ARIA Capital Management ATP Quarterly- Mercury Rising

January 2017

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» We see the global reflation trade continuing in 2017
» Regime change from monetary to fiscal policy means new winners and losers
» Economic activity measures are surprisingly on the upside
» The trajectory of US interest rates remains key to all asset class performance
» The stronger the US Dollar, the more likely commodities and emerging currencies suffer
» The new sector leaders of financials, healthcare and cyclicals have lots of time to run
» European and Japanese large cap preferred to US large cap
» Market momentum likely to persist for the early part of 2017

The global economy is likely in the first innings of a reflationary period, where deflationary forces are on the back foot, yet inflationary pressures rise only modestly. Activity data is surprising to the upside and leading economic indicators have turned higher. Belatedly, although nonetheless welcome, easier fiscal policy is providing a helping hand to growth again. Once more this is a trend early in its life cycle.


Unsurprisingly, market-based measures of inflation expectations are unmistakably trending up, as yet to be matched by rising nominal interest rates. This could be the wellspring of a pick-up in both business and personal consumption.


As financial markets and the global economy is gradually weaned off of the medicinal drip of unprecedented monetary stimulus, towards fiscal support, there is a risk that investors price in a smoother transition than inevitably transpires. The sharp move higher in equity markets since the US Presidential election, and the recent rise in business and consumer confidence are testament to that. Monetary policy was extraordinarily effective at inflating the value of financial assets, but it was clearly not as effective at strengthening the underlying fundamentals of the economy. As we stand the bearish posture would suggest that the coming fiscal expansion will not be sufficient to cure the more structural problems faced globally. A more positive persuasion gives the change in sentiment the benefit of the doubt. We believe the reflationary trends to be well set − rising nominal growth, wages and inflation – improving further globally in 2017, led by the U.S. This theme is central to how we are positioning portfolios for the coming year, including our preference for value stocks in the Eurozone and Japan, over bond proxies, or fixed income more generally, which have been the winners of recent years. The reflationary theme has already seen a major divergence in winning and losing sectors of the stock market, and much like the new President elect, will remain a divisive force for months to come.


The Trump administration has proposed a series of pro-growth initiatives that it asserts will restore the rate of US economic growth to a sustainable 4% growth rate. Regardless of whether this a realistic growth rate, animal spirits have been lifted. That said, as we set out in our last commentary (the Pound in your Pocket), we anticipated that earnings were to bottom in the fourth quarter of 2016. Having fallen for six consecutive quarters, it appears that there has been a bottoming in the earnings cycle. Potentially, Donald Trump has ‘timed’ his election very well, picking up an economy already on an improving trajectory.

However, as always, there is reason for caution. Within our asset allocation framework, we place significant store in the ‘liquidity’ environment. When liquidity is ample, financial markets generally move higher. In the short term, there is a growing divergence between the S&P 500 Index and the Goldman Sachs Financial Conditions index, which measures how loose or tight financial conditions are in the real economy. There was a very close correlation between these two indices up until the presidential election, but now they are moving in opposite directions. This reflects a stronger US Dollar and rising interest rates leading to a further tightening in financial conditions. That said the momentum in markets is strong, and it will likely need a sharp break higher in interest rates to derail the move in the coming weeks.


Ultimately markets are driven by company earnings. In fact, financial markets generally have held up remarkably well over the last two years given very uninspiring company earnings. However, we suggested a bottoming could well be afoot in the final quarter of 2017. S&P 500 corporate earnings rose on a year-over-year basis in the third quarter for the first time since the first quarter of 2015. Consensus estimates are for profits to rise 3.2% in the current quarter, followed by earnings growth of 11.5% in 2017. This would be a major plank in any new bull market, and provide ‘back bone’ to the bull, should some of the early enthusiasm for Donald and the Trumpettes dissipate as it becomes clearer that major tax reform will be a hard won, long drawn out battle.
Analysts have suggested that reducing the effective corporate tax rate to 20% could add as much as $10 to the consensus estimate of approximately $132 for the S&P 500 index. Lower tax rates on corporate cash that is repatriated from overseas could well extend the tsunami of stock buybacks, which have until now flattered earnings by reducing the number of shares amongst which they have to be shared by. Of course, infrastructure spend was a significant part of the Trump election campaign. The borrowing required to finance such proposals would likely push both interest rates and the US Dollar higher this year. We see a significant move higher in both these markets as the biggest single threat to the equity markets in the first half of the year.

As companies buy back their shares it reduces the number of shares outstanding for companies. That results in increasing earnings per share, by shrinking the latter number even if revenues or earnings aren’t improving. It would appear that this activity has peaked – and that to continue to improve earnings, companies will have to grow revenues organically. This is not to say that they can’t, but the percentage of companies in the S&P 500 that are employing buybacks to shrink their outstanding share count on a year-over-year basis peaked at 65%, which ominously is the same peak percentage we saw in 2007. As the chart above shows, it is declining along with total shares repurchased and the number of companies that are purchasing. It simply means that an important historic leg of the bull market to date has been kicked away.


In closing our Q3 letter, we highlighted the plight of the Eurobanks. From a chart perspective, against a backdrop of the most dire of headlines, it appeared the bank stocks in Europe were beginning to turnaround. Performance has continued to be firm – we wonder whether European banks are ultimately one of the best performing sectors in 2017.

The European economy, according to BCA Research, actually outperformed the US in 2016 in real terms, having expanded by 1.9%, compared to 1.6% over the pond. This hasn’t happened since 2007. The Euro political class finally shelved fiscal austerity measures.

The ECB is well aware of the need to further improve the balance sheets of European financial institutions and whilst having not ‘cleaned house’ as the US did, efforts continue. Moreover, as stresses in the banking system fade, southern Europe benefits. (That said we feel that Greece and Grexit still remains a necessary event, and one perhaps that will yet make headlines during 2017). There is perhaps a ‘political risk premium’ already priced into European shares. We do not believe that Marine le Pen, leader of the populist eurosceptic National Front will win out. Much of the potential for electoral shocks we believe is already priced into eurozone share prices. Italy may yet cause greater consternation and the Euro has less support amongst the Italian voters than almost any other country.

Of course, during March it’s expected that Teresa May will formally announce that the Brexit process has begun. It’s difficult to see beyond EU officials wanting to do anything other than send a very strong warning to others contemplating leaving the Eurozone club and hence negotiations will surely be protracted and terse at times. We also wouldn’t rule out another referendum being offered to the UK electorate once the terms of leaving the EU are clearer. There is much water to pass under the Brexit bridge before a definitive expulsion of Britain from Europe. It’s also unlikely that Scotland will sit idly by and watch Britain edge nearer to triggering Article 50, without demanding another referendum on its own future within the 300 year old union.

There are pockets of the global economy which still benefit from monetary stimulus – most notably Europe and Japan. Interest rates are unlikely to move at all and thus weaker currencies relative to the US Dollar should support their markets. In the large cap space, we much prefer European and Japanese companies to those of the US indices, on valuations grounds too, rather than simply being the beneficiary of weaker currencies. Emerging markets may yet see a rocky ride. As the US Dollar strengthens, whilst their currencies will weaken improving their terms of trade, it will also likely see some softness in commodity prices too, which of course many of their fortunes are tied too as exporters. Within emerging markets we would certainly take a ‘relative stance’ – investing in markets such as Korea, Thailand and Taiwan, whilst simultaneously hedging with positions against Turkey, Brazil and Peru.

From an equity sector perspective, the major determinant needs to be the path of interest rates. Whilst they trend higher, the sectors to favour include banks, healthcare and value stocks (see Chart 1). Should yield curves continue to steepen, banks net interest rate margins (the principle determinant of their earnings) increase, and share prices will continue to benefit. In fact, the ‘deflationary tide’ was so entrenched, that there is likely significant monies still invested into more defensive sectors such as REITs, utilities and consumer staples and hence the rotation of funds into what would be new leading sectors in a reflationary environment could have months and months to run. Finally, we have already seen significant outperformance of smaller company stocks relative to larger caps. Should corporate tax cuts prevail, they would be much more sensitive to the benefits, as compared to the bigger beasts of the US stock markets.


The traditional orthodoxy is that deflation is generally not conducive to attractive stock market returns, nor for that matter is stagflation. However, the stages of the inflation cycle which sit in between, reflation being one of them, are historically much more supportive. On balance, we can see a generally positive window for equity markets over the next 18 months. However, we do expect some notable 10% corrections to challenge investor’s faith in stock market’s upwards trajectory. These setbacks, historically commonplace, have been conspicuous in their absence in a monetary policy driven environment. The transition towards a new regime where fiscal policy takes the lead, will also herald a return to historical norms, where corrections in markets can be shuddering.

Reflation does not mean inflation. Before inflation we would need to experience economies globally overheating. The persistent weakness in the Euro has the potential to cause Germany difficulties, to the extent it is highly geared to exports and a weaker currency has meant strong German economic momentum. The current ECB set interest rates may be appropriate for Italy, Spain and Portugal but not Germany – a country with a distinct intolerance of inflationary pressures. Rising inflation in the US would lead to a higher greenback, US interest rate hikes and a natural restraint on inflation as the economic brakes are applied. There is still someway to go until the ‘inflation genie is out of the bottle’.

The prospect of serious tax cuts seems to be sufficient for rising investor sentiment and prices. By our lights, they will likely have a more pronounced impact on the stock market than the real economy. Momentum in markets may yet persist for a while, before preceding a decline that does more than raise eye brows. That could well be the best risk-adjusted entry point for the year. In anticipation we would likely raise cash, whilst we remain optimistic for the potential gains that can be made in this reflationary window, supported by a transition towards a fiscally led environment from an artificially stimulated monetary regime. It would be naïve not to expect a pothole or two. Regime changes are rarely seamless, if not divisive, both a newly minted reflationary environment and leader of the free world will precipitate the mercury rising in both political and financial markets.

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ARIA Capital management is a fully integrated company offering wealth management, fund management, stockbroking and structured investments, with a focus on absolute return investing. It is authorised and regulated by the financial conduct authority in the UK, and has offices in London and Dubai.

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