Jay Pelosky, president and founder at Pelosky Global Advisors, discusses the outlook for global growth and his thoughts on investing. He speaks with Alix Steel and David Westin on "Bloomberg Daybreak: Americas." (Source: Bloomberg)
Good back & forth this morning on BTV’s Morning OPEN show with Jon Farro. We covered my 3Ts: Trump, Tech & Tariffs, the revaluation of the S&P, the global opportunity in Small Caps, my Tri Polar World (TPW) GO SOUTH strategy: Europe’s Southern Tier, SE Asia and S American equity markets with a focus on Europe's relative value opportunity for USD investors.
Mr Pelosky, who is based in New York, believes regionalism is the new globalism and espouses a “tri-polar” world theory, in which the Americas, Europe and Asia go their own ways and the south of each region in particular prospers. He has a good point. Start with the geopolitics. Much of Latin America is coming out of decades of populism and protectionism while the rest of the world seems to be plunging headlong into it. While the US is at the end of a recovery cycle, many analysts believe Latin American markets have plenty of room to run.
Great Daybreak show this Monday morning with David & Alix. Nice to get some positive geo political news on Brexit - both sides want/need a deal. Tri Polar World (TPW) framework suggests Brexit deal will allow Resurgent Europe’s M&M team (Merkel & Macron) to focus on deeper integration - within Europe investment focus should be on the Southern Tier ( GREK, EWI, EWP, PGAL) for better growth, less tariff risk and reduced exposure to weak dollar/strong Euro….
The resignation of Donald Trump's top economic adviser Gary Cohn in protest at the President's trade tariffs is a devastating blow to the White House's economic credibility and should rattle investors around the world.
My argument that the Fed is no longer as important to financial markets as it has been draws some skepticism from Alix and David. The battle royale between the Global Growth Recovery & the 30 Year Bond Bull Market is included as are my USD views.
- US centric correction, ROW Outperforming
- Speed of equity mkt advance ran into speed of rate backup
- Short volatility wipeout a classic example of picking up nickels in front of a steamroller; sooner or later you are gonna get rolled
- Key Q is whether non US equity mkts can sustain outperformance & thus confirm regime change & non US equity leadership
- Buy weakness in GO SOUTH mkts in Europe, Asia and Latin America
Catalysts for correction: speed of rate back up & inflation worry - higher rates had been bullish for stocks for much of 2017 as the rise in rates confirmed the global growth recovery which supported rising EPS. The speed of the rate increase in the past few weeks has been unnerving and the better than expected jobs gains and AHE # Friday morning reinforced the sense that perhaps inflation is really coming and thus rates will have to move even higher, leading to stocks selling off.
I also think the political environment in DC does not help as the Nunes memo was released on Friday and the news cycle was filled with chatter about a pending Constitutional crisis - given that the US is a huge debtor requiring constant infusions of offshore capital to fund its debt such talk is not constructive for risk assets.
The pick up in selling led to an implosion in the short vol or short VIX trades which no surprise had been among the best performers in 2017 - it brings to mind the old market adage about picking up nickels in front of steamrollers - sooner or later you are gonna get run over and thats what happened.
The return to volatility is good for markets just as the return to inflation is good for the economy. A little inflation can go a long way to helping the economy, companies and workers…. a little volatility can help keep investors honest and allow markets to price risk correctly. The sharp run up in equity prices in January strongly suggested risk was not being priced correctly ( see comments below about not being able to find ANY attractive charts) and so the volatility spike, while overdone, will probably help equity markets have a better yr than if it had not happened. In other words we were heading for a fall and so better sooner rather than later.
Bond yields don't trouble me very much… as noted above it was the SPEED of the rate backup that was a little unnerving. Given the broadest and best global economic recovery in a decade or more one would expect rates to back up somewhat, in the US and in Europe in particular. I believe there is a lot of capital that continues to search for long duration safe assets and so I think the back end of the yield curve should be pretty well behaved though a weak dollar means losses for Euro, Yen and RMB based investors as Table One in Go SOUTH shows. As a global multi asset investor, rising rates suggest my benchmark, a 60-40 global equity/debt composite, should in fact be easier to beat bc bonds will not do as well as in the past few yrs. To wit, that benchmark was up 15% last yr - that is tough to beat… this yr should be easier.
From an equity mkt perspective the worry was that the fiscal stimulus was going to lead the Fed to tighten too much too fast and risk inverting the yield curve which has traditionally been the kiss of death for equities - the latest gyrations have led to a widening of the yield curve which is good news.
GO SOUTH piece published in late January discussed a correction and suggested buying the laggards by which I meant the Southern Tiers in the Tri Polar World's three main regions: Europe, Asia and Americas - I was a buyer of Greece (GREK) and Italy (EWI) equity yesterday.
We had our monthly Portfolio meeting last Thurs - Fri and it was V difficult to find an equity chart – any country, any sector, anywhere in the world - that didn’t look V extended. The only exceptions were the fixed income type sectors like Utilities etc.
That suggests the selloff - profit taking is V healthy bc it will allow one to reposition on the fundamentals without having to worry that the technical/sentiment stuff is gonna bite you… as we have seen.
Bottom line – a US centric, late cycle, healthy pullback - gets rid of the hype and allows one to refocus on the fundamentals of a solid, synchronized global recovery. Equity mkt weakness presents an opportunity to buy the Tri Polar World's regional laggards which are the most leveraged to the global recovery. Key Q is sustained non US relative outperformance to confirm global equity leadership regime change.
The Tri Polar World’s synchronized global growth recovery has been fully embraced by investors with both interest rates & stocks rising around the globe.
Rising Rates serve to confirm the global growth scenario & are BULLISH for stocks as they point to higher EPS and may start to lead investors out of FI and into equity, especially among the retail investor base.
A major risk is a sudden rate SPIKE, due to an inflation outbreak or perhaps a Central Bank policy mistake – unlikely but one may want to hedge that risk.
What sector represents the BEST equity hedge against a sharp rate rise? BANKS.
10 yr. UST rates have backed up roughly 50 bps in the past 3-4 months and banks (XLF) have rallied roughly 12% vs. 9% for the SPY.
Q4 Bank earnings are muddy given the new tax regime but the focus should be on 2018 where bank sector EPS are forecast to rise 21%, well above the 13% expected for the market as a whole.
BANKS also represent that rare breed: a 2-way player.
On offense, banks provide exposure to the growing economy via greater demand for credit, fewer bad debts & better NIM while also benefiting from reduced regulation.
On defense banks provide a hedge against rising rates.
BANKS may also provide leadership. Looking at the top 4 US sectors in terms of expected 2018 EPS growth, energy leads followed by financials, materials and Industrials.
Note all 4 sectors are cyclical, value plays. TECH 2018 EPS growth is forecast to be ONLY market growth or 13%, suggesting a possible rotation from growth to value and from Tech to Banks which could also serve to elongate the bull market.
European Banks (EUFN) also look attractive. While XLF now trades at roughly 1.4-1.5 x P/BV. Europe’s banks trade at close to a 30% discount at roughly 1-1.1x P/BV with roughly the same ROE.
10 yr. German Bund rates have backed up roughly 30 bps in the past month and EUFN is up 7%; it looks to be breaking out of a multi year range.
One ODDITY of the current market environment is the juxtaposition of the highest short-term rates in several years with a USD that is at its weakest point in the past 3 years.
I believe there are four factors undermining the USD at this point.
First, global investors are massively long US financial assets with the SPY up 370% since the March 2009 lows vs. 170% for Europe and a 120% for Japan (all in USD).
Second, while the Fed has been the leader of the great CB unwind the rest of the world looks like it wants to join in and so the gap between US monetary policy and ROW is narrowing.
Third, the US is running large deficits in both its trade account and its budget account with the latter now being forecast to rise to close to 5% by 2020 thanks to the tax cuts just passed.
That leads us to politics and here the US does not look good at all – from a looming Govt shutdown to an erratic White House to the Mueller investigation and on to the mid term elections this Fall, it makes perfect sense for offshore owners of US assets to think about lightening up.
This is especially true when neither the Euro, nor the Yen nor the RMB is fighting appreciation. Europe has a 3% current accout surplus and shows no sign of a Euro around 1.20 having any impact on trade. The Yen is one of the most undervalued currencies with fair value around 90-93 vs. the current 110. Finally the RMB, which is hovering around a two year high, welcomes strength as it helps reduce inflationary and hence rate pressures internally while a stronger RMB just may protect China from Pres. Trump’s trade salvos.
If the dollar is set to weaken further this will have large implications for Asset Allocation in the year ahead. More on that front in my next piece.
Investor focus will be on the Fed's economic forecasts and expected # of rate hikes in 2018, less so 2019. Mkt is pricing in roughly 2 hikes next year vs 3 that the Fed has in its dot plots.
The tax cut package will likely complicate the Fed’s job in the next year and so how the Fed talks about that in terms of the growth/inflation outlook will also be important. Fiscal stimulus in a late stage economy near full employment is likely to risk higher inflation which could push the Fed into a policy mistake - raising rates too far, too fast, creating a self inflicted inverted yield curve which both stock and bond investors are likely to take as a sign of impending recession.
The yield curve (2/10yr UST spread) had flattened considerably over the past year with short rates up close to 70 bps while 10 year rates have rallied roughly 10 bps leading to a yield curve of under 60bps which is very flat on a historical basis.With the long end supported by a demand imbalance between supply and demand for long duration, safe assets the Fed may be hamstrung in its efforts to raise ST rates.
It would be ironic if the tax cuts meant to boost growth actually do the opposite by creating the groundwork for an inverted yield curve which leads to stocks and bonds selling off creating potential recessionary conditions. Things are further complicated by what will essentially be a new Fed Board with Chair, Vice Chair and NY Fed Pres all turning over in the coming 6 months.
Higher short term rates may also support the USD which could reverse the USD weakening trend seen this year, a trend which boosted US corporate earnings thus providing support to US equity.
US and perhaps more importantly global growth is expected to be strong for the next several years - the OECD analyses 45 countries and it expects an average global growth rate of roughly 3.6% for 2017-2019 with none of those countries in recession over that three year period.
Such growth has led to quite strong earnings growth which has been the principal support for equity prices in 2017. Fun Fact: global equities, up roughly 20% this year, are trading on a cheaper PE multiple today than a year ago - you never see that stat cited in all the “bubble” talk.
So on the plus side for stocks in 2018: one of the most synchcronized global economic recoveries of the past thirty years leading to solid earnings growth. US stocks may be supported by a one off earnings boost driven by the tax cut leading to perhaps 15% EPS growth in 2018 - its hard to see big stock mkt downside with that EPS growth.
On the downside four main tailwinds are morphing into headwinds: stock buybacks are ebbing, dollar weakness turning to stability/strength, Central Bank liquidity is starting to reverse and China credit fueled growth is turning into tough love deleveraging.
Bottom line: investors should raise their volatility expectations and lower their return assumptions. Expect another year of non US equity outperformance - Japan and Europe most attractive. In US focus on small caps, industrials, financial, energy and telecoms.
Jay Pelosky, founder of independent investment advisory boutique, Pelosky Global Strategies, says the current global conditions are very favourable for stocks.
He points out the global economy is its strongest since before the 2008 financial crisis, companies are reporting double-digit earnings growth in major economies, interest rates are still low and inflation is subdued.
"That's certainly very supportive of asset prices," Pelosky says.
Pointing to those favourable tailwinds, he doesn't buy the idea that Trump has delivered the upswing in economic growth or the Wall Street bull market.
2 key tradeoffs between now and year-end: first, the best global synchronized economic recovery in decades vs. the onset of Quantitative Tightening (QT) and second, the US specific Fed balance sheet reduction process vs. the Trump tax plan.
Global growth is accelerating and so can’t think of a better time to begin withdrawal of CB support.
A US tax cut in next 6 months would give late cycle US economy a booster shot that could stimulate a cap ex cycle and provide a meaningful earnings boost to US companies and hence the stock market.
Global financial markets have been climbing the fabled Wall of Worry all year; 60/40 balanced portfolio up 10% ytd and 3% in Q3.
1St H Low volatility begets 2H low volatility with September having the lowest volatility for the month in 70 years.
This low volatility has persisted through what is historically the worst period for the SPY suggesting a strong run into YE.
Investors may not be BULLISH enough.
One underappreciated RISK: BIG TECH in the crosshairs of Govts around the globe: US with Russia etc., Europe with privacy concerns & China with Govt “encouraging” investments in SOEs.
In my Global Risk Nexus (GRN) scoring system, this falls under regulatory policy risk. TECH has been the equity leadership sector and represents 27% of EM equity (big #), 23% of SPY but only 13% of Japan and 8% of EU equity.
Tech risk is another reason to look to non US DM equity mkts, a long standing view of mine.
Sell Big Tech (XLK); buy Industrials (XLI) as play on late cycle cap ex boom.
Buy Commodities (DBC) – V out of favor, oil stabilizing, China stabilizing, inflation hedge.
Sell US big caps (SPY); buy small caps (IWM) as play on tax cuts.
Buy Hedged Japan equity (DXJ) – play on Fed policy vs. BOJ stand pat… strong EPS growth (+ 30% y/y) and foreign investors V underexposed.
BIG TECH is at regulatory risk; BANKS are regulatory winners. European banks have been big winners ytd, up nearly 30% vs 18% for US banks.
In the US, the easing of Dodd Frank and ability to return capital (banks are printing money) are big pluses, not to mention being a beneficiary of higher rates (XLF).
In Europe, the renewed focus on cleaning up NPLs and potential for consolidation (Commerzbank rumors) are real pluses together with ability to hedge against rate rises and the possibility that NIRP could disappear in 2018 (EUFN).
In China banks are benefitting from reserve requirements cuts and could also be big winners from possible regularly changes regarding financial market opening post the Party Congress (MCHI).
Europe is the RESURGENT region in my Tri Polar World (TPW) construct with political risk giving way to economic recovery.
Potential for a Franco – German leadership push for deeper European integration across financial and digital spaces among others provides a second leg for EU story.
A slow moving ECB, lots of economic slack, stable FX are all supportive as is attractive equity market valuation and earnings growth.
While Spain is a bit worrisome and German coalition building may take time, corporate integration is well underway with steel (ThyssenKrupp- Tata) and rails (Siemens – Alstom) leading the way.
In an America First world, the US has been the weak performer ytd with All Country World X US up 23% vs. SPY up 15%. The only bad investment decision this year has been to not be invested. It’s too early to sell – buy any dips.