Global Asset Allocation Insights

Market Perspectives
Mar 2014
March 7th, 2014
www.finlightresearch.com

Executive Summary: Global Asset Allocation
Whatever the EM and geopolitical risks in focus, the main
systemic risk remains China. China accounts for around 15% of
world GDP
At this stage, and over the short-term, we remain globally
long risk, with some tail hedges.
We summarize our views as follows
2
FinLight Research | www.finlightresearch.com

MACRO VIEW
The Good
Earnings growth is still solid
Jobless claims remain in a rather healthy 300-350k range.
Consumer confidence is holding up
Eurozone IFO and PMIs are at near 3 year highs
On an inflation-adjusted basis, household balance sheets have now finally made a complete
recovery from the effects of the global financial crisis, boosted by stock and housing markets
The Bad
Weak US retail sales reports and more announced store closings
GDP was revised lower from the Advance Estimate of 3.2%, to an annualized rate of 2.4%.
Pending home sales are down 9% YoY
Three of the big four economic indicators are showing a decline
ISM services was very weak at 51.6 and trending to the downside
Chinese dataflow continues to disappoint, with the February flash PMI falling to the lowest level since
July ‘13
Ukraine situation remains a big concern
The Ugly
China potential troubles during this new Jiawu year, now that money supply growth is slowing down
sharply
3

4
Big Four Economic Indicators
The global picture is that of a slow recovery.
The data for the past two months are showing contraction.
Among the 4 indicators, two (Real Retail Sales and Industrial Production) have already reached their all-
time highs. Nonfarm Employment remains on a positive trend. Only Real Personal Income is still
struggling.

5
Real Disposable income
Real disposable income has been slowing
for three years…
This could explain the similar trend in
consumption and even in capital spending

6
Household Income
The decline in real median household income over the last five years could explain the consumer
spending contraction.

7
Employment
According to the Labor Department reports, new
filings for unemployment benefits fell 26,000 last
week to a seasonally adjusted 323,000. But nothing
exciting yet…
The Job Report for February was a surprisingly
decent one.
175,000 jobs were added to the U.S. economy. The
unemployment rate rose slightly, up 0.1% to 6.7% .
December and January were both revised upward
by a total of +25,000.

8
Employment
There is clearly more confidence about the employment situation.
The present situation component of the Consumer Confidence Index (CCI) rose to a new cyclical
high. Expectations are on the same trend…

9
Inflation
The disinflationary trend in Core PCE Price Index continues…
After years of ZIRP and QE, Core PCE continues to move in the wrong direction. Troubling!

10
Inflation in Eurozone
A Japan-style deflation trap is not impossible…
Inflation may stabilize if GDP growth picks up

11
Durable Goods
The latest new orders number came in at -1.0% percent MoM and 4.6%YoY
If we exclude transportation, "core" durable goods came in at 1.1% MoM and 1.2% YoY.
If we exclude both transportation and defense, durable goods were flat MoM and up only 0.8% YoY.
The S&P500 continues to pull away from the durable goods figures

12
ISM
At 51.6, the ISM Services was the lowest
since February 2010. The ISM Composite
(51.8) was also the weakest since February
2010.
Both charts start looking ugly…

13
Eurozone Recovery?
Consumer confidence stands at the highest since mid ’11, pointing to an increase in spending ahead.
IFO and PMI are at near 3 year highs

14
Eurozone PMI
At 53.2 in February, the final seasonally adjusted Markit Eurozone Manufacturing PMI came in above
the earlier flash estimate of 53.0
France PMI is still in negative territories with 49.7. French PMI momentum has decoupled from the rest
of Eurozone and FDI has collapsed.
Peripheral PMIs are at their highest level compared to core since 2004.

15
Housing
There is clear deceleration in the housing market over the course of 2013

16
Consumer Sentiment
the University of Michigan Consumer Sentiment final
number for February came in at 81.6, a bit stronger than
the 81.2 January final.
The Conference Board Consumer Confidence Index
decreased by 1.63% in February
We see the same broad pattern in the Conference Board
Consumer Confidence Index as well as for small business
owners (NFIB Business Optimism Index)

17
Household Net Worth
On an inflation-adjusted basis, household balance sheets have now finally made a complete recovery
from the effects of the global financial crisis, boosted by stock and housing markets
Financial market (equity, pensions and mutual funds) gains now account for 43% of total household
assets. This contribution was only marginally higher during the tech bubble.

18
Household Balance Sheet
Is the Household BS really repaired?
The ratio of liabilities to net worth is now below the trend line

19
Real GDP
GDP was revised lower from the Advance Estimate of 3.2%, to an annualized rate of 2.4%.
The Q4 contribution from PCE came at 1.73%. This is a downward revision from the 2.26%
contribution in the Advance Estimate.

20
GS – Global Leading Indicator (GLI)
The GLI still locates the global
industrial cycle in the ‘Slowdown’
phase
Only 2 of the 10 underlying
components improved in February

21
China – Troubles ahead
Chinese dataflow continues to disappoint
February flash PMI falling to the lowest level since July ‘13

22
China's narrow M1 money supply and the
broader M2 are now growing at levels not
seen in many years
In Feb 14, China's M1 money supply
contracted sharply
Slowdown is obvious in bank loan growth
and "total social financing“ (including
shadow banking)

23
PMI data have been consistently weak for
instance, especially in the manufacturing sector
In real estate, the rate of price increases in the
large cities has begun to turn down lately
Chinese banks NPL ratio should be growing
faster that official estimates
A harder access to credit should reveal capital
malinvestment, large unused industrial
capacities …

24
Market Flows
Market flows are benefitting equities (driving P/E higher), and getting out of bonds…

25
EQUITY
Markets are now back to their highs…
We continue to think that any further upside on the S&P 500 should be driven by profit growth rather
than P/E expansion
Geopolitical risks, particularly in Ukraine, remain worrying.
In our February report, we have been for a limited correction (5% to 10%) on equities, targeting the
1757 - 1722 area on the S&P 500. The S&P500 stopped its downside move at 1742
Bottom line :
We are Neutral equities
We keep our UW on (deflationary) Europe and EM vs. US and Japan
We keep our bias to defensive high-yielding stocks.
Industrials and Tech are our preferred sectors as they have positive betas to the 10y yield and a
very strong earnings revision momentum

26
Earnings
Earnings revisions remain in negative territory, both for Europe and the US.
74% of S&P500 names have beaten Q4-2013 (lowered) earnings estimates. Q4 EPS growth is 9%
YoY.
Q1-2014 S&P500 earnings growth is now expected at +2.4%, which will be the lowest rate of growth
since Q3-2012
In Europe, only 53% of companies have beaten earnings estimates, with a negative surprise of about -
4% so far.

27
S&P500 – Earnings
Price performance is still coherent with last-twelve-month EPS
But earnings estimates continue to go south

28
MSCI Eurozone – Earnings
Eurozone equity performance over the last 3 years is entirely explained by PE expansion.
Eurozone EPS is now 35% below its 2007 highs

29
S&P500 – Investors Sentiment
Investors seem confident about future economic outcomes, as they continue to prefer growth-oriented
consumer stocks over more conservative consumer staples stocks

30
S&P500 – Earnings, Sales and Margins
Most analysts are still optimistic on EPS growth
Sales, like margins, are stabilizing…

31
S&P500 – Short-Term View
The LT structure for the S&P500
still looks very bullish. The index
has pushed above the big trend of
the highs of 2000 and 2007.
Like during the period from Jul. /
Aug 2013, and given the negatively
diverging oscillators, the break
above Jan ‘14 high could be
unsustained.
A pull back to the Jan. 15th high at
1,851 seems possible. Below it we
should target the 100-dma around
1800

32
Equity Derivatives
The skew seems very high, implying that the market remains concerned by the downside risks

33
Demand & Supply Balance
The demand-supply balance is supported by solid buybacks, trend inflows and short covering…

34
Japanese Equity
The Nikkei (Blue) and USD-JPY (red) have been the major beneficiaries of the ongoing liquidity (Broad
Money in green) additions from the BOJ.

35
EM Equity
EM situation remains precarious
EM equities have underperformed for the last 3 years.
Outflows from EM equities are not showing signs of stabilization and EM FX is still volatile.

36
Large Speculators / HF Positions
According to CFTC data (Feb. 25th) Large Specs have reduced their S&P 500 shorts a little, before
reaching the crowded short zone
Macro HFs reduced their long exposure to S&P500 and took short exposure to NASDAQ.

37
Trading Model - SPX
Our prop. Short-Term trading model went massively short on Mar. 4th at 1873.91 on the index
The model targets 1865 – 1847 - 1757 and stops its losses at 1903-1942

38
FIXED INCOME & CREDIT
In Govies, we keep our core strategic view for higher long-end yields going forward, especially in
US and UK.
Turmoil in Emerging Markets and geopolitical risks continued to provide support for DM fixed income
through flight to quality flows. But, we expect the selloff on Treasuries to resume very soon.
Last month, on UST 10y yield, we said “But given the continued downside pressure we see on this level,
we prefer to wait either for a clean breakdown (targeting 2.54) or for a clear rebound (to put on our short
positions).” The rebound was clear on 2.60 and we are now short UST
We continue to OW Eurozone vs. US and UK given disinflationary risks in Europe.
Within the Eurozone, we stay neutral Peripheral vs Core as we see lasting spread compression to be very
limited if any.
We stay neutral on TIPS
As a tail hedge, we keep our 10y bund swap spread receiver swap

39
FIXED INCOME & CREDIT
In corporate credit, we think the search-for-yield is likely to remain strong as growth improves, monetary
policy still remains accommodative, inflation stays low and macro risks remains contained
We think spreads will tighten slightly over the rest of the year. Given the rising government bond yields,
we choose to stay neutral on credit as a whole .
We stay OW High-Yield (BB and B) vs Investment Grade, and OW European HY vs US High Yield
Bottom line : UW Govies, Neutral credit, neutral TIPS, keep our OW High Yield vs High Grade

40
US Govies
Negative economic surprises (Citigroup
Economic Surprise – US, Blue, RHS)
seem to drive the 10y UST yield (Red,
LHS)
Both should reverse their course in the
coming days / weeks
But if the data continue to surprise to the
downside, an extended move lower in
yields may be possible 2.45. Breaking this
critical level would oblige us to revise our
tactical short on UST

41
Large Speculators Positions
According to CFTC data (Feb. 25th) Large Specs have decreased their UST 10y short position, before
reaching the crowded short zone
Macro HF increased their short exposure to 10-year treasuries.

42
Eurozone Govies
Bund yields should stay around current levels (1.65%-1.70%). Thus, we see UST-Bund spread to widen
this year
Peripheral spreads and yields keep compressing
We think that most of the move is now already done. Thus, we stay neutral Peripheral vs Core.as we see
lasting spread compression to be very limited if any.

43
US High Yield
HY bond yields are down 49bp over February to 5.30%. HY bond spreads are 45bp tighter since early
February to a post crisis low of 416bp.
Further spread compressions seems limited even if reproducing the last credit cycle exuberance (374bp
in 2004-06) is still possible!

44
Credit Derivatives
Our tactical position (OW HY vs IG, to prefer
BB & B bonds within the HY class) was
profitable. We keep it for the moment.
The relevant spreads are now reaching their
historical lows. Our position will be reviewed at
the end of the month.

45
Credit Derivatives
Both CDX.IG and CDX.HY are trading at multiyear
lows in spread.
CDX.HY trades very close to its all-time lows of
2007
As expected in our previous monthly report, iTraxx
Xover has outperformed CDX.HY

46
Credit vs Equity
HY issuers are taking advantage of favorable new-issue conditions. An important part of the debt
issuance by US corporates is being used for shareholder friendly activity (share buybacks, dividends)This
Our view is that credit should continue to underperform equities as re-leveraging risk increases
substantially.

47
Credit
In credit, too much money is chasing too few
assets.. Investors continue to move down in
quality in search for higher returns.
In our view, corporate re-leveraging remains
the largest risk to credit quality.
Net debt is on the rise and EBITDA is falling,
most notably in large caps in core countries
Fundamentals should continue their steady
deterioration because of rising corporate
leverage, M&A and share buybacks
There are a lot of similarities with 2006-07
period

48
EXCHANGE RATES
We keep our view for a stronger USD index in 2014 based on higher US rates and non-US
fundamental weakness
On the short-term, our tactical long USD against EUR loosed money.
On the EUR-USD, the pull back to 1.31-1.25 we were waiting for has not materialized. We are now
Neutral and wait for a clean break above 1.3825-33 (targeting 1.42) or a reverse back below the
downtrend from 2008 high
On the USD-JPY, we stay Neutral, watching for signs of a clean break above the area 103.27-103.73 to
become OW (and target 105.60 and 106.10)
Given the broad picture of EM markets, we stay short EM currencies (on countries with the largest current
account deficit) vs USD

49
EUR-USD
Contrary to our views, the EUR
showed a lot of resilience against
US$.
EUR is now breaking above its
downtrend from the 2008 high at
1.3825.
At this stage we prefer to take a
Neutral stance, keep an eye on the
current level and wait for a clean
break above 1.3825-33 (targeting
1.42) or a reverse back below the
downtrend from 2008 high

50
USD-JPY
Fundamentally, we still look for a
weaker Yen as further lifting from
BOJ is expected to counter the
economic deteriorating data
Last month, we said that a clean
break below 102.30 should open
the door to a test of 101.50. We’ve
been even lower…
Now, we stay Neutral, watching
for signs of a clean break above
the area 103.27-103.73 to become
OW (and target 105.60 and
106.10)

51
Large Speculators / HF Positions
According to CFTC data (Feb. 25th) Large specs
have:
covered net shorts in EUR at -$1.0bn to
become net long $1.2bn.
increased their Yen shorts to -$9.7bn Bull
Yen?
Macro HFs maintained their short exposure to US
Dollar Index

52
EM Currencies
EM currencies are suffering from the broad
picture of deteriorating current account
balances, less foreign investment in EM
assets and declining growth expectations
More weakness should be expected over the
short to medium-term

53
COMMODITY
We started 2014 by going OW on commodities, as we think that a more positive fundamental picture is
gradually developing. Commodities are outperforming other assets so far this year, despite the difficult
macro-economic environment (China, EMs, higher US$…).
We expect the GSCI index to deliver 5% to 10% thanks mainly to backwardation
Recently, commodity prices have been even much stronger than we expected, thanks to exceptional
weather conditions in US (for energy), droughts in Brazil (for crops). Thus, we prefer to move
commodities to UW on the short run.
Over the short run,
We remain Neutral on Energy
We are Neutral to moderately UW on Agriculture (because of higher supply) except premium coffee
and cocoa (where we are OW)
We are UW on base metals because of overabundance of supply, especially for copper
Although sentiment is clearly improving (short interest is reduced, outflows seems exhausted), we
think that a short-term consolidation is unavoidable after the strong upward move. We stay UW
precious metals (targeting 1180-1150 on gold and 18-17 on silver) because of rising real interest
rates and strengthening of the dollar.
Reaching a base will give a buying signal not only on physical gold but also on gold miners.
Over the MT, we stay UW copper. The downside risk due to increasing supply is too significant to be
ignored. We target 6600, and ultimately 6000.

54
Gold – Investors’ Sentiment
Gold ETP flow data show that after 13 straight months of net redemptions, February posted a net
inflow.
In our view, this is a first requirement for stabilization. This is not enough to declare a turning point in
gold… Gold investors should step in

55
Gold – Investors’ Sentiment
Sentiment is improving on gold…
Looking at short interest in GLD (biggest
physically backed gold ETP), we see it at
12.5mn shares (1.25 Moz), the lowest
level since March ’12. This is less then
half its peak of last year (30.8mn shares)

56
Gold – Technical View
Thus far, price action from
June ‘13 onwards appears
as a correction of the drop
from the Oct. ‘12 high. This
will be the case as far as
the move remains
contained within 38.2% of
the drop (below 1411 -
1433)
Once this correction is
finished, gold should
resume its downtrend to
1180 - 1170
Over the ST, the range
1335 – 1360 seems critical.
A break of either side
should lead to a further run
in that direction.

57
Gold – Fair Value Price
Our theoretical price (implied by US$, sovereign CDS and Real Rates) stands now at 1170 (as of Feb
28th), versus a market price at 1322. Our fair price should continue its downward movement as soon
as the US$ and real rates resume their move to the upside.

58
Gold vs Gold Miners
The ratio between Gold Miners and Physical Gold is very stretched, near 1 standard deviation below
trend since 2001, and 2 Std. Dev. Since 1984
Reaching a base on gold will give a buying signal on gold miners.

59
Large Speculators Positions
According to CFTC data (Feb. 25th) Large specs
have:
On Metals: Large specs increased Gold and
Silver long exposure, and decreased their
shorts in Copper.
increased WTI crude oil longs to $42.6bn
from $38.2bn notional. Being in the crowded
long zone should give a bearish signal on the
crude.
Macro HFs decreased their long exposure to
commodities as a whole

60
ALTERNATIVE INVESTMENTS
We are always OW on AI as we expect a 10% return in the coming year versus 5% on a traditional
balanced portfolio (stocks + bonds+ cash).
Our overweight position focuses on Commercial Real Estate (even if the current message is still mixed)
We are OW Equity long-short market-neutral, Convertible arbitrage, CTA’s and Global Macro

61
Global Macro Strategy
Global Macro remains one of our favorite risk-diversifier strategies

62
Other AIs
US Private Equity and US Property continue to outperform equities on a risk-return basis

Bottom Line : Global Asset Allocation
Whatever the EM and geopolitical risks in focus, the main
systemic risk remains China. China accounts for around 15% of
world GDP
At this stage, and over the short-term, we remain globally
long risk, with some tail hedges.
We summarize our views as follows
63

Global Asset Allocation Insights

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