finlight research | market perspectives - sep 2014

Market Perspectives

September 2014

Sep. 3rd, 2014

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Sucked into the Draghinomics bullish vortex…

“Insanity is trying the same thing over and over again and expecting different results.”Albert Einstein

“You can always count on Americans to do the right thing, after they've tried everything else.”Winston Churchill

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Executive Summary: Global Asset Allocation

� Economic news has been mixed with week consumption, but

yet strong confidence. Demand growth is far below what the US

economy is accustomed to.

� Eurozone financial markets can hardly be read other than as

anticipating a triple-dip recession

� Risky assets are not priced for any alternative scenario other than

the optimistic one. Current market sentiments are way too

optimistic. We do not want to be exposed to such a biased

situation..

� Equity markets are near record highs, but there are warning

signals that should not be ignored. Stocks keep rising on bad

news because bad news implies more central bank stimulus, and

more cash injection.

� We continue to see the main systemic risk coming from

China. China debt crisis still remains to unfold in our opinion.

� We remain neutral on global equities and think earnings growth

should be the only driver of markets from here. We remain

overweight commodities (but with a dispersion in views across

the sectors as individual fundamentals matter) and underweight

credit and government bonds. We continue to bet on USD

strengthening and on a spike in the VIX

� We summarize our views as follows �


MACRO VIEW

� The Good

� US Q2 GDP rebound was confirmed by the second estimate. Q3 Growth seems on track for 3%.

� Durable goods orders have been strong, regardless of the fact that most of that strength was due to

a surge in Boeing's aircraft orders.

� Business and consumer confidence are at, or near, post-crisis highs..

� Any way you look at it, the 2014 Q2 earnings season has been very positive

� The Bad

� The picture is worsening for the euro zone : Its strongest economy is weakening, its inflation came in

at a frighteningly low 0.3% and German consumer morale fell for the first time in 18 months

� M&A and IPO activity are getting close to 2007 peak levels. Stock buybacks seem to be declining

� Bullish sentiment (interpreted as a contrarian indicator) has spiked again, according to the latest AAII

Sentiment Survey

� Personal income and spending were below expectations. US consumption actually declined in July.

On a 3 month real growth basis, both personal income and expenditures continue to trend down

� New home sales report for July was weak

� The Ugly

� Geopolitics remain a wild card: A war between Russia and Ukraine is by far the biggest danger.

� China’s economy continues to be supported with credit and stimulus, strengthening the problem of

excess capacity and deflating the PPI. Without this support, Chinese economy will sink. China debt

crisis still remains to unfold in our opinion

� Ebola epidemic is spiraling out of control…



Big Four Economic Indicators

� There is no indication of a recession using the indicators monitored by the NBER, even during Q1-2014

� The average of these 4 indicators seems to suggest that the economy is moving sideways

� When adjusted for inflation, retail sales appear to be flattening since March. This is rather

disturbing for us.


The Good: Durable Goods Orders

� July durable goods orders rose by 22.6% thanks mainly to a surge in aircraft orders

� Even capital goods orders (that exclude transportation and defense sectors) have increased by over

8% yoy.

� Growth in US nonresidential fixed investment rose 8.4% during Q2, with investment in commercial

buildings up 9.4% and equipment investment up 10.7%.

� All theses figures confirm the positive trend in US growth


The Bad: PCE

� Real personal consumption (PCE ~70% of GDP) grew at annual rate of just 2% in July.

� PCE current range is 1% lower than the one that was prevailing before 2007 crisis

� PCE rate of growth has been on a negative trend since Mar. ‘14


Eurozone Deflation Risk

� Deflationary forces are proving more

persistent than previously thought,

according to ECB President Draghi, who

also said “within its mandate [the ECB] will

use all the available instruments needed to

ensure price stability over the medium

term”.

� In the Eurozone, short and medium-term

inflation are plunging. 5Y5Y inflation swaps

(one of the measures used by the ECB to

gauge medium-term inflation expectations)

has already slided below 2%


Fed Policy

� According to the large gap between potential and actual GDP, Fed seems a long way from adopting a

restrictive policy…

� The Fed should keep an accommodative stance until the gap is eliminated.


Individual Investor’s Sentiment

� According to the latest AAII Sentiment

Survey,

� bullish sentiment topped 50% for the first

time since end of 2013

� bearish sentiment fell below 20% for the

first time this year.

� Both figures are more than one standard

deviation away from their respective historical

averages.

� According to this data, there are not many

buyers left


Individual Investor’s Sentiment

� The “herd mentality" is in action…

� Individual investors’ exposure to stocks is the

highest since 2007. Cash reserves are the

lowest!

� As stocks are hitting record highs, the level of

cash held by mutual fund managers is also

hitting record lows (3% of assets in June,

according to Ned Davis Research). This is

lower than previous market tops in 2000 and

2007


Consumer Sentiment

� Michigan Consumer Sentiment for August came in at 82.5.

� The Conference Board Index is reflecting the same optimistic mood…


Business Sentiment

� The pattern of the NFIB Business Optimism (capturing the mood of small business owners) Index looks

similar to the Michigan Index.


Any Financial Stress?

� There is no stress at all within the system!


GS – Global Leading Indicator (GLI)

� Little improvement since last

month. The Aug. GLI came in at

3.1%yoy, flat from last month.

Momentum increased to

0.29%mom from last month’s

reading of 0.25%mom.

� GLI places now the global

industrial cycle clearly in the

‘Expansion’ phase (defined by

positive and increasing momentum)

but close to border with

‘Slowdown’.

� 6 of the 10 underlying components

improved in August

� We continue to think that the

current acceleration remains

quite modest for a typical

expansion phase.


US GDP

� The second estimate of Q2-2014 US GDP

was announced at 4.2%, confirming the

weather-related rebound . This is a good

number but still leaves the first half of

the year hardly better than 1%.

� In our view, reaching 2% is still a

challenging target for 2014

� The increase in Q2 real GDP is mainly due

to positive contributions from PCE and

private inventory investment,


Current GDP vs Pre-crisis Trend

� Current GDP is far from filling the gap the financial crisis opened below the pre-crisis trend.

This gap is still widening…

� U.S., like Eurozone, real GDP stands 15% below the pre-crisis trend.


Chinese Economy

� According to Capital Economics, the latest Chinese data suggest a significant loss of momentum in

China's economic growth coming into Q3.

� Growth in electricity output seems to point to a deceleration in industrial activity.


Chinese Economy

� China’s housing market has reached a top at the end of 2013 and, since then, has been going down

at an accelerating pace.

� In July, home prices fell in 64 of the 70 cities the Chinese government tracks


Chinese Economy

� Another sign of weakening fundamentals

is the SHIBOR interest rate curve.

� The curve has become inverted while

declining in level.


EQUITY

� Last month, we had argued that the correction of late July was the beginning of a typical technical

correction with modest fundamental support, and that a fast rebound should follow unless medium-

term supports were broken.

� The dip of last July / early August was recovered and the S&P500 closed above 2000 for the first time

ever this week. Big gains in US and European stocks came on hopes for new ECB stimulus.

� Weak economic outlook is offset by good company earnings (especially in the US), lower bond yields

and lower risk premia.

� We stick, however, with our view that risk-reward trade-off points to a more cautious approach

to the equity markets, at least tactically on the near term.

� We continue to think that any further upside on the S&P 500 should be driven by earnings

growth rather than P/E expansion. But the return potential for equity markets looks corrupted by

limited room for valuation and margin expansion.

� Given the point in the credit cycle, we favor equities over corporate bonds.

� Bottom line :

� We remain Neutral equities. Our prop. trading model is now short targeting 1947 with a stoploss

at 2021. Breaking through the 1900-1920 pivot area on the S&P500 would likely be the signal we

wait for to go short stocks, as that could lead to a temporary sell-off in equities. We keep our UW

on Europe vs. US. We remain neutral to UW on Japan.


EQUITY

� We made the losing bet of underweighting EM stocks since early 2014. Since then, and after

having spent 2013 in the red, the MSCI EM Index has gained 8.5%

� Tactically, we are now positive again on EM equities, as the EM cycle continues to strengthen.

� We like Brazil (fueled by the prospect of political reforms) and India. We remain bearish on China

despite the recent rebound in stocks, as recent cyclical data have been mixed (July credit and

August manufacturing PMI)

� We favor an UW in US small caps vs large caps because of the relative expensiveness of the

former. We are aware that the momentum is currently against us.


US Equity - Earnings

� The Q2 earnings season is over. Per FactSet, earnings grew at 7.7% yoy and sales grew 4.5% �

Any way you look at it, the Q2 earnings season has been very positive

� Earnings growth rate for the S&P 500 was 7.7% in Q2. Combined with the 2.1% growth rate for

Q1, that averages out to less than 5% for the first half of 2014. We expect around 7% growth for

2014 in full. Thus, S&P 500 is trading today at 17.4 times 2014 expected earnings.

� Sustaining 7% earnings growth when sales growth is just 4.5% requires more margins.

Source: Factset


US Equity - Earnings

� Peaking earnings does a good job at predicting market peaks

� Are earnings near a peak? Only time will tell…


S&P500 Technicals

� The S&P500 is currently testing

the very important psychological

2000 level.

� The ability of the index to

continue its upside trend will

depend greatly on the price

action around this major pivot.

� Just keep in mind that the last

move up was mainly driven by

the BCE dovish statement.

� The market looks stretched but

bullish sentiment may drive

higher on no/bad news!

� On the downside, only a clean

break of the Nov. ‘12 uptrend

may change the global

(constructive) picture.


Trading Model - SPX

� Our prop. Short-Term trading model went short on Aug. 18th at 1971.74 on the index

� The model targets 1941 - 1903 and stops its losses at 2021


Emerging Markets

� EM stocks are just recovering from the

losses they experienced since early 2013.

MSCI EM Index is up 8.5% YTD after

having spent 2013 in the red

� We expect EM equities to keep pace with

DM equities (including US equities) and

probably to outperform as they are

supported by strengthening growth and

supportive financial conditions

� The downside risk on this view is linked to

China’s cycle and global risk appetite. EM

stocks are usually the first to suffer a

pullback when conditions get less friendly.

� Tactically (for one or so), we are positive

again on EM equities

28

FIXED INCOME & CREDIT

� We stay underweight on government bonds. We keep our short positioning on UST and expect

10-year yields to reach 2.90%-3.20% over next months, because of sustained US growth, increasing

US inflation. Only a material weekly/monthly close below the 2.40-2.30 range could make us change

our mind.

� A sell-off in Govies will, in our view, induce a sell-off in equities.

� We continue to OW Eurozone vs. US and UK given continued policy divergence and BCE action.

� ECB credit easing measures should induce further Peripheral-Core spread convergence. We see,

however, reasons to be cautious as the current low volatility environment is encouraging complacency.

We remain neutral Peripheral vs Core as we see lasting spread compression to be very limited.

� Our view on TIPS breakevens is unchanged. We remain bullish on them and keep our 5y-TIPS

breakeven wideners.

� Over 12 month horizon, we expect 10Y HICP swaps to move up 20-40 bps. Thus, we go long 10Y

Euro HICP inflation swaps

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

FinLight Research | www.finlightresearch.com

29


� In corporate credit, investors appear to be seeking out risk on the margin, moving down in

quality in search for yield, encouraged by low default rates and benign event risk

� We remain UW on corporate credit, due to valuation, to position within the credit cycle, to the

expected rise in government bond yields and given the weak total return forecast

� Spreads are now so tight that carry and additional spread compression is not enough to compensate for

the rise we expect in government yields (especially in the US). Despite this risk (which normally has a

bigger relative impact on IG then on HY), we continue to prefer IG over HY on a risk-adjusted basis

� Intra credit, we keep our Neutral stance between the US and Europe. European credit has the

potential to outperform its US counterparty. But the tail risk of systemic shocks in European financials is

too big to be ignored.

� Bottom line : Still UW Govies, UW credit, OW TIPS and HICP Inflation, UW High Yield vs High Grade


30


� This has been a minor move higher in spreads thus far, but as credit typically leads, one that

should not be ignored.

� We also like emerging market high yield corporates because they have relatively strong balance

sheets and low expected default rates. Inflows into emerging market bond funds have also been

positive, therefore generating positive price momentum for this asset class.

� Weak growth, low inflation, and easy money have all been very supportive for yield seeking strategies.

We favor seeking extra yield in the higher-yielding government bond markets, both outright and as a

spread to core markets: periphery Euro area, Australia, New Zealand, and Brazil). These are followed

by select FX carry positions in EM, earning roll in energy futures

� Our caution on credit is that spreads are already near past cycle lows and credit tends not to perform

well in later stages of the cycles as corporates then typically start re-levering their balance sheets


31

US Yields

� The long-term trend for

10y UST yield remains

clearly to the downside.

But we detect signs of a

trend exhaustion.

� 10y UST yield stands at a

major support and should

bounce higher from this

point

� We keep our UW on UST

for the moment. Only a

material weekly/monthly

close below the 2.40-2.30

range could make us

change our mind.


32

German Yields

� The 10y German yield

has broken below its

prior cycle lows, without

showing any base

formation.

� The downtrend should

continue over the short

term.


33

Euro HICP inflation

� Given last Draghi’s statement and potential BCE QE next year, we think that Eurozone headline

inflation has reached a trough in Aug. at 0.3%

� Over 12 month horizon, we expect 10Y HICP swaps to move up 20-40 bps. � Open long

position in 10Y Euro HICP inflation swaps


Source: Bloomberg

EUR HICP Inflation Swap EUR HICP Inflation Swap

34

High Yield

� We remain UW on corporate credit, due to valuation, to position within the credit cycle, to the

expected rise in government bond yields and given our weak total return forecast

� Spreads are now so tight that carry and additional spread compression is not enough to compensate

for the rise we expect in government yields (especially in the US). Despite this risk (which normally has

a bigger relative impact on IG then on HY), we continue to prefer IG over HY on a risk-adjusted

basis


Euro HY & IG Total ReturnEuro HY Total Return by Rating

35

High Yield – Monitoring Ratings and Default

� On an issuer base, rolling twelve-month default rate is bottoming

� In the same time, upgrade to downgrade ratio seems to be bouncing. We should keep an eye on this

ratio to detect the relapse we expect given the point where we stand within the credit cycle.


36

High Yield – Issuance

� Easy access to credit has a tendency to increase

defaults

� The global picture is driven by the search for yield.

Investors are moving down in quality and

accepting less protective convenants.


Convenant-lite loan new-issue volume ($Bln)

37

EXCHANGE RATES

� The US dollar is broadly higher against the major and emerging market currencies, mainly driven by the

divergence between the US on one hand and the euro area and Japan on the other

� We continue to expect the USD to strengthen against the major crosses.

� The ECB’s dovish rhetoric and action should gradually drive the Euro weaker. US GDP surge to 4.2% in

Q2 gave another sign that the US and Eurozone economy are diverging. The EUR-USD underlying

structure looks very negative.

� On EUR-USD, we remain UW and continue to target 1.31 - 1.28 and ultimately 1.25 – 1.23

� The ongoing deterioration in Japan's current account deficit , further policy initiatives (including both

additional QE and asset allocation out of domestic bonds), combined with the rise in US yields, should

drive USDJPY higher

� On the USD-JPY, after a consolidation phase during which we moved from UW to Neutral (please see

our previous report), we switched from Neutral to OW with 105.45 as a target. (please see our

previous report). As we are close to the target, we keep our OW position but set a close stoploss at

104.84 and wait for a clear break above the big monthly pivot at 105.6 (that stands on the primary

downtrend from 98)

� EM fundamentals still feel less robust broadly speaking: As the Fed continues to taper (without being

hawkish), we expect many EM currencies to remain under pressure versus USD


38

EUR-USD

� The string of weak

activity data in the Euro

area is clearly weighing

on BCE and EUR

� Over the short term,

EUR-USD seems to be

close to a first support at

1.3105 – 1.3115, on

which we may take some

profit on our previous

short views.

� Breaking this level

should bring EUR-USD

to 1.28, our next target.

� Over the long term, the

picture remains very

skewed towards 1.23


39

USD-JPY

� A set of disappointing data

recently released for July has

reinforced the doubts about

Abenomics economic impact.

Additional easing should be

negative for JPY.

� Last month, we saw USD-

JPY breaking higher through

a triangle consolidation

pattern and set 105.45

(January high) as a

reasonable short-term target.

� As we are close to the target,

we keep our OW position but

set a close stoploss at 104.84

� We still wait for a clear break

above the big monthly pivot

at 105.6 (that stands on the

primary downtrend from 98)


40

COMMODITY

� We have been OW commodities since end of June, with a preference for energy and base metals and an

UW on agriculture and precious metals. Unfortunately, commodities are down another 1.6% over August

(and a substantial -6.8% QTD : from Jun.30 to Aug. 29) led lower by energy (-7.5% QTD) and agriculture

(-9.4% QTD). Our tilted position has made money vs. the benchmark because our losing bet on

energy was counterbalanced by our UW on agri, and because we were also UW Precious metals (-3.3%

QTD) and OW Industrial Metals (+3.5% QTD)

� We continue to like owning the GSCI energy index. Prices have fallen too far in our view

� We continue to think that commodities hold value as cross-asset portfolio diversifiers.

� While we are neutral on prices we continue to see substantially positive roll returns in many

commodities.

� We remain OW commodities but with a dispersion in views across the different sectors. At this stage,

individual fundamentals matter a lot!

� We maintain most of our previous views: OW on energy (on geopolitical tensions), favoring

commodity futures with steep backwardation (for positive carry). We also remained UW on

agriculture (except on premium coffee and cocoa) and precious metals.

� We become UW on base metals as Chinese manufacturing PMI has now fallen for two months in a row.

Within the industrial metals complex, we prefer Zink, Nickel and Aluminium to copper and Iron Ore,


41

COMMODITY

� We choose to keep our OW bias on energy (especially crude oil) for strong roll and as a hedge for

geopolitical risk in Ukraine and Middle-East, as well as supply risk in Lybia.

� .Among base metals, we still prefer Aluminium, Zinc and Nickel as these metals suffer from a low

supply growth following years of underinvestment

� Over the second half of 2014, we continue to see significant downside for :

� Agriculture, as there are expectations of record inventory builds for staple cereals. We keep

however our OW view on premium coffee and cocoa because of the risk of El Nino and weather

volatility around the equator

� Precious metals: We think that recent gains in gold cannot be sustained as US real rates, the

S&P500 and the US dollar move higher. We expect precious metals to resume their downward trend

(targeting 1170-1150 on gold and 17 and eventually 12.50 on silver)

� Among base metals, Copper is expected to underperform sharply over a 3-12m horizon, due to

sluggish demand growth, especially by the construction sector in China. We target 6400 (Q3-2014),

and ultimately 6000.


42

Market Sentiment

� Accourding to SentimentTrader, market sentiment is at “excessive pessimism” level.

� If history is any guide, commodities should bounce from this point


Source: Sentimenttrader

43

Gold

� The weak gold demand from China and

India and strong dollar are weighing on

gold prices, On the other hand,

geopolitical events, and gold buying by

central banks are still supporting them.

� At this stage, the risk is still biased to the

downside. Our model favor another low

(around 1050-1150) before reaching a

multi-year bottom.

� We remain bearish on gold and silver,

but aware that if the situation in Middle-

East or Ukraine deteriorates then gold

prices may break to the upside (above

1350-1400). Under 1170-1150, we start to

accumulate gold, even if an eventual

retracement towards 1000 looks possible

� Technically speaking, it’s a matter of

weeks before we see the final

resolution (up or down)


44

Gold Miners

� Most of gold miners

underperformance vs. gold

(the commodity) since early

2012 could be explained by

delays in new projects and

cost overruns.

� Given the new focus of

CEOs on containing costs

and correctly assessing /

boosting profitability, we

think that gold miners

could outperform gold

going forward, but still wait

for a bounce in gold prices

(after a last leg down) before

betting on that

outperformance.


45

VOLATILITY

� We stick to the view that volatility is

bottoming after months of historical lows

through improving economic outlooks. We still

expect an upward pressure on vol over the

coming months, with rising inflation volatility,

rising earnings volatility and increasing default

rates and macro surprises

� The rise in implied volatilities we’ve seen in

July has reversed in August, especially on

equities and credit. It was more technical than

fondamental.

� On average, implied vols across the 5 asset

classes has fallen to historical lows. But

realized vols has fallen even more making

it very unattractive to be long vol.

� Buying hedge funds with volatility positive

positioning is probably the solution


46

ALTERNATIVE STRATEGIES

� As markets recouped their losses of early August, Hedge Funds which are overall long risk, recovered

from their previous difficult months.

� Long Term CTAs were among the best performers during the month as they made money out of their

long equities, long rates, short energy and short EUR/USD.

� Things were more mixed for Global Macro which suffered from long energy positions and made

money from directional trades in the Yen and the Euro

� Market Neutral recovered strongly thanks to both positive beta and alpha contribution. They made

gains across factor-based models as well as fundamental and trading oriented strategies, according

to HFRX indices.

� Within the Vol. Arb. Universe, the picture was mixed: Only funds with short positioning on volatility

made money.

� We maintain our previous positioning: While preferring risk diversifiers to return enhancers, on a risk-

adjusted basis, we keep our OW on:

� Equity Market Neutrals both for their “intelligent” beta and their alpha contribution

� CTA’s and Global Macro as a diversifier and tail hedge.

� Vol. Arb strategy and prefer funds that trade volatility globally (all assets / all regions). This strategy

has shown a great ability in terms of protecting capital during adverse periods, and a volatility that

compares favorably with the hedge fund industry.

� We keep our Neutral stance on Event-Driven, as M&A activity is calming down, volatility is likely to

bounce, and geopolitics are threatening…


47

Event Driven

� Event Driven strategies have been the best performing strategy over the last 12 months.

� 37% of investors surveyed by Preqin in July 2014 stated that Event Driven performance over the

previous 12 months has exceed expectations.

� We think that M&A activity is calming down. Deals withdrawn or terminated are increasing…


Hedge Fund Strategies Sought by Investors over next 12 Months

48

Global Macro

� In term of performance, global macro

strategies are ahead of where they

were in 2013. Macro was the best

performing strategy in Q2 2014. The

last time it did that was in Q3 2011.

� Like CTAs, Macro strategies funds

have clearly failed to meet the

expectations of institutional

investors, with 48% of investors

(Preqin Survey) saying that this

strategy had disappointed.

� Nevertheless, we like Global Macro

for their lower volatility, lower

correlation to equity markets, and

their proved ability to mitigate losses

should the tides turn in equity

markets. It’s well known that Macro

hedge funds deliver higher Sharpe

ratios during recessions than any

other hedge fund strategy.


Hedge Fund Portfolio Performance Relative to Expectations

over the last 12 Months by Strategy

49

CTA

� CTAs has reduced their exposure to European

equities

� CTAs have been also reducing their net

exposure to Energy since June. This move

was beneficial for the performance over

August.


Bottom Line: Global Asset Allocation

� Economic news has been mixed with week consumption, but

yet strong confidence. Demand growth is far below what the US

economy is accustomed to.

� Eurozone financial markets can hardly be read other than as

anticipating a triple-dip recession

� Risky assets are not priced for any alternative scenario other than

the optimistic one. Current market sentiments are way too

optimistic. We do not want to be exposed to such a biased

situation..

� Equity markets are near record highs, but there are warning

signals that should not be ignored. Stocks keep rising on bad

news because bad news implies more central bank stimulus, and

more cash injection.

� We continue to see the main systemic risk coming from

China. China debt crisis still remains to unfold in our opinion.

� We remain neutral on global equities and think earnings growth

should be the only driver of markets from here. We remain

overweight commodities (but with a dispersion in views across

the sectors as individual fundamentals matter) and underweight

credit and government bonds. We continue to bet on USD

strengthening and on a spike in the VIX

� We summarize our views as follows �


51

Disclaimer


This writing is for informational purposes only and does not constitute an

offer to sell, a solicitation to buy, or a recommendation regarding any

securities transaction, or as an offer to provide advisory or other services

by FinLight Research in any jurisdiction in which such offer, solicitation,

purchase or sale would be unlawful under the securities laws of such

jurisdiction. The information contained in this writing should not be

construed as financial or investment advice on any subject matter.

FinLight Research expressly disclaims all liability in respect to actions

taken based on any or all of the information on this writing.

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perspective, on Portfolio Construction, and all related quantitative aspects and risk management issues.

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carry, volatility), real assets (real estate, infrastructure, farmland, timberland and natural resources).

Private equity and venture capital should be the next step…

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finlight research | market perspectives - sep 2014

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