Are we in a risk-off rally?

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1 November 4 th, 13 Are we in a risk-off rally? MARTIN LEFEBVRE Asset Allocation and Investment Strategist (514) martin.lefebvre@bnc.ca Monthly review Stock markets around the globe enjoyed a hefty rebound in October reflecting a change in market expectations for future monetary policy in the USA, the nomination of Janet Yellen at the head of the Fed, and a partial resolution of the debt ceiling debate. Emerging markets led the pack with a 4.9-gain in US dollar terms, just a tad above the S&P 5 (+4.6). Canadian equities gained 4.7 during the month, but the 1.2-fall in the loonie leaves the TSX somewhat short of the month s leading performance in US dollar terms. After rising in the first half of October due to the uncertainty linked to a possible default on U.S. government debt, 1-year treasury yields fell in the second half of the month to a low of close to 2.5. Asset allocation strategy As the Fed continues to keep its excess liquidity backdrop in place and since we expect growth to accelerate in 14, we remain overweight equities with both the short and long term in mind, with a preference for developed markets over emerging markets. We are reducing our emerging markets weighting to neutral and raising exposure to EAFE equities to an overweight position. In the short-run, our approach is to adopt a more defensive equity stance by rotating from early cyclical to counter cyclical sectors. Our preferred sectors remain consumption stocks (both staples and discretionary). Financials remain a favorite in the long-run, but should be underweighted until the Fed signals anew its intention to taper its bond purchases program. Table 1 Market total returns Asset classes October Q3 13 YTD* Cash (3-month T-bills ) Bonds (Dex Overall Universe) Dex Overall Federal Dex Overall Corporate Dex BBB World equity (MSCI AC) S&P/TSX S&P/TSX Small cap S&P5 (USD) Russell (USD) MSCI EAFE (USD) MSCI EM (USD) Commodities (CRB index) WTI oil (US$/barrel) Gold (US$/ounce) Copper (US$/tonne) Forex (JPM US Dollar index) USD per EUR JPY per USD CAD per USD * 13/11/1 CHART OF THE MONTH Developed markets for the long run? A softening of growth in emerging market, combined with declining commodity prices, doesn t bode well for Canadian equities on a relative basis. Moreover, the fall in commodity prices and a more dovish stance on the part of the Bank of Canada should exert downward pressure on the loonie which could result in foreign capital outflows. 1 Source: Datastream For investment professionals only

2 How high can the S&P 5 fly? While the political circus in Washington will likely produce another bout of uncertainty early in 14, there is a good chance that it will once again be offset by the Fed, since it is now believed that the latter will keep its bond purchase program in place until there is a firming of employment data. The impact of the shutdown on job creation is still uncertain and it will likely take a few months of data to confirm a turnaround in the recent downtrend (chart 2). Employment still trending down In fact, even considering that seasonality is usually a positive factor on average in the fourth quarter, the rally in October doesn t leave much upside potential for the rest of the year, and we re looking for some consolidation to take place. Moreover, some indicators pointing to weakness in the economy suggest that the outperformance of stocks over bonds is stretched (chart 4). Stocks still outperforming bonds despite slower growth ' United States 35 ' United States Stocks outperformance Bonds outperformance ECRI WLI Stock-to-bonds (change from avg.) - Job creation 3-mth mov. avg. 2 Source: Datastream 4 Source: Datastream As long as the Fed postpones its intention to taper its bond purchase program, this will be market supportive. And any bad news will be perceived as good news if it reinforces expectations that the Fed will maintain the high liquidity backdrop for longer. Until we see more evidence that economic growth is reaccelerating, there is still a chance that we could see lower interest rate in the very short run (chart 5). Interest rates on the rise in a downtrend! Risk-off rally in the short term After a brief pre-shutdown correction of about 4, stocks are already flirting with overbought conditions and look to be at risk of a short-term pullback (chart 3) United States Looking for consolidation S&P Jan-1 Jan-11 Jan-12 Jan year Treasury notes 3 5 Source: Datastream D MA (left) S&P 5 (left) -D MA (left) -spread with -d MA (right) 3 Source: Datstream 1-1 Therefore, we think that a change in leadership will be required for the S&P 5 to post new highs. To be sure, the drop in the economic surprise index since mid-september suggests that the outperformance of cyclical sectors over more defensive ones could reverse course until there is evidence that interest 2

3 rates are bottoming out, or until analysts lower their expectations far enough to create positive surprises (chart 6). Staples have a lot of upside potential Favour a defensive equity stance in a risk-off environment Consumer Staples 8 Staples relative performance 8 Ratio Risk off Risk off Risk off Risk off? S&P 5 Consumer Staples S&P 5 Cons. Staples vs S&P Source: Datastream Cyclical vs Defensives (left) Citigroup G-1 Surprise index (right) 6 Source: Datastream Favour consumption in the U.S. Sector wise, in the U.S. consumption stocks look the most appealing in the short term for two reasons. First, consumer staples have broken out of their trading range and they have started to bottom out on a relative basis (chart 7). Consumer discretionary still in an uptrend On the flip side, some cyclical sectors are struggling. It is certainly the case for financials stocks (early cyclicals) which have felt the brunt of the change in market expectations and should continue to underperform as long as the Fed doesn t send another signal of an intention to taper its bond purchase program (chart 9). Financials are struggling Consumer Discretionary Discretionary relative performance Financials Financials relative performance S&P 5 Consumer Discretionary S&P 5 Cons. Disc. vs S&P 5 S&P 5 Financials S&P 5 Financials vs S&P 5 9 Source: Datastream 7 Source: Datastream Second, although consumer discretionary stocks have outperformed the market by nearly 12 over the past twelve months, they remain in a clear uptrend and their relative value should bounce off the 5-day moving average (chart 8). One of the big catalysts could come in the form of slightly lower interest rates, thanks to the Fed, and lower gasoline prices, as U.S. oil production increases before our very eyes both of which leave more money in consumers pockets. Risk-on rally in the long run We remain firm believers that the economy will accelerate in 14, led by continued improvements in the housing sector, a pick up in capital expenditure and less fiscal austerity. Therefore, in the long run, we see no value in federal bonds since yields have nowhere to go but up once the normalisation process of interest rates takes its course. Our preference is much more tilted towards equities, for which the longer-term outlook remains strong, and from which we expect decent performance for the next months driven 3

4 by earnings growth, lower commodity prices and a decline in market uncertainty worldwide. We favour developed markets over emerging markets (Chart of the month p.1) where growth has been faltering lately due to tighter financial conditions. Although postponing the tapering measures has helped emerging markets lately, interest rate hikes in developed markets remain the most likely scenario and this represents an impediment to growth in countries that are the most in need of structural adjustments. We are reducing our emerging markets weighting to neutral and raising exposure to EAFE equities to an overweight position. A softening of growth in emerging market, combined with declining commodity prices, doesn t bode well for Canadian equities on a relative basis. Moreover, the fall in commodity prices and a more dovish stance on the part of the Bank of Canada should exert downward pressure on the loonie which could result in foreign capital outflows (chart 1). Not much upside for the loonie 1 Source: Datstream 4

5 Table 2 Global Asset Allocation (Tactical vs Strategic) Cash Asset classes 3-month horizon Bonds Bonds (Duration) (Duration) Federal Federal Investment grade Investment grade High yield (USD) High yield (USD) Non-traditionnal income Non-traditionnal income World equities World equities S&P/TSX S&P/TSX S&P 5 (USD) S&P 5 (USD) Growth vs Value Growth vs Value Large cap. vs Small cap. Large cap. vs Small cap. Defensives vs Cyclicals Defensives vs Cyclicals MSCI EAFE (USD) MSCI EAFE (USD) MSCI EM (USD) MSCI EM (USD) Alternative investments Alternative investments Commodities Commodities Energy Energy Base metals Base metals Gold Gold Hedge funds (USD) Hedge funds (USD) REITS REITS Source: Consultating Investment Committee Cash 12 to 18-month horizon Weight Weight Asset classes Min Under Equal Over Max Min Under Equal Over Max National Bank Financial is an indirect wholly-owned subsidiary of National Bank of Canada which is a public company listed on the Toronto Stock Exchange (NA: TSX). The particulars contained herein were obtained from sources we believe to be reliable, but are not guaranteed by us and may be incomplete. The opinions expressed are based upon our analysis and interpretation of these particulars and are not to be construed as a solicitation or offer to buy or sell the securities mentioned herein. National Bank Financial may act as financial advisor, fiscal agent or underwriter for certain companies mentioned herein and may receive remuneration for its services. National Bank Financial and/or its officers, directors, representatives or associates may have a position in the securities mentioned herein and may make purchases and/or sales of these securities from time to time on the open market or otherwise. 5