Friday, October 11th, 2019

New Risk Conditions Indices

The asset allocation picture remains confused. Our models are clear that equities are unattractive, even though there have been occasions when it looked as though would rally. By contrast, the momentum behind fixed income returns has been strong for most of the year apart from a brief period of profit-taking in early September. So far, so simple, but this isn’t happening in the way it normally does – and it is certainly not a repeat of Q4 2018.

Normally when equities struggle, their volatility relative to bonds rises strongly. In other words, the excess volatility of equities vs bonds is inversely correlated with their excess return. In the year to date, both asset classes have done well in absolute terms, but equities are unattractive because they carry much higher risk. However, in recent months, equity volatility, which is already low in relation to history, has been falling, while the volatility of governments bonds has begun to rise, even though it is already at its long run average.

This is a puzzle, which may have important implications for the rest of the year. We don’t have a good answer at the moment, but we can set out the data, so that clients understand the situation and are prepared to act when necessary. Regular readers will be familiar with our risk conditions index, which looks at multi-asset volatility across a number of equity regions, fixed income categories and alternatives. This week, we introduce more detailed versions of the same thing, based on a selection of developed and emerging equity markets and their equivalent government bond markets. Everything is based on local currency returns and benchmarked to the median volatility of individual country/asset over the last 25 years, except in the case of EM bonds, where we do not have a complete data set.

The risk conditions index for DM equities is 77 (versus a 25-year median of 100). It got to a local peak of 103 in March 2019 as we recovered from the sell-off in Q4 2018. Both the correction and the recovery were high volatility episodes. After that, the index fell to a local trough of 68 in July, before rising slightly to its current level. On its own, this would normally support a significant position in equities. The reason it doesn’t at the moment, is that bond returns are so strong. The risk conditions index for DM government bonds is 100 – in line with its long-run median. More importantly, it is now at a 30-month high, having risen from a low of 73 in June 2019. If it rises another 10 points to 110, it will hit a new 5-year high. We would normally regard this trend of rising volatility as a sign that central banks were losing control of their domestic bond markets, but most investors regard their current policies as being positive for performance.

The bottom line is that bond markets are behaving as though a recession is imminent and equities aren’t. We are just about to start the Q3 results season in the US and then Europe. If the news is bad, we expect to see a spike in equity volatility and a decline in returns, which would remove most of the inconsistency between the two risk conditions indices. This is our base case. But if there is no significant reduction to consensus forecasts for 2020, there may be a sharp sell-off in government bonds. This would make their risk-adjusted returns look a lot worse in absolute terms and those of equities look a lot better on a relative basis. Equities can’t stay where they are at the moment. There has to be a big correction or a big rally.

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Friday, September 27th, 2019

Six Sector Ideas

When the asset allocation picture is confused as it is at the moment, there are essentially two options. The first is do nothing. The second is to concentrate on stock and sector selection. Doing nothing is not a bad option, particularly as we are just about to start the third quarter results season, but nobody pays for research which recommends no change. Our recommendations could be implemented immediately, but because they relate to sectors, the timing of this note allows investors to prepare their shortlist of stocks in advance of the deluge of earnings announcements.

Before we get into the detail on sectors, we need a quick word on the main asset allocation models – sterling, dollar and euro. At first glance, an increase in the recommended weight of equities should be good news. However, this was driven by profit-taking in fixed income after a strong summer. Together with a spike in fixed income volatility, it reduced the hurdle rate that equities need to beat in order to be risk-efficient. The bad news is that the return from equities has risen only slightly and may be peaking. In other words, a temporary reduction in the return per unit of risk in fixed income does not necessarily lead to an improvement in the risk-adjusted returns of equities, even though the relative performance improves for a bit.

The rest of this note focuses on sectors rated underweight where we see potential for an upgrade in the near future, and on overweight sectors which are vulnerable to a downgrade. Our job is to highlight these situations. We will let others supply the narrative.

Potential upgrades: UK Telecom has been rated underweight for most of the last three years, but has now broken above the 26-week and 52-week moving averages (MAV) and has a high-conviction lead indicator, which is sloping upwards and is much better than it was four weeks ago. This has everything we look for when evaluating the potential for an upgrade. Eurozone Materials are still technically in a downtrend that has lasted since Q1 2016, but are above both MAVs and have an upward-sloping lead indicator with good (as opposed to high) conviction. Another two good weeks could see it break out of the downtrend and challenge for an upgrade by the end of October. Japanese Materials is not the biggest sector in the world, but we have recently upgraded Japan to overweight and the sector has the same technical characteristics as the others that we like.

Potential downgrades: US Staples and Pan-European Consumer Goods are both trading below their 26-week MAV and have high conviction downward-sloping lead indicators. European Consumer Goods are rated overweight and are still well-above their 52-week MAV, but have suffered a sharp reversal in the last month. US Staples are downgraded to neutral this week and are just about to break down through their 52-week MAV. Essentially these are the same stories about a month apart. Chinese Financials have all the negative signals we look for – below both MAVs with a high conviction, downward-sloping lead indicator. They were downgraded to neutral four weeks ago. Investors may not have much direct exposure, but this could be telling us that the shadow-banking system is in trouble following the devaluation of the renminbi, and that is potentially a very important message.

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Thursday, September 12th, 2019

Hyper-stability is destabilizing

This week’s commentary on many of our equity sector models mentions that fact that the recommended weights and the rankings are largely unchanged over the last four weeks. We note that this level of stability is unusual and can be the preface to a period of significant change. The price action in the US this week suggests that this was a prescient call. We now have headlines like “Quant Crash”, highlighting that many of the individual stocks which had performed very strongly over the previous three and six months have sold-off aggressively this week and that many of the previous losers have seen a surge of interest. There are even comparisons to August 2007, when a similar rotation took place. What does it all mean?

First, we are suspicious of any attempt to try and tie this in with any macro-economic story. It is true that yields on the US 10-year Treasury have suddenly stopped falling, but proving that this caused the rotation is quite another matter. There have been many occasions when a much larger movement in yields has not caused a significant rotation at a factor or a sector level. November 2016 is a good example. Furthermore, any serious analysis of the macro-economic causes of factor rotation would use a multi-variable, not a single variable approach. To call this is a coincidence has all sorts of derogatory overtones, but that’s what it is.

Second, bearing in mind that we are less than a week into this episode, we need to be cautious of the parallels with August 2007. Harlyn does not run the sort of factor models that are the basis for these headlines, but your analyst was doing exactly that, some 12 years ago. The important lesson of August 2007 was that the losses incurred during that month were largely eradicated by the middle of Q4 2007. The investors who really lost money were those who changed their process or reduced the amount of capital they allocated to it. This is not the death of momentum or growth or low volatility as attractive investment factors.

Third, we think the best explanation for the sudden increase in rotation is the fact that it was so quiet beforehand. We can’t test this for factors at the individual stock level, but we can look at the amount of activity recommended by our sector models (i.e. the gross change in recommended sector weights over the last four weeks) and compare that with our 24-year history. Just to be clear, this is not a measure of stock market volume; it is an internal measure of the changes our model thinks are necessary on a week to week basis. As of last week, this number was in the third percentile of all observations – i.e. very low. We have not adjusted this time-series for seasonality, because there is no significant seasonal pattern in the data, even though there may be in stock market volumes. We see the same effect in our Eurozone model, 1st percentile, and in Japan, 3rd percentile, but not in the UK, 41st percentile, which is probably because of Brexit and the volatility of sterling.

Finally, going back to August 2007, there are many strategists (us included) who would argue, with hindsight, that this episode marked the beginning of the late-late cycle in the last equity bull market. We have a sample size of one and we don’t even know if the current episode qualifies yet, so any sort of statistical analysis is impossible. Nonetheless, for asset allocation purposes, this may be the most important lesson. Time will tell.

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Thursday, August 29th, 2019

Catch-22 and Japan’s response

In our last note, (Rhyming or Repeating), we highlighted the fact that our main asset allocation models were back to where they were in August 2018. Since then, the US dollar and euro-denominated models have fallen to a level which is, for all practical purposes, maximum underweight in equities. The sterling-denominated model is not quite there yet, because sterling weakness has supported the returns of international equities by enough to justify a small equity position. We also stressed the point that history is not destiny. Just because we had a 20% correction in global equity markets last year, doesn’t mean that we have to repeat it this year. There is still time for governments and central banks to change the script. Equally, what was done to support equities last time may not necessarily work this time.

The broad consensus amongst global investors is that one of the most important reasons for the slowdown in global growth has been the escalating trade war between China and the US. There is still disagreement about whether this is sufficient to cause a recession in the US, but there is good evidence that we have already got to this stage in major economies, like Germany. Most investors identify President Trump as the first mover in this argument, even though many think that China’s non-tariff barriers in her own economy are also to blame. No matter who is responsible, if investors want the trade war to stop, they have to persuade President Tump to change his mind, in the hope that the Chinese government will respond.

Rational economic arguments do not seem to work, which means that other forms of persuasion will have to be applied. Maybe there are other pressure points, but one of the main themes that the President has used to illustrate the success of his economic policies has been the performance of US Equities since he took office. Remove the opportunity to make this boast and there may be a chance that he will come back to the table. The only people with enough leverage to make this happen are US investors themselves. In order to get the President to abandon a policy which is depressing the value of US Equities, investors have to sell US Equities. The flip-side of our Rhyming or Repeating paradigm is that just because the Fed agreed to stop raising rates during the last correction, they may not agree to proactively accelerate rate cuts this time round. If tariffs are the problem, what good is a 25 or 50 bps rate cut?

None of the above is a prediction, merely an illustration of how complex it is to model the reaction functions of the main participants. In the meantime, investors have portfolios to run. If they are already close to their minimum equity exposure, is there anything else they can do? All our equity sector models have increased their exposure to defensive sectors, led by Consumer Goods and Utilities – and Healthcare outside the US. Our regional equity models have a big overweight in the US – a sort of “our President, your problem” strategy. However, they have also boosted their exposure to Japanese Equities, despite the risk of a stronger yen, which normally causes the domestic index to sell off. This may just be a timing difference, but there may be other forces at work. This is just a suggestion, but of all the developed economies, Japan has by far the most effective policy tools for official, direct intervention in its equity market. If our models are right, these could be very useful in the near future.

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