Leaning on income generation in an uneven growth environment
Financial markets are navigating a time frame that features a challenging global growth backdrop and an aggressive monetary stance by the global central banking system. The U.S. economy has been on a sturdier footing as a result of healthy credit conditions, a recovering housing market and a renaissance in domestic energy production. Global policy execution is still very important as developed economies are facing structural demographic headwinds and extended fiscal policies. In Europe, we continue to observe economic divergences and a fragmented political landscape. Moreover, in emerging markets, China’s transition to a sustainable economic model is an ongoing issue to monitor as Asian economies are closely correlated. From our investment perspective, we are tactically cautious as equity market expectations in particular seem to have run ahead of underlying fundamentals. After a strong start for the year, we have raised our cash levels recently and our portfolios are leaning on income generation from MBS and late-cycle dividend growing equities. Thus, we are seeking to take advantage of favorable risk-reward opportunities as they arise; especially in cash rich sectors that have lagged the overall equity market e.g. technology.
The U.S. economy is likely to register a strong rebound in the first quarter for the year (~3%). Credit conditions continue to improve, house prices are rebounding and the U.S. banking system is well capitalized. As the number of underwater mortgages gradually declines, we expect labor mobility to increase i.e. to states with higher growth opportunities. For example, we are still very encouraged by the strength in domestic unconventional oil production that is boosting economic activity in states such as Texas and North Dakota. On a more cautionary note, recent economic data has been softening e.g. manufacturing orders and job growth. In our view, this is due to an uneven global growth backdrop and U.S. fiscal headwinds in the coming quarters. Therefore, we remain nimble in our equity selection and we favor cash heavy sectors that offer secular/late-cycle growth potential e.g. healthcare and software.
In a low volatility environment, U.S. equities seem to be showing some signs of complacency e.g. leveraged positions have been on the rise as shown below by the increased use of margin debt. Moreover, there seems to be some divergence between price action and underlying global economic fundamentals; as shown below by the softening economic surprise indices and crude oil prices. Therefore, tactically, some caution is warranted and a tilt towards more defensive income themes is prudent.
In Europe, the ECB has managed to contain systemic risk by providing significant liquidity to the eurozone banking system. More needs to be done however, by both the ECB and national governments in southern Europe. Realistically, excessive debt levels need to be restructured and the banking system could use higher capital buffers. Moreover, the economic and capital flow divergence between Germany and other core countries (Italy, Spain, and France) need to be addressed. This can only be achieved with real structural reforms and bank recapitalizations. Therefore, we are looking for signs of a sustainable turning point that will ultimately unleash significant pent-up demand. In such a scenario, we would be willing to assume more European cyclical risk via U.S. multinationals.
Lastly, the global macro landscape this week witnessed a radical monetary policy change by the Bank of Japan. The monetary base is likely to double by the end of 2014 in an attempt to end two decades of deflation and low growth. Japan has been facing numerous headwinds such as aging demographics and declining competitiveness vs. S.Korea. Moreover, Asia in general has been challenged by the economic transition in China i.e. less infrastructure and investment spending. This transition has been weighing on base metals such as iron ore and copper. The Chinese slowdown is also reflected in its declining FX reserve accumulation. From a currency perspective, we note that USD strength has historically weighed on emerging markets as USD denominated debt becomes more expensive to repay. Hence, as emerging economies utilize their foreign FX reserves to defend their domestic currencies, this leads to a de facto monetary tightening in their economies. Therefore, we are monitoring global currency trends and attempts for competitive currency devaluations; that ultimately weigh on global trade.
In conclusion, the global growth environment remains uneven and still dependent on prudent policy execution. Tactically, we are cautiously positioned in our portfolios as market expectations seem to have outpaced underlying economic fundamentals. Therefore, we are leaning on income generating financial instruments such as MBS and dividend growing late-cycle equities.
Christos Charalambous CFA
Senior Strategist
christos.charalambous@edgewealth.com
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