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TOP SECTIONS INSIDE

THE FED’S DOVISH

PIVOT IS NOT A GREEN

LIGHT FOR EQUITIES

OUR LEADING INDICATORS EXPECT INFLATION WILL BEGIN

RISING AGAIN IN 2019

Has the Fed Given the Kiss if Life to Equities?

Wall Street loves a good maxim, and one of the best is “business cycles don’t die of old age, they are murdered by the Fed”. As

violent as this sounds, there is some truth to it as often the Fed is too slow to raise rates, and then has to catch up, raising them too quickly, causing a recession.

Perhaps it was a reluctance to “murder” the current business cycle that led Jerome Powell, the Fed Governor, to reassure the public that the Fed would be very cautious about further rate hikes. This dovish tilt has driven a further re-pricing in the interest-rate markets. No rate hikes are now expected for 2019 – when up to four were expected only a few months ago - with the rate curve for the next 12 months flat as a pancake. This is a clear sign that the market believes the Fed is at end of its tightening cycle. Equities have taken this with great cheer. But it is too early signal the green light just yet.

The Leading Edge keeps investors on the right side of trends in the economy and markets, with an actionable asset allocation recommendation each month

Has the Fed Given the Kiss of Life to Equities?OVERVIEW

Inflation is higher than people are expecting, and when this happens, inflation tends to rise.

INFLATION STATIONS

EQUITY FUNDAMENTAL SUPPORTS

ASSET ALLOCATION

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THELEADING EDGE

February 2019 www.variantperception.com

OVERVIEW INFLATION STATIONS EQUITY SUPPORTERS ASSET ALLOCATION THELEADINGEDGE

A SLOW GRIND LOWER IN US GROWTH

Firstly, the US economy is clearly set to slow. Leading indicators of

the US economy, such as consumer confidence and the ISM manufacturing survey all show that US growth has likely peaked and is set to slow as the year progresses.

This slowdown, along with the market turbulence in in the last

few months of 2018 is what the Fed is responding to. However, the Fed has a dual mandate: not only do they need to respond to slowing growth, they also need to respond to rising inflation.

Inflation is subdued at the moment, but that

is set to change later in the year

US growth has peaked and is set to slow as the

year progresses



INFLATION STATIONS

Headline CPI has been rolling over in the US (due to the rising dollar

last year and the recent fall in oil prices), but inflation surprises – the degree to which inflation is different to that expected by economic forecasters – is rising, meaning that inflation is higher than forecasters currently expect. As the chart shows, when this happens, actual inflation tends to rise.

This is not something we expect to happen over the next few months, but towards the summer, we expect to see inflation picking back up.

Our leading indicator for core CPI aims to gauge where inflation

will be over the next year or so. As the chart shows, our leading indicator (red line) expects core inflation should remain supported and begin rising again in 2019.

The Fed will have to respond by sounding like rate hikes are back on the table. So we see the respite that equity markets are taking from the Fed becoming more dovish as only temporary, and equities will likely see greater headwinds again.

Core inflation – which is headline inflation but without more volatile food and energy prices – we also expect to see rising again towards the middle of the year. Inflation is something that tends to rise when the business cycle is very old, as it is today. All the pressures of an overheating economy lead to higher prices, and inflation thus rises.

Inflation is higher than forecasters currently

expect



Where are on equity markets from a technical standpoint?

So far in 2019 US equity markets are seeing a strong technical rebound, with strong market leadership.

Some market internals have recovered, but some are still

lagging. The percentage of S&P 500 stocks trading above their 50-day moving average has bounced strongly, but we would like to see the percentage of stocks trading above their 150-day and 200-day moving averages stabilize above 50%.

On its own, this would be a positive sign for equity markets. However

today, the fundamental support for equity markets is actually looking more shaky.

The chart shows red when more stocks on the NYSE and NASDAQ exchanges are making new 52-week lows than are making 52-week highs, and it shows green when more stocks are making new highs. It’s often better to avoid owning the market in red the blocks.



EQUITY FUNDAMENTAL SUPPORTS

Secondly, company profit margins are also unlikely to continue

rising. The largest single cost for most companies is usually wages and the US labour market is now very tight, which will help to boost wage growth.

We can break down an equity market into its component

drivers. Revenue growth, the profit margin on those revenues and the P/E multiple Mr Market is willing to pay on those profits.

To begin with revenue growth looks set to slow, after being very strong over the past 2 years. US leading indicators are starting to roll over, suggesting overall economic activity is set to slow, which will translate into slower revenue growth.

overall economic activity is set to slow, which will

translate into slower revenue growth.



Total wages as a percentage of GDP has been very low in the current

growth cycle, which has helped to boost profit margins. This is unlikely to last now that wage growth is starting to pick up.

Finally, P/E multiples are what investors are willing to pay for stocks given a certain level of earnings. Once again there is reason to believe that the P/E multiple will be unlikely to rise. Using the 10 year cyclically adjusted P/E first popularised by Robert Shiller, we can see that valuation multiples are still at very elevated levels despite the recent dip lower.

Therefore given that the fundamental support for equities

is starting to weaken, in the form of slower revenue growth, falling profit margins and already elevated cyclically-adjusted P/E multiples, we recommend that investors remain defensive and do not overcommit to equity markets by trying to chase the current relief rally. Although market technicals are improving, the macro outlook does not warrant an aggressively long position.

VERDICT: Equities will continue to struggle, despite the Fed pulling back from rate hikes (for now). We advise positioning defensively in equity markets, and hedging part of positions with cash. See our model portfolio below.



ASSET ALLOCATION

The dovish Fed has put the market into a holding pattern, but the macro headwinds from slowing growth and falling

profit margins remain. Therefore we continue to recommend a defensive portfolio positioning with more than 30% in cash. We recommend holding EM equities and EM bonds as a relative value play as EM assets are very cheap relative to the US and

offer higher yields. Sector-wise we continue to recommend maintaining underweight positions in technology stocks

where too much growth was priced and where earnings are exposed to the China slowdown. We recommend

overweights on Energy and Financials as these sectors are extremely beat up with

most of the bad news already priced in.

... We recommend holding EM equities and EM bonds

as a relative value play

SYMBOL WEIGHT FUND/ETF SECTOR LAST PRICEXLC 3.0% COMM SERV SELECT SECTOR SPDR Comm. Svs. 46.13XLE 7.5% ENERGY SELECT SECTOR SPDR Energy 63.78XLF 13.5% FINANCIAL SELECT SECTOR SPDR Financials 25.94XLI 4.5% INDUSTRIAL SELECT SECT SPDR Industrials 71.77XLK 3.0% TECHNOLOGY SELECT SECT SPDR Technology 66.28XLP 5.0% CONSUMER STAPLES SPDR Cons. Staples 53.39XLV 7.0% HEALTH CARE SELECT SECTOR Health Care 90.67XLV 5.0% CONSUMER DISCRETIONARY SELT Cons. Discr. 108.78EMB 10.0% ISHARES JP MORGAN USD EMERGI EM Bonds 108.88EEM 10.0% ISHARES MSCI EMERGING MARKET EM Equity 43.1CASH 31.5% CASH/MONEY MARKET/SHORT-TERM TREASURIES

THELEADING EDGE

VP’s asset allocation model aims to tell you how you should be positioned each month in US equity sectors, EM equities and bonds, and cash

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