Top Down Macro Analysis

Jonathan Casteleyn, CFA, CMT - Analyst

2016/2017

Market Thesis: After a volatile 2015 with our call for the market to be down a little looking prescient,
we are now calling for a more substantial equity market decline in 2016. Late cycle indicators are
flashing more brightly and with the Federal Reserve boxed in for a rate hike in the New Year, the
effectiveness of quantitative easing will now reverse. U.S. corporate earnings have tripped into
recession with the second consecutive quarter of negative growth in the current 3Q15 earnings season.
The Street however is not heeding this warning and is still modeling mid-single digit corporate earnings
growth in 2016 which will lead to disappointment. The U.S. labor market has peaked with
unemployment as measured by initial jobless claims having hit their low water mark in May. Historically
initial jobless claims have averaged 33 months underneath 330,000 claims per week (the mean of the
Bulls of the late 80s, the late 90s, and in 2007). This post Financial Crisis Bull has now entered the 20th
month below this threshold indicating that, while there may be a year left of track for claims to stay low,
the path of least resistance is higher and that claims should back up outside of Bull market ranges.
While the Fed has overly telegraphed its intensions with short term rates, what is not well understood is
that EVERY single rate hiking cycle has resulted in credit spreads widening over Treasuries. Thus with
20% of corporate credit up for refinancing in 2016/2017, rising interest costs with be a consideration for
non-healthy corporates. The high yield market is reflecting SOME of this concern with non-investment
grade indices down sharply to 2011 levels (down over 20% YTD in 2015). Thus with U.S. equities down
only marginally entering 16, we think there is a catch up move downward in stocks to adequately
reflect the more realistic move in the bond market. Lastly, the Senior Loan Officer survey from the Fed is
relaying that lending standards are no longer loosening and are tightening in the C&I category,
something that occurred all throughout 1999 and 2007 before substantial market declines.
In Financials, we continue to like the Exchange group which benefits from the return of nascent
volatility; the U.S. Housing Complex as lower for longer puts U.S. interest rates with minimal upside,
with still more housing stock needed domestically; and select assets managers that benefit from a
pension rotation into fixed income and alternatives; Conversely, we remain short the equity asset
managers on the rotation from mutual funds and forthcoming negative beta; recommend shorts on the
heavily indebted specialty finance names who will get hit on re-finance and leverage difficulty; and
remain short Canadian banks on an economy in recession with high debt/income ratios.
No variable has correlated more closely to the equity market like the trajectory of jobless claims:

and the year-over-year improvement in jobless claims peaked in May and is now converging towards
zero:

and Bull Market levels below 330,000 per week is getting long in the tooth now eclipsing over 20
months:

During the start of the past 7 rate hiking cycles, high yield spreads over Treasuries have widen EVERY
single time between 200-2,000 basis points (yellow line right hand scale)

The Feds Senior Loan Officer Survey has been leading/concident with the trajectory of the Financials
sector. C&I lending standards peaked (loosened most) in 2014 and is now tightening which it did all
throughout 1999 and 2007 before the decline in the Financials sector:

Corporate earnings are entering a recession in 3Q15 with then an unrealistic recovery to mid single digit
growth in 2016 (some of this will be comping the negative comp):

And some thing has to give with High Yield prices at 2011 levels with U.S. equities only marginally off
their highs (either high yield prices rise and equities make new highs or equities need a catch up trade
downward):

A recent Barrons contributor outlined that 20% of corporate credit needs to be refinanced in 2016/2017
which means widening credit spreads matter:

Late Cycle Financial subgroup outperformers include Fin Tech, Exchanges, and Credit Card companies.
Convesely, the Debt Collectors, Mortgage Finance, and Auto Insurers perform poorly:

While the economy is late cycle and we are cautious on excessive equity risk, U.S. Housing is mid-cycle
with the new post crisis high in residential construction only in line with the troughs of prior cycle
auguring that U.S. housing equities can outperform:

The housing demand indices (as measured by Pending Home Sales) lead home prices (HPI) by about a
year and HPI tethers closely with housing equities:

And U.S. HPI is positively inflecting again which will push U.S. Housing equities higher:

The landscape North of the Border is in an inverse state with high leverage in the system and
Canadian banks now posing a risk to the economy:

And the Canadian housing market is now +50% higher than where the U.S. housing market imploded:

And Canadian Debt/Income ratios have continued to grow to over 160%, surpassing the U.S. peak
of 130%: