finlight research

Market PerspectivesMar 2014

March 7th, 2014

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Executive Summary: Global Asset Allocation

� Whatever the EM and geopolitical risks in focus, the main systemic risk remains China . China accounts for around 15% of world GDP

� At this stage, and over the short-term, we remain g lobally long risk, with some tail hedges.

� We summarize our views as follows �

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MACRO VIEW

� The Good� Earnings growth is still solid� Jobless claims remain in a rather healthy 300-350k range.� Consumer confidence is holding up� Eurozone IFO and PMIs are at near 3 year highs� On an inflation-adjusted basis, household balance sheets have now finally made a complete

recovery from the effects of the global financial crisis, boosted by stock and housing markets

� The Bad� Weak US retail sales reports and more announced store closings� GDP was revised lower from the Advance Estimate of 3.2%, to an annualized rate of 2.4%. � Pending home sales are down 9% YoY� Three of the big four economic indicators are showing a decline � ISM services was very weak at 51.6 and trending to the downside� Chinese dataflow continues to disappoint, with the February flash PMI falling to the lowest level since

July ‘13� Ukraine situation remains a big concern

� The Ugly � China potential troubles during this new Jiawu year, now that money supply growth is slowing down

sharply

Big Four Economic Indicators

� The global picture is that of a slow recovery. � The data for the past two months are showing contraction.� Among the 4 indicators, two (Real Retail Sales and Industrial Production) have already reached their all-

time highs. Nonfarm Employment remains on a positive trend. Only Real Personal Income is still struggling.

Real Disposable income

� Real disposable income has been slowing for three years…

� This could explain the similar trend in consumption and even in capital spending

Household Income

� The decline in real median household income over the last five years could explain the consumerspending contraction.

Employment

� According to the Labor Department reports, newfilings for unemployment benefits fell 26,000 lastweek to a seasonally adjusted 323,000. But nothingexciting yet…

� The Job Report for February was a surprisinglydecent one.

� 175,000 jobs were added to the U.S. economy. Theunemployment rate rose slightly, up 0.1% to 6.7% .December and January were both revised upwardby a total of +25,000.

Employment

� There is clearly more confidence about the employment situation.� The present situation component of the Consumer Confidence Index (CCI) rose to a new cyclical

high. Expectations are on the same trend…

Inflation

� The disinflationary trend in Core PCE Price Index continues…� After years of ZIRP and QE, Core PCE continues to move in the wrong direction. Troubling!

Inflation in Eurozone

� A Japan-style deflation trap is not impossible…� Inflation may stabilize if GDP growth picks up

Durable Goods

� The latest new orders number came in at -1.0% percent MoM and 4.6%YoY� If we exclude transportation, "core" durable goods came in at 1.1% MoM and 1.2% YoY.� If we exclude both transportation and defense, durable goods were flat MoM and up only 0.8% YoY.� The S&P500 continues to pull away from the durable goods figures

� At 51.6, the ISM Services was the lowestsince February 2010. The ISM Composite(51.8) was also the weakest since February2010.

� Both charts start looking ugly…

Eurozone Recovery?

� Consumer confidence stands at the highest since mid ’11, pointing to an increase in spending ahead.� IFO and PMI are at near 3 year highs

Eurozone PMI

� At 53.2 in February, the final seasonally adjusted Markit Eurozone Manufacturing PMI came in abovethe earlier flash estimate of 53.0

� France PMI is still in negative territories with 49.7. French PMI momentum has decoupled from the restof Eurozone and FDI has collapsed.

� Peripheral PMIs are at their highest level compared to core since 2004.

Housing

� There is clear deceleration in the housing market over the course of 2013

Consumer Sentiment

� the University of Michigan Consumer Sentiment finalnumber for February came in at 81.6, a bit stronger thanthe 81.2 January final.

� The Conference Board Consumer Confidence Indexdecreased by 1.63% in February

� We see the same broad pattern in the Conference BoardConsumer Confidence Index as well as for small businessowners (NFIB Business Optimism Index)

Household Net Worth

� On an inflation-adjusted basis, household balance sheets have now finally made a complete recoveryfrom the effects of the global financial crisis, boosted by stock and housing markets

� Financial market (equity, pensions and mutual funds) gains now account for 43% of total householdassets. This contribution was only marginally higher during the tech bubble.

Household Balance Sheet

� Is the Household BS really repaired?� The ratio of liabilities to net worth is now below the trend line

Real GDP

� GDP was revised lower from the Advance Estimate of 3.2%, to an annualized rate of 2.4%.� The Q4 contribution from PCE came at 1.73%. This is a downward revision from the 2.26%

contribution in the Advance Estimate.

GS – Global Leading Indicator (GLI)

� The GLI still locates the globalindustrial cycle in the ‘Slowdown’phase

� Only 2 of the 10 underlyingcomponents improved in February

China – Troubles ahead

� Chinese dataflow continues to disappoint� February flash PMI falling to the lowest level since July ‘13

� China's narrow M1 money supply and thebroader M2 are now growing at levels notseen in many years

� In Feb 14, China's M1 money supplycontracted sharply

� Slowdown is obvious in bank loan growthand "total social financing“ (includingshadow banking)

� PMI data have been consistently weak forinstance, especially in the manufacturing sector

� In real estate, the rate of price increases in thelarge cities has begun to turn down lately

� Chinese banks NPL ratio should be growingfaster that official estimates

� A harder access to credit should reveal capitalmalinvestment, large unused industrialcapacities …

Market Flows

� Market flows are benefitting equities (driving P/E higher), and getting out of bonds…

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EQUITY

� Markets are now back to their highs…

� We continue to think that any further upside on the S&P 500 should be driven by profit growth rather than P/E expansion

� Geopolitical risks, particularly in Ukraine, remain worrying.

� In our February report, we have been for a limited correction (5% to 10%) on equities, targeting the 1757 - 1722 area on the S&P 500. The S&P500 stopped its downside move at 1742

� Bottom line :

� We are Neutral equities

� We keep our UW on (deflationary) Europe and EM vs. US and Japan

� We keep our bias to defensive high-yielding stocks.

� Industrials and Tech are our preferred sectors as they have positive betas to the 10y yield and a very strong earnings revision momentum

Earnings

� Earnings revisions remain in negative territory, bo th for Europe and the US.� 74% of S&P500 names have beaten Q4-2013 (lowered) earnings estimates. Q4 EPS growth is 9%

YoY.� Q1-2014 S&P500 earnings growth is now expected at +2.4%, which will be the lowest rate of growth

since Q3-2012� In Europe, only 53% of companies have beaten earnings estimates, with a negative surprise of about -

4% so far.

S&P500 – Earnings

� Price performance is still coherent with last-twelve-month EPS� But earnings estimates continue to go south

MSCI Eurozone – Earnings

� Eurozone equity performance over the last 3 years is entirely explained by PE expansion.� Eurozone EPS is now 35% below its 2007 highs

S&P500 – Investors Sentiment

� Investors seem confident about future economic outcomes, as they continue to prefer growth-oriented consumer stocks over more conservative consumer staples stocks

S&P500 – Earnings, Sales and Margins

� Most analysts are still optimistic on EPS growth� Sales, like margins, are stabilizing…

S&P500 – Short-Term View

� The LT structure for the S&P500 still looks very bullish. The index has pushed above the big trend of the highs of 2000 and 2007.

� Like during the period from Jul. / Aug 2013, and given the negatively diverging oscillators, the break above Jan ‘14 high could be unsustained.

� A pull back to the Jan. 15th high at 1,851 seems possible. Below it we should target the 100-dma around 1800

Equity Derivatives

� The skew seems very high, implying that the market remains concerned by the downside risks

Demand & Supply Balance

� The demand-supply balance is supported by solid buybacks, trend inflows and short covering…

Japanese Equity

� The Nikkei (Blue) and USD-JPY (red) have been the major beneficiaries of the ongoing liquidity (Broad Money in green) additions from the BOJ.

EM Equity

� EM situation remains precarious� EM equities have underperformed for the last 3 years.� Outflows from EM equities are not showing signs of stabilization and EM FX is still volatile.

Large Speculators / HF Positions

� According to CFTC data (Feb. 25th) Large Specs have reduced their S&P 500 shorts a little, before reaching the crowded short zone

� Macro HFs reduced their long exposure to S&P500 and took short exposure to NASDAQ.

Trading Model - SPX

� Our prop. Short-Term trading model went massively short on Mar. 4th at 1873.91 on the index� The model targets 1865 – 1847 - 1757 and stops its lo sses at 1903-1942

FIXED INCOME & CREDIT

� In Govies, we keep our core strategic view for high er long-end yields going forward, especially in US and UK .

� Turmoil in Emerging Markets and geopolitical risks continued to provide support for DM fixed income through flight to quality flows. But, we expect the selloff on Treasuries to resume very soon.

� Last month, on UST 10y yield, we said “But given the continued downside pressure we see on this level, we prefer to wait either for a clean breakdown (targeting 2.54) or for a clear rebound (to put on our short positions).” The rebound was clear on 2.60 and we are now short UST

� We continue to OW Eurozone vs. US and UK given disinflationary risks in Europe.

� Within the Eurozone, we stay neutral Peripheral vs Core as we see lasting spread compression to be very limited if any.

� We stay neutral on TIPS

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

FIXED INCOME & CREDIT

� In corporate credit, we think the search-for-yield is likely to remain strong as growth improves, monetary policy still remains accommodative, inflation stays low and macro risks remains contained

� We think spreads will tighten slightly over the rest of the year. Given the rising government bond yields, we choose to stay neutral on credit as a whole .

� We stay OW High-Yield (BB and B) vs Investment Grad e, and OW European HY vs US High Yield

� Bottom line : UW Govies, Neutral credit, neutral TIPS, keep our OW High Yield vs High Grade

US Govies

� Negative economic surprises (CitigroupEconomic Surprise – US, Blue, RHS)seem to drive the 10y UST yield (Red,LHS)

� Both should reverse their course in thecoming days / weeks

� But if the data continue to surprise to thedownside, an extended move lower inyields may be possible 2.45. Breaking thiscritical level would oblige us to revise ourtactical short on UST

Large Speculators Positions

� According to CFTC data (Feb. 25th) Large Specs have decreased their UST 10y short position, before reaching the crowded short zone

� Macro HF increased their short exposure to 10-year treasuries.

Eurozone Govies

� Bund yields should stay around current levels (1.65%-1.70%). Thus, we see UST-Bund spread to widen this year

� Peripheral spreads and yields keep compressing

� We think that most of the move is now already done. Thus, we stay neutral Peripheral vs Core.as we see lasting spread compression to be very limited if any.

US High Yield

� HY bond yields are down 49bp over February to 5.30%. HY bond spreads are 45bp tighter since early February to a post crisis low of 416bp.

� Further spread compressions seems limited even if reproducing the last credit cycle exuberance (374bp in 2004-06) is still possible!

Credit Derivatives

� Our tactical position (OW HY vs IG, to prefer BB & B bonds within the HY class) was profitable. We keep it for the moment.

� The relevant spreads are now reaching their historical lows. Our position will be reviewed at the end of the month.

Credit Derivatives

� Both CDX.IG and CDX.HY are trading at multiyear lows in spread.

� CDX.HY trades very close to its all-time lows of 2007

� As expected in our previous monthly report, iTraxxXover has outperformed CDX.HY

Credit vs Equity

� HY issuers are taking advantage of favorable new-issue conditions. An important part of the debt issuance by US corporates is being used for shareholder friendly activity (share buybacks, dividends)This

� Our view is that credit should continue to underperform equities as re-leveraging risk increases substantially.

Credit

� In credit, too much money is chasing too few assets.. Investors continue to move down in quality in search for higher returns.

� In our view, corporate re-leveraging remains the largest risk to credit quality.

� Net debt is on the rise and EBITDA is falling, most notably in large caps in core countries

� Fundamentals should continue their steady deterioration because of rising corporate leverage, M&A and share buybacks

� There are a lot of similarities with 2006-07 period

EXCHANGE RATES

� We keep our view for a stronger USD index in 2014 b ased on higher US rates and non-US fundamental weakness

� On the short-term, our tactical long USD against EUR loosed money.

� On the EUR-USD, the pull back to 1.31-1.25 we were waiting for has not materialized. We are now Neutral and wait for a clean break above 1.3825-33 (targeting 1.42) or a reverse back below the downtrend from 2008 high

� On the USD-JPY, we stay Neutral , watching for signs of a clean break above the area 103.27-103.73 tobecome OW (and target 105.60 and 106.10)

� Given the broad picture of EM markets, we stay short EM currencies (on countries with the largest currentaccount deficit) vs USD

EUR-USD

� Contrary to our views, the EUR showed a lot of resilience against US$.

� EUR is now breaking above its downtrend from the 2008 high at 1.3825.

� At this stage we prefer to take a Neutral stance, keep an eye on the current level and wait for a clean break above 1.3825-33 (targeting 1.42) or a reverse back below the downtrend from 2008 high

USD-JPY

� Fundamentally, we still look for a weaker Yen as further lifting from BOJ is expected to counter the economic deteriorating data

� Last month, we said that a clean break below 102.30 should open the door to a test of 101.50. We’ve been even lower…

� Now, we stay Neutral, watchingfor signs of a clean break abovethe area 103.27-103.73 to becomeOW (and target 105.60 and106.10)

Large Speculators / HF Positions

� According to CFTC data (Feb. 25th) Large specs have:

� covered net shorts in EUR at -$1.0bn to become net long $1.2bn.

� increased their Yen shorts to -$9.7bn � Bull Yen?

� Macro HFs maintained their short exposure to US Dollar Index

EM Currencies

� EM currencies are suffering from the broad picture of deteriorating current account balances, less foreign investment in EM assets and declining growth expectations

� More weakness should be expected over the short to medium-term

COMMODITY

� We started 2014 by going OW on commodities, as we think that a more positive fundamental picture is gradually developing. Commodities are outperforming other assets so far this year, despite the difficult macro-economic environment (China, EMs, higher US$…).

� We expect the GSCI index to deliver 5% to 10% thanks mainly to backwardation

� Recently, commodity prices have been even much stronger than we expected, thanks to exceptional weather conditions in US (for energy), droughts in Brazil (for crops). Thus, we prefer to move commodities to UW on the short run.

� Over the short run, � We remain Neutral on Energy� We are Neutral to moderately UW on Agriculture (because of higher supply) except premium coffee

and cocoa (where we are OW)� We are UW on base metals because of overabundance of supply, especially for copper� Although sentiment is clearly improving (short interest is reduced, outflows seems exhausted), we

think that a short-term consolidation is unavoidable after the strong upward move. We stay UW precious metals (targeting 1180-1150 on gold and 18-17 on silver) because of rising real interest rates and strengthening of the dollar.

� Reaching a base will give a buying signal not only on physical gold but also on gold miners.

� Over the MT, we stay UW copper . The downside risk due to increasing supply is too significant to be ignored. We target 6600, and ultimately 6000.

Gold – Investors’ Sentiment

� Gold ETP flow data show that after 13 straight months of net redemptions, February posted a net inflow.

� In our view, this is a first requirement for stabilization. This is not enough to declare a turning point in gold… Gold investors should step in

Gold – Investors’ Sentiment

� Sentiment is improving on gold…

� Looking at short interest in GLD (biggest physically backed gold ETP), we see it at 12.5mn shares (1.25 Moz), the lowest level since March ’12. This is less then half its peak of last year (30.8mn shares)

Gold – Technical View

� Thus far, price action from June ‘13 onwards appears as a correction of the drop from the Oct. ‘12 high. This will be the case as far as the move remains contained within 38.2% of the drop (below 1411 -1433)

� Once this correction is finished, gold should resume its downtrend to 1180 - 1170

� Over the ST, the range 1335 – 1360 seems critical. A break of either side should lead to a further run in that direction.

Gold – Fair Value Price

� Our theoretical price (implied by US$, sovereign CDS and Real Rates) stands now at 1170 (as of Feb 28th), versus a market price at 1322. Our fair price should continue its downward movement as soon as the US$ and real rates resume their move to the upside.

Gold vs Gold Miners

� The ratio between Gold Miners and Physical Gold is very stretched, near 1 standard deviation below trend since 2001, and 2 Std. Dev. Since 1984

� Reaching a base on gold will give a buying signal on gold miners.

Large Speculators Positions

� According to CFTC data (Feb. 25th) Large specs have:� On Metals: Large specs increased Gold and

Silver long exposure, and decreased their shorts in Copper.

� increased WTI crude oil longs to $42.6bn from $38.2bn notional. Being in the crowded long zone should give a bearish signal on the crude.

� Macro HFs decreased their long exposure to commodities as a whole

ALTERNATIVE INVESTMENTS

� We are always OW on AI as we expect a 10% return in the coming year versus 5% on a traditional balanced portfolio (stocks + bonds+ cash).

� Our overweight position focuses on Commercial Real Estate (even if the current message is still mixed)

� We are OW Equity long-short market-neutral, Convertible arbitrage, CTA’s and Global Macro

Global Macro Strategy

� Global Macro remains one of our favorite risk-diversifier strategies

Other AIs

� US Private Equity and US Property continue to outperform equities on a risk-return basis

Bottom Line : Global Asset Allocation

� Whatever the EM and geopolitical risks in focus, the main systemic risk remains China . China accounts for around 15% of world GDP

� At this stage, and over the short-term, we remain g lobally long risk, with some tail hedges.

� We summarize our views as follows �

finlight research - market perspectives mar 2014

eurozone pmi

consumer confidence

eurozone recovery

consumer spending contraction

core durable goods

flash pmi

eurozone ifo

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