The investment landscape is changing for the first time in 8 years.
According to the IMF‘s data, America’s economy is operating at if not above capacity (output gap closing), with a relatively tight labour market and leveraging by both corporations and households.
A pickup in investment began early last year, as growth accelerated and companies started to take advantage of expensing benefits due to the tax code changes brought about by the Trump Administration.
As the US economy enters the later stages of its business cycle, a more active and tactical investing strategy is needed. Typically, interest-rate sensitive areas are to be avoided, while cyclical sectors should outperform.
Other than long term government bonds, ‘bond proxies’ also have to be avoided. These ‘bond proxies’ are defensive equity segments of the investible market that income-seeking investors go to. They tend to be perceived as safer segments due to their defensive characteristics as compared to cyclical sectors like financials and consumer discretionary.
Their stable business models are generally well liked by yield-seekers as cash flows and revenue are more predictable (easier to forecast). However, this makes them vulnerable to a change in interest rates as their duration profile is high. When rates that are used to discount their future cash flows increase, valuations will be affected (decline).
Additionally, as risk-free rates gradually rise during the later stages of the business cycle, the opportunity cost of holding ‘bond proxies’ for income increase, as both compete for limited capital flows by yield seeking investors. Remember, yield-seekers desire income with minimal volatility, so the opportunity cost of holding onto ‘riskier’ income assets are high when risk-free assets offer higher yields.
There are three sectors in the US that are deemed as ‘bond proxies’. These three sectors are Utilities, Real Estate, and Consumer Staples.
They trade at elevated valuations (utes are above 16.0X 12M forward earnings!) – a symptom of the low interest rate environment that we are in. Below are the weekly price charts of the SPDR exchange-traded funds that track these sectors respectively:
From a higher time-frame perspective, they seem to have topped out, and are slowly rolling over as the late cycle progresses. In fact, they are starting to look like good tactical short candidates.
The underlying revenue of these industries will get squeezed as their expenses rise (debt service costs increase for utilities) and as they face headwinds for business prospects (real estate as mortgage rates rise).
Regarding the consumer staples sector, while there are many sturdy and high quality businesses in that segment, the reality is that they are often viewed as a ‘semi-cash’ allocation among real money and asset managers.
In a late cycle in equity markets, conservative and value-sensitive asset managers who are measured against a market-cap index and have been overweight in their cash allocations will be forced to reluctantly ‘chase prices’, and that is when money is moved out of this area to be deployed in the stronger and usually more expensive segments.
The professional community seems to have been positioned for the underperformance of these 3 sectors, as shown in BofA’s Global Fund Manager Survey below. This means that the broad movement lower for these sectors will be slow:
While avoiding these 3 areas, the most important chart to monitor now is the US Dollar Index (DXY). Here’s a chart of the Dollar Index since 2000:
The broad-based weakening of the greenback since the start of 2017 has greased the wheels of the global economy, allowing easy liquidity conditions across emerging markets and enabling global trade to rebound. It is now reaching a key inflection point and where it goes next has huge implications for the trend of every financial asset class across markets worldwide.
If the DXY breaks lower and continues its broad-based weakness against both developed and emerging market currencies, emerging markets and commodities may continue their strong performance. Gold will also look interesting in that context given its high negative correlation against the greenback.
However, there’s also a possibility of the US Dollar rebounding given growth and rate differentials between the US and the rest of the world, and the fact that sentiment is overwhelmingly bearish on the greenback (positioning is lopsided). Should that happen, shorting gold and going long the USD against currencies such as the AUD and the CAD will payoff.
At this inflection point, letting price action guide us is the best course of action. Imposing an opinion on the markets can be costly and detrimental at inflection points.
As macro investors, we game various scenarios, discern the possibilities, and adapt ourselves according to conditions and play the game accordingly.
As George Soros says:
“I don’t play the game by a particular set of rules; I look for changes in the rules of the game.”
This is how we survive for the long term. Afterall, capital preservation is the primary objective before everything else.