Still bullish on equity, happy with 7–10-year bonds

Genevieve Signoret

Letter from the President

Notwithstanding the collapse in oil prices, we hold to our view that interest rates globally will remain low for long. This view is driving our portfolio strategies, so they remain unchanged also: we remain comfortable in our 7–10-year position on the U.S. investment grade yield curve and bullish on equity. We’re setting very patient (abysmal) limit prices when buying energy stocks.

Rate outlook

We hold to our view that global interest rates will remain low for long and that the Fed won’t hike rates before the second half of 2015. The global oil price collapse has reinforced that view.

Brent oil fell this week $6.31 to $50.11/barrel. Equity is zig-zagging, as investors try to fathom what the collapse in oil prices means for the economy, interest rates, and corporate profits.

Even before the collapse, we did not expect the Fed to hike rates as early as June 2015. This put us in a lonely spot outside the consensus of analysts and even the Federal Reserve Board members and Federal Reserve Bank presidents—a group that includes but is larger than the Federal Open Market Committee (FOMC). We differ from the Fed’s forecast of its own behavior because we’re less optimistic than the Fed as to how much the U.S. labor market will heal in 2015. Remember, to declare labor markets healed, the Fed wants to see improvement over a broad range of indicators—more jobs and lower unemployment rates alone will not suffice. The clincher, in my view, will be real wages, which remain stagnant.

We believe that the fall in oil prices bolsters our case. First, because we see a large risk that the oil price collapse will weaken drilling for new oil immediately, while boosting consumer spending with a lag, causing demand for labor and real wages to weaken before they improve.

Second, because we see a risk that cheaper oil will eventually pass through from headline to core inflation, slowing it down.

All this of course rests on our oil price central scenario assumption that oil prices may stabilize soon but won’t start to recover before 2017.

In summary, despite the oil price drop, we hold to our view on Fed action: it will come in the second half, not the first half, of 2015.

We continue to expect the ECB to announce this quarter that it will extend its quantitative easing program to include the purchase (on secondary markets) of sovereign bonds. Also, for the Bank of Japan and the Bank of England to hold to their own programs. And we think that, once the Fed and Bank of England begin to normalize their rates, they will do so gradually.

Turning now to other central banks, with inflation rates declining globally and growth all over developed Europe weak, this year at least, we expect the number of central banks around the world cutting or holding interest rates to far exceed the number raising them.

Strategy

Our views that global rates will remain low for long is driving our portfolio strategies. So, because we hold to our rate views, we hold also to our strategies. In particular, we remain comfortable in our 7–10-year position on the U.S. investment grade yield curve and bullish on equity. Thus we feel secure in our equity overweight. Our thinking is that low rates for long will drive investors, hungry for returns, back to risk assets time and again after each correction till they start to anticipate that global rates will soon head back up to more normal levels.

Trading tactics

This past week, to invest new USD capital flowing in from new and existing clients and rebalance client accounts[1], we bought ETFs exposing clients to U.S. financial services, small cap, and energy equity, and shares in Master Limited Partnerships.[2] We set aggressive limit prices for U.S. energy stocks but just a hair below market prices for the remaining three asset classes.

U.S. energy stocks. We see strong downward momentum in both energy prices and energy stock prices. Energy stock prices are highly sensitive to energy prices. So, for the purchase of energy stocks, we set limit buy prices at very patient levels—about 20% lower than market prices.

Small-cap and financial service equity, and MLPs. For these three asset classes, we bought ETFs during market hours on inter-day dips and set limit prices just a sliver below market prices. Why in these cases were we not more patient?

• U.S. small-cap stocks. We see no fundamental reason why this asset class should trend down now.
• U.S. financial services. Once rate hikes begin, financial service share prices should benefit or at least suffer less harm than share prices for other sectors. As a corollary, if we shift out our expected date for the first Fed rate hike, our perception of downside risks for share prices in this sector should heighten. But we are not shifting out that date. Even before the oil price collapse, we did not expect the first Fed rate hike before the second half of 2015. In fact, the energy price collapse has lowered our uncertainty around our rate views. Hence, we see no fundamental reason to expect financial services equity to start trending down.
• U.S. MLPs. MLPs are generally less sensitive to energy prices than are energy stocks. So, even though we expect energy prices to keep falling, we have no near-term view on MLP prices.

Previous Letters from the President

While we huddle, here’s my guest column on oil (2015 01 02)
Where the peso’s going and what to do (2014 12 15) 
U Turn (2014 08 12)
Prices falling? By rebalancing, buy more (2014 12 01)

[1] To rebalance is to reestablished target exposures to various asset classes in accordance with our asset allocation strategy. This strategy, in turn, obeys the investment mandate agreed that governs how we manage each client portfolio.

[2] MLPs are securities that pass through to investors earnings from the oil and gas infrastructure—especially transport.