Millennial Partners CEO Natalie Trunow: When Risks Subside, Smaller Caps Up, Growth Stocks Weaken.

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Includes: DIA, IWM, QQQ, SPY
by: Harlan Levy

Summary

Small caps with domestic focus to do better, while growth stock leadership is wanes.

More attractive buying opportunities ahead after Q1.

Risk of deflation is low.

Rate hike not likely in March, maybe in H2.

Natalie Trunow is CEO and Chief Investment Officer at Maryland-based Millennial Partners.

Harlan Levy: What do you see ahead for stocks?

Natalie Trunow: I maintain my view that U.S. stocks will be supported by decent, although not stellar, economic fundamentals in the U.S. as well as the comparatively strong dollar.

Outside of the U.S., economic growth remains challenged despite concurrent quantitative easing efforts by multiple central banks around the globe which end up competing with and canceling each other.

Economic transition in China from a manufacturing and investment-driven model to consumer-driven model will also take some time to implement. So, in aggregate, it is hard to see a specific area or a region of the world aside from the U.S. that will provide growth leadership. As such, I am comfortable focusing on opportunities that leverage the U.S. domestic economy and growth.

Market consensus is now more fully incorporating a rising interest rate environment, which will ultimately challenge growth-stock leadership.

Growth stock leadership will be challenged

Once the risk-off environment subsides, U.S. small caps should do better, benefiting from earnings profiles that have smaller exposure to international economic growth and to China and are driven primarily by U.S. domestic economy.

Q: Do you think the Federal Reserve will stick to a suggested schedule of regular rate hikes this year?

A: In our last discussion at the end of September I said that the initial reaction of the market to a rate hike was likely to be negative, especially in longer-duration assets, higher dividend yielding stocks, and emerging market names. We also said we anticipate that the rising interest rates in the U.S. will provide support for the U.S. dollar and hurt emerging markets.

Today we have seen all of these predictions come true. And 42 out of 54 emerging country currencies are down versus. the U.S. dollar this year.

We have seen continued volatility in the emerging markets, driven by both the interest rate hike in the U.S., which put pressure on emerging market currencies, but also because of the continuous economic slowdown in China and other emerging economies.

Global and U.S. economic growth is low. Inflation is low because of lower commodity prices, especially oil, and there's market turmoil, so the Fed is going to have a problem raising rates again soon, and will probably push out until later in the year.

Also in September I mentioned that my long-standing position that a hard landing in China is a distinct possibility. That is becoming more of a reality. The market participants are now focused on this risk as one of the most important drivers.

These conditions in China and other emerging markets will continue to produce deflationary pressures for the global economy, so low inflation levels in the U.S. will also deter the Fed from raising rates too far too soon.

To sum it up, I maintain my position from last year that the trajectory of the interest rate increases in the U.S. is likely to be tame. More specifically, with the first rate hike out of the way, the global growth rate low and deflationary pressures coming from China and other emerging markets, the Fed is not likely to raise rates again in March and may only do so later in 2016, possibly only in the second half.

At the same time, I don't think we are at risk of deflation in the U.S. as some components of inflation, like rents and wages, are continuing to rise.

Q: What's ahead for China, and what effects on the global economy will it have?

A: Economic transition in China from a manufacturing and investment driven model to consumer-driven model will take some time to implement, possibly several years. Reforming the state owned enterprise sector will also take a while.

The current growth rate is probably quite a bit lower than officially reported and, while still respectable, may not be sufficient for sustainable social balance in the country. If China experiences social unrest, it can become a source of instability.

This year's El Nino effect could be a significant source of disruptions in supply chains and agricultural and food commodity markets. Many emerging market countries could get impacted, including China.

China's foreign reserves are continuing to erode, and the yuan is likely to continue to depreciate. Depreciation in the yuan will have a deflationary impact on major currencies.

I still think that this significant economic slowdown in China and other emerging markets, currency depreciation in emerging market countries, and the resulting negative impact on the global commodity cycle will continue to have a deflationary impact on the global economy. These deflationary pressures are continuing to fuel accommodative monetary policies on the part of central banks around the globe. We see this in the recent announcement by the ECB and are likely to see further easing measures by the PBOC and BOJ, possibly in the first half of this year.

Q: How will Europe do this year?

A: The European economy is getting significant support from the ECB's stimulative efforts and may show signs of improvement in the short term but still lacks much needed structural economic and fiscal reforms to be a long-term buying opportunity. As austerity fatigue sets in, political will is not there to introduce much needed labor market and product reforms and liberalization. Fiscal policy and regulatory consolidation in the EU will take a long time.

Japan too will likely need to provide further monetary stimulus for its economy in the short run, while labor market and governance reforms will take a while to implement.

Q: What sectors do you like and which ones look weak?

A: First, let me say that the last time we spoke I mentioned that more volatility and pressure from economic challenges in emerging markets and Europe are likely, and that is what we have observed in the past several weeks. I also said then that this heightened volatility environment will create attractive investment opportunities in the coming quarters. I still believe that, but I think these opportunities are now developing and could get more attractive as the quarter and year unfold.

I still like U.S. regional and local banks with floating rate loan portfolios, which benefit from the rising interest rate environment in the U.S.

U.S. consumer sectors will continue to benefit from sustained domestic economic activity, employment and wage growth, lower oil prices, and further improvements in the U.S. housing market. Having said that, consumer stocks have done well, and the sector has gotten quite a bit more expensive.

Q: How does U.S. manufacturing look?'

A: A higher dollar and weak commodity prices are hurting the U.S. manufacturing sector and exports. I expect this environment to continue for some time - at least as long as global economic growth remains challenged. China will continue to have growth issues for a while, so the manufacturing sector will continue to have challenges. At the same time, U.S. consumer and residential sector are doing better.

Q:. How much of an influence on market direction and stock prices are oil prices and what's happening to that commodity?

A: The global commodity cycle is still unwinding with China being the biggest negative factor impacting the industrials and materials sector. I see this pressure continuing for a while.

Likewise, dampened demand from China, coupled with strong supply of oil as well as further advances in high-efficiency vehicle technology and consumer adoption will likely keep the pressure on oil stocks elevated in the long run, although given current depressed price levels I see short-term trading opportunities, Having said that, asset owners in the oil sector are probably a risky investment in the long run.

Q: Are we headed toward a recession? Are we headed toward an even more significant correction?

A: Falling oil prices and the slowdown in China probably significantly worse than official numbers indicate are driving markets at the moment and rightfully so. China's supply chain is being impacted by its slowdown. Many market observers are also worried about the potential for a U.S. economic recession. The risk-off environment and negative sentiment among investors is quite high today with sovereign bonds of developed countries at unprecedented levels, offering negative yields.

U.S. economic data are mixed but not negative enough to signal a recession. I am cautiously optimistic and will need to see significant further deterioration in the macroeconomic data to move to the U.S. recession camp. While recent ISM data are particularly soft, the manufacturing sector of the economy represents a smaller portion of the U.S. economy today than it did historically, while the services sector is becoming ever more meaningful.

Given this dynamic, it is important to keep in mind that the service sector of the economy has been healthy. That, combined with positive consumer sentiment and job market gives me comfort to stay optimistic. On balance, I believe the U.S. economy and consumer are still healthy and can weather the global slowdown well. Job creation in the U.S. continues to be good, which supports consumer sentiment.

The market at current levels after the sell-off is more attractive from my perspective, but I would wait till later in the quarter to re-enter the market. As volatility continues, investors will be more reluctant to step in to buy the market, which will allow for attractive buying opportunities in the weeks and months to come, especially in the U.S. market.

While the ECB's efforts are welcome, I am still not a fan of European equities for the same reasons we discussed in the past. I would be buying U.S. equities on dips here, as I believe that the U.S. economy is the only one currently in good enough shape to defy further global economic slowdown.

Once the risk-off environment subsides, as I said above, I would favor U.S. smaller caps as they have less foreign earnings exposure and are more leveraged to the U.S. economy. I would still emphasize good fundamentals, clean balance sheets, and lower leverage given risks in the system and rising interest rate environment.

The tug of war between the negative earnings impact in the energy sector from the plunge in the oil prices causing capex cuts that spill over into the rest of the economy and the positive impact on the consumer and the economy through the positive tax from lower fuel prices will continue. However, on balance, the impact will become more positive as incremental consumer spending generates positive multiplier effects in the economy.

Q: How will first-quarter GDP come out, and will you be surprised?

A: I think that the unusually strong El Nino can derail the first-quarter results in a meaningful way, so much so that we could see negative GDP growth in the first quarter, followed by a pick up in activity later in the year. I think that this impact can be even more devastating outside of the U.S. and particularly in emerging markets and can impact prices of agricultural commodities and food prices. Given this possibility, it is likely that the financial markets may have further jitters after the first quarter results can be anticipated and sell off, allowing for good buying opportunities in the upcoming weeks and months.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.