The coming months will see a continuation of the recent slow growth, low interest rate environment along with a rise in uncertainty stemming from Brexit and the November US presidential elections. In this environment, defensive strategies focused on income, events that re-price securities and US relative strength should outperform.
US equity market uncertainty has recently risen from abnormally low levels to the range typical of election years. Equity market uncertainty – measured based on articles in more than 1,000 US newspapers containing the terms “uncertainty,” “economics,” and “equity market” or “stock market” – had until June been tracking below any previous election year since 1988.1 The surprising Brexit result raised the index to above-average levels, but the historical pattern suggests it will likely rise even further as Election Day in November nears.
Rates Lower for Longer
The recent rise in uncertainty and tightening in financial conditions have reduced the likelihood that the Fed hikes rates this year. With most global (now the Pound and Euro) currencies depreciating against the US$, the Fed must also be wary of the diminished, future sales of US multinationals, should US$ be hyped further by higher rates. The fed futures market is pricing in less than a 20% chance of a fed funds rate hike between now and year-end.2
Favoring Equities with US Domestic Sales, Income (Dividends) Growth, Events
Macro conditions appear to favor, and the Fund will position for a continuation of strong high-income securities performance in the coming months. Low global bond yields are pressuring US Treasury yields, while the inflation outlook is muted and the Fed appears on hold with rate hikes. All of this suggests a favorable environment for high dividend yielding stocks. At the same time, periods of risk aversion could arise from multiple sources, ranging from Italian Banks, Brexit, the US Presidential election and/or Chinese growth. Risk aversion would also favor defensive, and low beta stocks and therefore higher yield stocks. Note: we are not saying larger cash positions or increased hedges.
The S&P 500 should continue to be range-bound during the remainder of 2016. While we cannot rule out a pullback of 5-10% driven by rising policy uncertainty, unstable global growth, and decelerating buybacks, the likely above-trend US GDP growth, a cautious Fed, and an earnings recovery should buoy US equity markets in the second half of 2016. Absent some more material, presently unforeseen risks, the cash position held by the Fund is, in part, earmarked to take advantage of dislocation in markets for reasons other than fundamental…particularly human-biased based movement (like Brexit caused).
All things being equal, in the present market environment, the Fund will seek to identify companies with plausible catalysts that also enjoy:
- High US Domestic Revenue Over Those with High International Revenues. We seek to insulate the Fund from possible Brexit fallout, China growth risks, and a strengthening US dollar, while benefitting from the relative stability of the US economy. Domestic-facing firms also carry a P/E discount relative to foreign-facing firms (19x vs. 20x) while growing 2016 EPS faster (7% vs. 2%). Additionally, there may be select, attractive European companies, reporting in local depreciating currencies, generating revenues largely in US$.
- Above-Average Dividend Yield and Plausible Dividend Growth (as suggested by Free Cash Flow). Our standard financial review of a company’s performance includes analysis of FCF as a barometer of the ability to initiate and/or increase or make a special dividend payment to shareholders. Such equities are bond-like in their lessened volatility and stability of income (from dividends). However FCF can drive “surprise” dividend initiation, dividend increases or large one-time special dividends that are in fact, Revaluation Catalysts.
- Defensive Sector-Centrism. Defensive sectors have typically outperformed when uncertainty rises. This is not as doctrinaire as the two bullet points above, particularly as plausible catalysts can occur in varied sectors, but it is something we note and favor.
1 Second Half Strategies – Portfolio Strategy Research, Goldman Sachs Global Investment Research, July 5, 2016
The above post has been excerpted from a letter of Tiburon Capital Management.
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