U.S. Equities: The Total Return Trap

High dividend yields hold appeal in a sluggish economic environment. But, investors should be wary of overpaying dividend streams in overvalued groups.

US Equities: The Total Return Trap

T he Fed stretched out its zero-rate expectations even further last week, reaffirming that low interest rates will remain a key feature of the investment environment. This would seem to continue to favor high-income-generating assets, but our U.S. Equity Strategy recommends that investors should be selective when looking for total return plays. Valuations of traditionally high-yielding equities are well beyond levels justified by underlying earnings. For example, equity fixed income proxies like utilities, telecoms and REITs are overvalued according to our industry valuation models. On the other hand, pharmaceuticals, integrated oils and hypermarket equities offer a high yield at prices that are not demanding versus their own relative valuation histories. Also, these equity groups (unlike the traditional high yielding ones) offer protection should long-term Treasury yields rise on the back of positive economic surprises.

Bottom line: Traditional high yielding equity sectors have very demanding valuations, and investors seeking total return should consider other less popular yield plays, including pharmaceuticals, hypermarkets and integrated oil & gas.

Fed Chairman Heavily Skews the FOMC Statement

The FOMC statement was on the dovish side, but almost two-thirds of policymakers would raise rates before the end of 2014.

Fed Chairman Skews FOMC Statement

T he FOMC signaled a later start date to the next tightening cycle, stating that exceptionally easy policy will be required “at least through late 2014”. The weighted average of the newly released fed funds projection across 17 policymakers was roughly in line with market expectations, in both real and nominal terms. Interestingly, however, data on the appropriate timing of policy firming shows that 11 policymakers would begin raising rates before the end of 2014 (three favor hiking in 2012). These include projections from non-voting members, but the divergence with the forward guidance language in the Statement shows that Chairman Bernanke and other high-profile FOMC members are heavily skewing the tone of the Statement in a dovish direction.

If it were a simple majority vote, the Fed would be inclined to tighten much earlier. In theory, one benefit of the new communication strategy will be to reduce volatility in the Treasury market, especially during periods when growth is surprising on the upside. Policymakers could use the rate projections to temper Treasury selloffs that risk prematurely tightening financial conditions and truncating the fragile recovery. However, it is not clear how the market will react to seeming inconsistencies between the FOMC statement and the rate projections, were they to persist and widen. The new policy could potentially backfire by adding uncertainty rather than reducing it. Still, investors should watch the Chairman as he will clearly continue to dominate Fed policy, no matter what happens with the rate projections.

Another Tough Year For Europe’s Periphery

The weakening euro will eventually help Germany to revive its export sector and contribute to growth. However other countries in Europe are less lucky.

Tough Year Europe's Periphery


I mbalances within Europe have developed gradually since the creation of the eurozone, resulting in a cumulative current account surplus in the core countries and a current account deficit in the non-core areas. Fiscal austerity is limiting growth, which contributes to a rebalancing across countries by dampening import demand. The extensive fiscal austerity measures implemented in Spain, Italy and other non-core markets have offset the automatic stabilizers that otherwise would smooth out GDP growth in times of crisis, so the recession could be quite severe within these countries. S&P’s real GDP forecast for the eurozone is +0.2% in 2012, so a less rosy growth outcome could trigger more downgrades.

Our model projects eurozone GDP of about -1% this year.

The mild recession represents our base case scenario for the euro area as a whole, but this will be concentrated in the periphery.

Bottom line: Recessionary forces are significant in the peripheral countries, which keeps pressure on sovereign spreads as these countries struggle to meet debt targets. Stay neutral non-core Europe within a global hedged fixed income portfolio until there are clearer signs of growth and lower political risk.

China: Still On Course For A Soft Landing

The most recent economic data out of China confirmed that the economy remained incredibly resilient in the wake of slowing external demand and harsh policy tightening last year.

China Soft Landing or Hard Landing

L ooking forward, business activity will likely continue to moderate. Our model currently predicts that GDP growth will continue to decline to about 8.3% in the first quarter, with no bottom yet visible, suggesting high odds that growth will dip below 8%. Nonetheless, barring a major global shock, our China Investment Strategy team expects the Chinese economy to be sluggish but able to avoid a crash.

It is important to note that the economy’s various trouble spots were able to withstand severe policy headwinds in the second half of last year, when the tightening campaign was at its maximum strength. The odds of an economic crash will likely decrease because the policy pendulum is clearly swinging back to easing. This should increase the availability of credit, reduce the cost of borrowing and help the economy to stabilize. In terms of the stock market, we suspect that investors have become pessimistic enough on both China’s cyclical outlook and structural fundamentals.

This means that the market has priced in enough bad news and is more likely to respond to positive growth surprises and policy reflation going forward.

Can The U.S. Dollar Be Pro-Cyclical?

Factors behind the positive dollar/stock relationship from the late 1990s are no longer in place.

U.S Dollar Pro Cyclical

I n level terms, the rolling 26-week correlation between the trade-weighted dollar and U.S. equities is about to turn positive. But this is nothing out of the ordinary as it occurred for brief periods in the past and none of those previous episodes marked a structural return to a positive relationship. Our Foreign Exchange Strategy service argues that the fundamental factors that drove the dollar/stock relationship in the late 1990s are not in place today. A key reason for the positive correlation in the 1990s was the growing importance of foreign equity inflows, which tend to be unhedged.

Currently, government fixed income instruments account for the vast majority of capital flows into the U.S., and these flows are more likely to be hedged. If the U.S. current account deficit continues to reflect the large fiscal deficits, then foreign capital inflows must be largely into government fixed income securities, not into U.S. equities. This will make it difficult for a positive dollar/equity correlation to reassert itself. Also, in the 1990s, “risk on” meant buying U.S. tech stocks and therefore the dollar.

Today, the risky assets that investors want are outside of the U.S., particularly in emerging markets. So, when markets have a “risk on” bias, private capital leaves the relative safety of U.S. government securities for risky assets elsewhere; consequently, the dollar comes under pressure.

Bottom line: Over the last few weeks, both U.S. stocks and the dollar have managed to strengthen. We doubt that this is the start of a long term positive correlation like that seen in the late 1990s.