Cameron Hurst, CEO at Equium Capital Management
Focus: U.S. equities

MARKET OUTLOOK

We’ve been flagging potential ripples of a reversal in global liquidity for some time now, highlighting the likelihood that emerging markets (EM) would lead an eventual downturn in risk assets. While we aren’t yet hiding in a bunker stuffed with cash and gold, it’s noteworthy that EM credit default swap spreads led related equities lower from all the way back in March. Accordingly, we were not surprised EM equities lost global leadership status starting in the second quarter.

Similarly important yet on the other end of the quality spectrum, U.S. credit spreads diverged from equity performance this year, with BBB spreads well wider than the lows made back in January 2018. In healthy market environments, it’s considered positive to see equity strength confirmed by tighter credit spreads, not wider. In spite of this warning sign and standing as possibly the best example of Trumponomics, the S&P 500 is only marginally off all-time highs set in August, decisively leading global equities.

This parallel credit weakness across multiple geographies reminds us that capital markets are global, not local in nature; what happens in China, Turkey and Europe affect North American stocks, bonds and currencies. For this reason, among others, our investment process is global and multi-asset in scope. We believe it only makes sense to account for as many influential variables as possible in the pursuit of better downside protection and superior risk-adjusted investment returns.

In step with the evolving market environment, our process shifted exposures significantly in the Equium Global Tactical Allocation Fund over the last sefveral months. Broader global equity exposure was almost completely exited starting with EM, which went to zero in March/April, while continental Europe was taken down to underweight in April/May. While the allocation to equities remains neutral at close to 60 per cent, its constitution has changed dramatically. For example, health care and real estate are now our top two sector exposures, while financials and technology, the top two six months ago, are now well underweight. Fixed income has increased very modestly but remains underweight and skewed to shorter durations.

All these changes belie a more balanced view, principally because the research team is still able to find suitable opportunities in U.S. equities even as emerging market falls apart and Europe struggles. This dynamic environment highlights well the benefit of a process that combines technical discipline with the rigour of deep fundamental research. Fundamentally, we know health care has incredibly steady earnings growth and technically it has become leadership among U.S. equity sectors, causing our process to flag higher exposure levels at a stage of the cycle that intuitively makes sense.

It’s important to emphasize we haven’t turned outright bearish. Neither our technical analysis nor our fundamental research suggest markets are on the cusp of a major breakdown. Moreover, it’s telling that our process, inherently conservative as it’s, maintained at least neutral equity exposure throughout the last few months of growing divergences. This should have investors sticking with winners, but minding their stops and exiting breakdowns expeditiously.

Trade issues with China, Italian politics and rising stress in emerging markets are all bogeys to watch this month, even as the U.S. maintains its Goldilocks status. Global liquidity continues to recede and with it investment opportunities.

TOP PICKS

We believe it’s time to balance portfolios with incremental defensive exposure and real estate’s modestly pro-cyclical tilt, versus other bond proxy sectors, make it a favorable first step.

• We prefer broad-basket sector ETF exposure through XLRE over the industry-standard IYR owing to lower cost and preferential industry weightings towards secular growth themes, namely data centres, storage and towers.

•  “Growing slower” is good for REITs:

  • Trade war rhetoric is more significantly impacting equity volatility and economic indicators around the globe.
  • It now appears economic momentum could be slower in 2H/18 and 2019 than expected, although still positive, which caps longer-term interest rates and staves off cap rate compression from what we previously expected.
  • Secular growth in industrial (think fulfilment centres for Amazon), health care and tech-centric REITs maintains growth in the group despite slower than expected marcoeconomic tailwinds.'


• If we’re too optimistic and growth slows more precipitously, rate compression will support low cap rates in the sector for the early stages of the slowdown, allowing time for more defensive tactical repositioning

HEALTH CARE SELECT SECTOR SPDR ETF (XLV.N)

The health care sector has become a leader on the back of the strong, steady earnings while pharma and biotech names approach breakout levels, supporting other strong groups like managed care and medical equipment.

• Pharma has stabilized and rallied since summer lows after strong 2Q earnings, but the group is still trading at P/E of 15 to 17 times, slightly below the market at18 times. Sentiment improving and stress from drug pricing debate has receded.
• It's seen great strength in SMID cap biotech with 59 biotech IPOs year-to-date, which is on track to exceed the peak in 2014/15.
• We've seen managed healthcare and drug retailers recover as headlines around the Deparment of Justice nearing approval for pending health care deals.
• Secular themes continue to support the sector, namely aging populations, lifestyle diseases/obesity epidemic, worldwide hospital spending and EM demand.
• Midterms will likely increase drug pricing rhetoric; however, we have seen much improved investor tolerance for the debate and believe Congressional action is needed for any meaningful change.

MICROSOFT (MSFT.O)

Technology continues to lead in the market, with strong relative price performance and benefiting from a myriad of structural tailwinds.

• Microsoft has set itself up to be a key beneficiary of many of the critical themes such as cloud (Azure), AI and the Internet of Things while still benefiting from the shift of Office users to higher value subscription plans.
• Q4/18 was yet another clean beat, with strong sales growth (17 per cent year-to-date) and improving margins ahead of consensus. Key categories continue to perform very well. Guidance was modestly ahead as well.
• Office365 now has over 150 million total commercial and consumer users driving mid-teens growth, with the help from mix as usage expands and customers trade up to higher value plans. Microsoft believes the O365 commercial business could more than triple by 2023 (to over $40 billion) as the installed base increases and pricing averages positive high single-digit growth.
• Azure was up 85 per cent year-over-year and expectations are for public cloud workloads to increase from 21 per cent to 44 per cent in the next three years, pointing to significant market growth ahead. Microsoft's hybrid structure (some local, some cloud) seems uniquely suited to where the market is headed, likely meaning share gains on top of end market growth.
• The GitHub acquisition (the largest global open source code repository) for $7.5 billion provides direct access to 27 million developers that should help expand the use of Microsoft tools and services.
• Microsoft is well positioned in other growth areas such as gaming, data centers, machine learning and AI providing further support to the outlook for the stock.
• Still exposed to some legacy areas such as PCs and servers, so high growth needs to sustain in order to continue to grow overall revenue and earnings and justify peak multiples.
• All in, well positioned to take advantage of huge structural opportunities while expense discipline, a strong balance sheet ($58 billion net cash) and cash returns ensure solid returns for shareholders.

PAST PICKS: SEP. 12, 2017

UTILITIES SELECT SECTOR SPDR FUND (XLU.N)

• Then: $54.90
• Now: $54.28
• Return: -1%
• Total return: 2%

VISA (V.N)

• Then: $106.21
• Now: $145.94
• Return: 37%
• Total return: 38%

ISHARES U.S. AEROSPACE AND DEFENSE ETF (ITA.N)

• Then: $169.64
• Now: $209.41
• Return: 23%
• Total return: 25%
   

Total return average: 22%