Thursday, August 2nd, 2018

Europe Can Set the Agenda

Why are US investors are so obsessed by Technology? Are they really concerned about its future growth and valuation? Or, is it because they have no other exposures to worry about? We think it’s the latter. Our US clients report that their exposure to non-US assets (equities and bonds) is close to its all-time low and that the strength of the dollar effectively prevents them from looking at any international opportunities. The withdrawal from international assets has been going on since mid-2017. It may not have much further to run but it is unlikely to go into reverse. If so, two points follow. In the period of underperformance by non-US assets, prices were set by the marginal seller, often but not exclusively, a dollar-denominated fund. They were driven as much by the currency as a view on the underlying asset. As of early July (based on our models) prices are now being set by the marginal buyer, who is almost certainly not from the US. We can’t speak to the actions of non-European funds but we detect renewed interest in EM assets from euro-denominated and sterling investors.

The rationale for EM Bonds is very simple. European investors like US dollar-denominated assets, but they don’t want to increase their exposure to the US. US Equities have outperformed global equities, even without the impact of the dollar. US Treasuries have run into profit-taking and yields may have to rise given the ballooning budget deficit. US High Yield has also done well, but spreads can’t contract much further and probably ought to be rising at this stage of the cycle. Apart from commodities, this leaves only dollar-denominated EM sovereign debt, where yields of 4.5% are available for the index as a whole. They can be higher for a modest increment in credit risk, without buying basket cases such as Turkey and Argentina. This comes with volatility of 5.8%, which makes for a very attractive return per unit of risk before dollar appreciation.

We normally argue that there is a six to eight-week time lag between a recovery in EM bonds and a recovery in EM equities, each relative to their own asset classes. This time we are more cautious, partly because of where the buying is coming from and partly because of China. Since May, this now accounts for some 33% of the equity index compared with 0% of the bond index. Add in South Korea and Taiwan and there is about 60% of the equity index which is not represented in the bond index. All of these countries are in some way threatened by US tariffs on China. It goes without saying that such a large change in the composition of the equity index may also affect its historical relationships.

However, this does not mean that individual countries cannot be attractive to European investors, even if the headline index isn’t. We identify three – India, Israel and Mexico – where the return per unit of risk has already begun to improve, and has generated a buy signal, provided the returns are measured in euros and compared with Eurozone, not US, government bonds. We could include Taiwan in this list, but if investors are nervous about tariffs, there is no need to buy it. We also think that Russia and Poland may soon produce the same buy signal as the other three. We should be clear that if there is a significant slowdown or sell-off in China, all EMs will suffer. But if there isn’t, here are three which are already attractive and all of them can be bought in ETF form.

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Thursday, July 26th, 2018

Can US Equities Break-Out?

We have come to a moment when the entire process of asset allocation boils down to one question: “Will the main US equity indices hit a new high before the end of the Q2 earnings season?” If the answer is yes, we would expect more new highs over the summer and autumn, driven by momentum buying. Many long-only investors would not commit significant new money, but they would not push the sell-button either, which is just as important. If the answer is no, there is a possibility of a material correction, even if there are no further shocks on tariffs or geo-politics. If the index cannot make a new high on the back of one of the best earnings seasons in recent years, the bears will argue that we have hit an important double top. The difference between break-out and no break-out could be as much as 10%.

Our asset allocation models normally arbitrage between the risk-adjusted returns of equities and government bonds, but there is nothing to prevent us from comparing equities to cash using the same process. For the record, we use the total return from cash (i.e. including interest) and we pay more attention to the changes in the PRATER (see page 14) and the relationship with moving averages than we do to the actual level itself. Our preferred MAV is 26 weeks, which we use in all our sector models. Over the last two years, buying the index when it moved above this MAV (and selling when it moved below) would have yielded a better risk-adjusted return than a buy and hold strategy for equities. It would also have yielded a better risk-adjusted and unadjusted return than a constant 50/50 portfolio.

The good news for equity bulls is that we broke up through this MAV as of last week. The not-so-good news is that the margin is small and could be reversed by one bad day. However, if we were following the rules of this simple model, we would be buying US equities this week. Our model thinks we have already had the break-out. If this is right, the question is what happens next? Which other equity markets will participate? For US investors, the strength of the dollar means that the answer is none. The UK market scores best when compared to US T-bills, but it is still some 20% below its MAV, and the gap is unlikely to narrow quickly because a strong US equity market also implies a strong dollar.

In local currency terms, non-US markets divide into three groups: the UK, Australia and Canada staged their equivalent break-outs from mid-May to mid-June; the Eurozone and Switzerland broke out two weeks ago and confirmed the signal this week; everybody else, including all the main emerging markets, is still several weeks away from generating this signal. The critical country, as so often, is China where the slow-down has forced the government and central bank to announce a series of fiscal and monetary stimulus measures this week. We don’t yet have a reading post these announcements, but last week’s PRATER vs Chinese T-bills was close to its minimum permitted reading and it would take a dramatic rally to bring it close to the MAV before September. Our conclusion is that the major developed markets in Europe plus Canada and Australia will participate fully if the US has a break-out, but China, most of the EM universe and Japan will have to wait until the autumn.

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Thursday, July 19th, 2018

Three Unrelated Ideas

Few of our models have produced a tradeable signal in recent weeks. Here are three ideas (two new and one worth repeating) which we think are interesting. At first sight, there is not much linkage between them but maybe they all reflect the rising risk of a trade war.

Since the end of March, the recommended weight of Japanese Equities relative to the rest of the world has hovered in a very narrow range, just above its benchmark weight. This sort of stability is very rare. It is OK for a region to have a large and stable over or underweight. In the neutral zone, stability is normally a sign that we are approaching a major move, but that nobody is sure of the direction. The longer the period of stability, the bigger the eventual move. This is where we were in Japan until two weeks ago. Last week, we fell below benchmark. This week we are in the verge of a downgrade to underweight. The risk of the country being caught in the cross-fire of a trade war between the US and China is obviously rising, even though it’s hard to find a new development which “caused” this move.

The good news is that Japan’s problems allow us to upgrade the Eurozone to neutral from underweight. Investors are still increasing their overweight on US equities, funding it mainly with a large underweight in Emerging Markets. At the beginning of this month we were concerned that they would soon need a new source of funding and that this would probably be the Eurozone. Now it looks as though Japan will fund the next leg up in US Equities, which means that the Eurozone should also be able to participate if there is any upside.

Our second idea concerns US High Yield, which has been our preferred fixed income category for the whole of 2018. We are still overweight, but the model has begun to reduce exposure and this week has broken down through some important moving averages. High Yield is also falling against each of its main comparators: US Treasuries; EM Sovereign Bonds and Investment Grade. Again, it’s hard to pin this on a news item, which arguably means that we should pay more attention, because it represents a considered, data-driven decision to move away from this asset class. We would the credit-cycle to be turning down at this stage of the economic cycle, but a trade war would negatively impact the credit quality of weaker industrial companies and the risk return for bond investors is always asymmetric.

The third idea is Healthcare. On current trends we will upgrade the sector to overweight in both the US and Europe by the end of this month. This is not a new trend, but it has clearly got stronger in the last two weeks. The sector started to rally in the UK back in March. The Eurozone followed in late April and the US and Pan-Europe (including the Swiss giants) in late May. There is no mystery why this is happening: rising corporate activity (Shire/Takeda & Novartis/Alcon), promising trials in key therapeutic areas (GSK, Biogen) and better earnings. The sector has been neglected for a long time. In Europe, our model has not had an overweight recommendation since late 2015. In the US, it is the same story apart from a four-month period around Q3 2017, which ended in a return to underweight. The idea fits well with last week’s note on defensives, because the sector has very low exposure to any trade-war related risks. We also believe that the sector would do well if the US and European markets were able to move higher over the summer.

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Thursday, July 12th, 2018

Defensive Mindset

This is a simple survey note. Regular readers of Synopsis will know that our equity sector models have been turning more defensive for several weeks. This fits with our top down view, where we are underweight in equities, having downgraded in the last three weeks. Our first chart shows the average recommended weight for the four defensive sectors: Consumer Goods, Healthcare, Telecom and Utilities for the five regions we cover, US, UK, Eurozone, Japan and China. We don’t make sector recommendations on a global basis. If we did, the recommendation would have been hovering on the neutral/ underweight boundary since mid-April and would have been upgraded to neutral three weeks ago. Since then, we have had the three biggest moves this year, all of them in the same direction and consecutively.

The shift towards defensives actually started in the first quarter and was led by Japan and China, However, part of this was down to the strength of Chinese Healthcare, which has since been pegged back. The move in the second quarter was also led by Asia. Even though the Chinese index has performed worse, it is Japan where we have the highest weight in defensives – verging on overweight. Our model can’t provide reasons, but this would be consistent with the idea that Asian and Emerging Markets will be more severely affected by a trade war.

The US and Europe have very similar defensive exposure (as do the UK and the Eurozone). The US is still a little more optimistic than Europe thanks to two factors. First, it naturally has a higher exposure towards Technology, which is still ranked in the top three. Second, Financials are ranked #10 in Europe, compared with #6 in the US. Something has to fill the gap left by such a large sector. However, the similarities are more important than the differences: both regions recommend a higher weight for all four defensive sectors than they did a month ago and both have seen the recommendation rebound from levels close to multi-year lows in May and then accelerate.

Utilities has seen the biggest increase in all regions, apart from Japan, where it is second. Other notable increases come from Telecom in Japan and China and Healthcare in the US and Europe. The only sector to see a net reduction in exposure (albeit very marginal) is Consumer Goods. This is led by Japan and China, where it was rated overweight earlier in the year. Again, the model offers no explanation for these moves, but we think that the gain in Utilities is consistent with the failure of long bond yields to ris, as much as expected, and higher oil prices, which normally translate into higher margins for electricity generators.

We are not too concerned about the detail, because the big picture is more important. Defensives are attractive because of what they are not. Investors are reducing exposure to Cyclicals, Financials and Small Caps. They have already increased their exposure to Energy. They could buy more but it would lead to a very concentrated portfolio. They started buying defensives because they were the least bad alternative. Then they looked at a world with falling dollar liquidity, rising interest rates, rising oil prices and rising tariffs and wondered why they hadn’t bought more, sooner. The shift towards defensives has clearly accelerated; it will take a very good US earnings season to stop it.

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