Legacy Weath Weekly - July 8, 2016 (From Downside to Upside Risk)
Penni Johnston-gill - Jul 08, 2016
In the July edition of the Quantitative Strategist published Monday, we suggested that new lows on US investment grade bond yields could lead to new highs on the S&P 500. Here we are this week with Moody’s Baa yields falling to 1956 lows at 4.2% and
Weekly Market Wrap-Up: From Downside to Upside Risk
In the July edition of the Quantitative Strategist published Monday, we suggested that new lows on US investment grade bond yields could lead to new highs on the S&P 500. Here we are this week with Moody’s Baa yields falling to 1956 lows at 4.2% and the S&P 500 just a fraction short of its all-time high at 2,135. With bond yields falling once again this week, the dividend yield on the S&P 500 is now above US Treasury 30-year bond yields for the first time since the 2008-09 global financial crisis. Could the “dividend-yield” trade become a broad “equity-market” trade and push unloved US equities to new highs? Credit says yes! Again this week, higher-risk debt instruments such as US high-yields (HYG-US) and emerging-market debt (EMB-US) rose to multi-week highs in prices. Moreover, high-dividend yielders such telecoms and utilities lagged the market rally. Those are positive inter-market dynamics that will need to prevail for equities to push to and sustain new highs. Ditto for corporate earnings where the reporting season begins next week. S&P 500 earnings-growth expectations stand at -4.8% YoY. Forward EPS estimates must continue to climb or else the spread between the S&P 500 forward P/E ratio and the VIX could flash red again. Stay tuned
Many market pundits alluded to the 2%/20% scenario for stocks earlier this year, meaning 2% upside and 20% downside. But when performing asset allocation work, one must always look for the upside risk scenario and assign probabilities. We believe the 1998-99 post-Asian crisis market recovery is a legitimate bullish scenario. Our Chart of Week exhibits this roadmap. As we can see, despite the S&P 500 trading at 22.5x forward EPS, the index added 20% past the July 1998 breakout point. Amazingly, this 20% was consumed over six months only. As the second panel of the chart illustrates, the melt-up was fueled by a major asset mix shift with investors rotating out of bonds into stocks. US 10-year bond yields rose 150bps through the equity rally. Now, the key question for investors is which asset class is the most overvalued? Stocks or bonds? We lean on the latter. Does that mean that the S&P 500 is headed for ~2,500 by year end? No but equities’ upside potential seem significantly more than 2% and asset allocators should adjust their expected returns and stock-bond mix accordingly.
Regarding economic data this week, in Canada, it was a disappointing week. First, the economy lost 700 jobs in June (vs. +5k exp.). Notably, full-time jobs fell 40.1k (vs. 39.4 part-time jobs created). Second, while the trade balance deficit improved slightly (-C$3.28B), exports in May deteriorated to C$41.2B (from C$41.5B). Last, on housing, building permits declined 1.9% MoM. In the US, nonfarm payrolls blew off estimates with a 287k print (vs. 175k exp.). As for inflationary pressures, wages only slightly advanced (+0.1% MoM) but settled at 2.6% YoY (from 2.5%) due to a lower comparison base. Nonfarm payrolls seem consistent with the ISM non-manufacturing rebound (56.5 from 52.9) and the employment sub-component (52.7, from 49.7). However, despite encouraging news, FOMC minutes suggest that central bank officials are leaning towards a prudent approach given the uncertainty surrounding global growth and inflation forecasts. In Europe, the Markit service PMI declined to 52.8 (from 53.3) but the overall composite remained flat at 53.1. Meanwhile, retail sales improved 0.4% MoM in May, up 1.6% YoY. Only time will tell if the Brexit vote will impair growth going forward. Finally, in China, the outlook seems improving with the Caixin service PMI improving to 52.7 (from 51.2).
Next week, the BoC is on deck. In the US, we await the CPI, the NFIB and industrial production. In China, we will focus on GDP growth, inflation, the trade balance, retail sales and industrial output
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