weather” in the markets ahead.
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