Cyclical and systemic stability can support risk assets
Financial markets continue to climb the proverbial wall of worry. Despite fiscal jitters in the U.S. and political volatility in Italy, U.S. equities continue their upward trajectory (Dow Jones +8.8%, S&P 500 +7.9% and +6.6% Nasdaq - YTD). With inflation in check, monetary policies across the globe remain very accommodative, especially as developed market fiscal policies are becoming stretched. In the medium-term, despite some U.S. fiscal tightening, our cyclical indicators remain positive and global systemic risk appears to be in check. From our investment perspective, we maintain our strong income focus and late-cycle sector positioning. We see value opportunities in large-cap dividend growing equities e.g. in healthcare, technology, energy and late-cycle industrial securities.
At this stage of the business and profit cycle it is imperative for corporations to move the needle on their capital expenditures. As credit conditions continue to improve and balance sheets are repaired, this is the time for the corporate sector to invest in capital and labor. Our cyclical indicators point to a U.S. growth rebound in Q1 of 2013. As we can see below, our manufacturing leading indicator has recovered and we expect a pick-up in fixed asset investments by corporations. As such, we have recently increased our enterprise spending exposure in the technology sector. Moreover, our confidence indicators appear to be bottoming out and we are encouraged by the recent employment reading in the ISM non-manufacturing index i.e. services. As the U.S. budget and debt ceiling negotiations are still pending, we expect political compromises to be a positive catalyst for business and household sentiment.
From a cyclical standpoint, with the U.S. economy operating below potential output we see more upside risk on capacity utilization. We point to the recent strength in the S&P 500 Transportation index as a leading indicator of cyclical resilience. After the inventory drawdown in Q4 2012, we see room for an inventory rebound, especially as the inventory to sales ratio of wholesale and trade goods is not stretched.
To be sure, the cyclical recovery since March 2009 has largely been driven by extraordinary fiscal and monetary policies. As a result, both households and corporations have made material progress in deleveraging and repairing their balance sheets. Moreover, the housing price rebound is an important component for the economic recovery, especially for small businesses which account for 50% of labor hiring. Clearly, both the housing market and corporate sector earnings have benefited from lower credit costs. In our view, the corporate sector has to increase its capital spending in order for a sustainable economic expansion to take place. Hence, with a capital expenditure rebound in sight, we have a preference for enterprise spending exposures i.e. via technology (e.g. business software analytics) and industrials (electrical and energy infrastructure equipment).
From both a cyclical and secular growth perspective, we are especially encouraged by the ongoing strength in the U.S. energy sector. Domestic oil production is back to 1992 levels. At the global level, U.S. total liquids production has surpassed Russia and is now second to Saudi Arabia. Thus, given their secular growth potential, we favor exposure to North American energy infrastructure MLPs, oil services and specific exploration and production (E&P) companies. Lastly, as the U.S. gradually becomes energy independent, we are keen to see how the U.S. trade deficit will evolve over time and how it may alleviate long-term fiscal challenges that arise due to entitlement spending.
The biggest long-term risk to U.S. economic growth is unsustainable entitlement spending. If left unresolved, fiscal pressures can put pressure on interest rates which may lead to a negative feedback loop within the economy. Therefore, healthcare spending is the big elephant in the room and we are certainly assessing whether Congress has the necessary wherewithal for true entitlement reform.
In the medium-term, the technical backdrop for specific security selection remains favorable. As we can see below, equity volatility and intra-stock correlation remain subdued. As long as policymakers remain accommodative and recession risks are at bay, we see value opportunities in U.S. equities. In a zero-rate environment, we have a preference for large-cap dividend growing equities in industries that offer late-cycle or secular earnings growth. For example, we favor commercial aerospace, energy infrastructure and emerging market healthcare spending. At this stage of the business cycle, we are cautious on the materials and consumer discretionary sectors. Lastly, from a valuation perspective, we see fewer opportunities in the consumer staples and the utilities sectors.
In Europe, despite a hung parliament in Italy after the recent elections, we believe the ECB will continue to be the lender of last resort. Most recently, certain European banks have been repaying part of their ECB LTRO short-term loans. This has led to a short-term contraction in the ECB’s balance sheet. Thus, we see scope for additional ECB accommodation. In our view, the key next step for the Eurozone, is to recapitalize the banking sector in order to repair the credit channel; which largely depends on lending by banks. Such a step would be beneficial to European growth and U.S. multinationals by unleashing pent-up demand in peripheral countries.
In conclusion, we continue to assess both the macro and micro backdrop across our portfolios. Cyclically, we see encouraging signs that can support the recent rally in U.S. equities. We remain positioned for steady cash flow generation from low duration fixed income securities (MBS) and dividend growth from large-cap equities that have good earnings visibility. From a valuation viewpoint, we seek securities that offer us a margin of safety.
Christos Charalambous CFA
Senior Strategist
christos.charalambous@edgewealth.com
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