Friday, September 10th, 2021

Three Quick Ideas

There are two times of the year when we tend to be cautious about the recommendations that come out of our models: the first week of the New Year and the week after Labor Day in the US. We try not to make any major calls without additional confirmation. This week’s note is therefore just a quick summary of three ideas which have come up during our normal review process. The most important is a change of view on Japanese equities, the other two are warnings about extreme overweight positions in US equities and in European industrials.

First, Japan has just generated an important technical buy signal, which is uncannily like the one it produced at the beginning of the Abenomics rally in 2012. When a region has been out of favour for a long time, we pay great attention when our recommended weight crosses back up through its 26-week MAV, particularly if this happens deep in underweight territory and we also have a high-conviction positive lead indicator. All these conditions are met in Japan at the moment. It has crossed the MAV at almost exactly the same level and with the same gradient as it did in December 2012, when Shinzo Abe was appointed Prime Minister for the second time and launched the Abenomics reform programme. This may be a coincidence, but we would follow the technical signal in any case.

The signal actually happened three weeks ago, before Mr Suga announced his resignation, and has since been confirmed twice. Of course, the reform story may subsequently be disproved by events, but that’s not the point. The point is that investors are prepared to give Japan the benefit of the doubt. Alongside the “pull” story, there is also a “push” story. Those US investors who still believe in international diversification are under pressure to reduce their exposure to the US, because of its recent strong performance. They already own Europe and have done well, but they need to divert the money they were putting into China somewhere else. No other Emerging Market is large enough to absorb these flows, which leaves Japan as the only other viable destination.

Our other two observations are more tentative. We mentioned that US investors are under pressure to reduce their exposure to the US. Our recommended weight for the US relative to the World ex US is just below its 10-year high, which occurred in September 2018. The only other time it was close to this level was in January 2015. On both previous cases, the recommended weight stayed at this level for 4-6 weeks and then fell sharply. Last week was the second week at this peak level. We are not aware of any catalyst which would force the US to underperform other regions, but given where we are, we don’t really need one. An absence of buyers would be enough.

One possible catalyst could be a series of GDP downgrades for 2021 due to Delta variant. US Industrials have begun to respond to this risk and we are now slightly underweight at -6%. However, European Industrials have seen their relative weight rise throughout the summer and the sector is now ranked #2, as opposed to #6 in the US. The difference between their relative weights in the US and European model is also just below a 10-year high. Given that most European majors also have significant exposure to the US economy, we don’t think such a large gap is sustainable.

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Friday, August 27th, 2021

China vs US Exceptionalism

At the index level, we find that the two-country model has underperformed the US index by just over 25% and that most of this underperformance took place between 2010 and 2017. Since then, the performance has been range-bound, with the current relative index level being about 7 percentage points above its 2017 low. However, the results for individual sector vary widely. The best model is Technology, where the two-country sector model has outperformed the US sector. But it has fluctuated in a wide range since 2014 and is now close to the bottom of that range. The worst model is Small Caps, where the two-county model has consistently underperformed, with no tradeable rallies in the entire 11-year history. Financials, Industrials and Telecom are almost as bad, but each of them has had at least one tradeable rally during this time

Our last two notes have been very sceptical about the investment potential of Chinese equities. We believe that the regulatory crackdown across so many sectors increases the likelihood that China will fail to escape the middle-income trap that has impacted some other Emerging Markets. China’s recommended weight in our global equity portfolio is close to zero and at its all-time low. This obviously creates a situation which contrarian investors find extremely interesting, so it is worth taking a closer look at how and when diversification into Chinese equities has benefitted global investors.

At the same time as Chinese equities are close to maximum underweight, our recommendation for US equities is close maximum overweight. We recently heard one US money manager on Bloomberg argue that he was happy with no international equity exposure at all – and no US Treasuries either. His portfolio was mostly US equities, with a small allocation to US credit and more cash than usual. In the short term, we agree with him, more or less. The difference is that he was proposing this as a long-term strategy, whereas we believe that this will go badly wrong at some point in the future and the only interesting question is when.

US Equities have been the best performing asset class over the last 25 years, but they still don’t beat our tactical asset allocation model. Every time they have got close to it, there has been a correction. Diversification via fixed income and international equities is fundamental to our process and Emerging Markets are an integral part of this in both main asset classes. Indeed, a model with only US and EM Equities and US and EM sovereign bonds outperforms our tactical asset allocation model by over 2 percentage points a year, even though this model can also invest in European and Japan equities as well as the full range of US credit.

This brings us back full circle to the issue of China, which now accounts for over 45% of the capitalisation of the EM index. In our last note, we argued that investors should split their allocation to EM Equities in two: China and EM ex China. India, Mexico and most of Eastern Europe, are currently rated overweight and we are happy to repeat this recommendation. But it is still worth asking the question whether there is any segment of Chinese equities which can be successfully used to diversify a global equity portfolio.

Our approach is to look at each of the ten major sectors and see whether our systematic approach – allocating between US and Chinese equities on the basis of prevailing risk and return conditions – would have beaten the performance of the US equity sector on its own. We also look at Small Caps and the index as a whole. We have to be a bit careful about timescales as well. We disregard anything before China began to liberalise its exchange rate regime in late 2005. These reforms prompted a surge in the outperformance of all the two-country sector models, which lasted until the global financial crisis. It would be unfair to evaluate these models starting from a local peak, so we have chosen January 1st 2010 as our inception date, by which time the new US monetary policy regime was well understood, as was the Chinese response to it.

All of the two-country sector models, apart from Technology, have underperformed over the period since inception, but some of them have performed much better in the recent past. Consumer Staples has outperformed strongly since the beginning of 2020, but peaked in February 2021 and has since retraced about half of its gains. Energy has been in an uptrend since 2017, but has been erratic in the last two years. Consumer Discretionary has also been in an uptrend since 2017, but it is much more stable, though not as powerful. Materials has been in an uptrend since 2020 and has broken out of the downtrend which has been in place since 2010.  Healthcare has performed strongly since 2020, but may have reached a local peak.

On the pages which follow, we publish the relative performance charts for all ten sectors plus Small Caps and the overall index. These compare the total return in dollars of our two-country model vs the US sector. The two-country model switches between the US and the Chinese sector on the basis of our normal probability-based approach.

Conclusions: We believe it will be several quarters before Chinese equities provide successful diversification for a portfolio of US equities or a global balanced portfolio. As previously mentioned, we do not believe this should deter investors from looking at other Emerging Markets. If you must invest in China earlier, we recommend that you avoid exposure to Financials, Industrials, Telecom and Small Caps. We see no reason to bet against such well-established downtrends.

We believe that the best opportunities lie in Technology, Healthcare and Consumer Staples, but we are concerned that now is not the right entry point. If you have to invest today, we would recommend you look for opportunities in Energy, Materials and Consumer Discretionary. On balance, we believe you should wait for the right entry point in the sectors we like.

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Friday, August 13th, 2021

Time to Separate China from EM

When MSCI was considering how to include China A shares in its global indices, there was a considerable body of investor opinion which favoured keeping them in a separate category from other Emerging Markets. Among the reasons for exclusion were the incomplete nature of financial market reform and the fact that China A and B shares would comprise over 40% of EM’s market capitalisation (not counting Hong Kong). The reasons for inclusion were that this would create a higher sustainable growth rate for the EM index as a whole, that China’s returns were weakly correlated with other EMs and that the volatility of returns was also lower. All three factors contributed to an improvement in the risk-adjusted returns of the overall EM index, and it was this that really clinched the argument (China and the future of equity allocations – June 2019

The last major increase in the weight of China came over the course of 2019. Since then, the performance data have fluctuated. Over the two years, China has outperformed Emerging Markets ex China, but over the last year it has begun to lag badly and this is the period which coincides with the regulatory crackdown. There has also been a significant crackdown in Hong Kong, albeit more political than economic.  In the light of this, we no longer think it makes sense to treat these two territories separately. According to FactSet, 75% of the revenues of all Hong-Kong listed companies are derived from the Chinese mainland. We also doubt that China will allow the Hong Kong dollar to exist as a separate currency indefinitely. Over the last two years, the risk-adjusted returns of China + Hong Kong (C+HK) are almost the same as the rest of Emerging Markets (EMxCHK), but over the last year they are much worse. Greater China doesn’t automatically enhance the returns of Emerging Markets.

Rather than putting 20% of large cap A shares into a global EM index, it seems better to create a new benchmark index for all Chinese equities, irrespective of where they are listed, (also including mid-caps) and keep it separate from the rest of EM. It gives everyone more flexibility. Global investors who are worried about China’s human rights or ESG record can choose to be benchmarked to an EMxCHK index. Investors who think these issues are manageable would have the tactical flexibility to switch between the two indices, while those who wish to specialise in C+HK can do so without having to constantly reference their performance to other EMs. If the Chinese government is going to renege on its obligations to international investors, there should be a readily available EM index (and an ETF) allowing passive investors to avoid exposure to any territory/company which may be affected.

We have proxied how these indices would have behaved and we find that the flexibility of having two separate benchmarks would have been very useful over the last two years. Our recommended weight for C+HK (vs the World ex US) held up well during the global sell-off in March 2020, while EMxCHK fell consistently to a substantial underweight in February 2021. Since then, the situation has reversed dramatically, C+HK is now close to maximum underweight, while EMxCHK has rallied strongly and is now in neutral territory. The performance of C+HK has masked the beginning of a strong and actionable rally in India, Eastern Europe and Mexico. Emerging Markets still face many challenges, but the situation is a lot better than it appears, once we strip out China.

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Friday, July 30th, 2021

The China Question

Most investors are aware that the US and Chinese governments no longer like each other as much as they did, but they may be surprised by just how bad the situation has become. Our data suggest that this is the greatest loss of confidence in China since the turn of the century. The global equity model currently recommends an underweight of -91% on China in a World ex US portfolio – and there may be further downside as a result of this week’s price action.

China has been in extreme underweight territory (worse than -75% underweight) for 12 weeks, worse than the previous record of seven weeks in 2004, and there is clearly more to come. This is more than a temporary misunderstanding between trading partners; this is more like US investors en masse withdrawing their trust from the investment proposition offered by China.

It is impossible to forecast how this situation will develop, partly because it intimately connected with the geo-political rivalry between these two superpowers. But there is one issue which China bulls frequently gloss over. President Xi is likely to be in power for at least the next seven years. He will be the first person since Chairman Mao to serve more than two terms as China’s paramount leader and he may go on for more than three, like President Putin in Russia.

The thing about a change of leadership is that it offers international investors a chance to re-evaluate a country and re-invest where appropriate. But they won’t have this opportunity in China for several years and they don’t like losing this option. When it became apparent, in 2011, that Putin was going to amend the Russian constitution to allow himself a third term, our model sent Russia to an underweight and kept it there for the next four years, almost continuously.

None of the events which have spooked investors, from the Ant IPO to Didi Chuxing and the abolition of private for-profit tuition, could have happened without the approval of President Xi and they are likely to be repeated until he goes. We cannot know how US investors will react to this situation, but we can observe what they have done in the past when confronted by similar events.

First, they increase their exposure to the US, as a safety-first exercise. Our model currently has a recommended overweight of 73% on US Equities, and we saw a similar reaction in 2011 and 2012, when President Putin made the same move. The US overweight was not caused by Russia in 2011 and is not caused by China now, but there is nothing like a bit of geo-political uncertainty for sending US investors back to the safety of their own market.

The second thing they do is to disinvest from other countries in the region. Poland, Hungary and Czechia all fell deep into underweight territory from late 2011 to the middle of 2012. At the moment, all of south-east Asia, Malaysia, Thailand, Indonesia and the Philippines is close to maximum underweight and their own all-time lows. There is clearly a Covid dynamic, but China’s aggressive attitude in the South China Sea adds a dimension of political risk as well.

The third issue investors face is what to do with the rest of their allocation to EM Equities. Here the parallel with Russia is not particularly useful because China is an order of magnitude larger than Russia in the EM index. China and south-east Asia account for some 45% of total EM capitalisation, depending on which index series you use. It is therefore very difficult not to be overweight everything else. In order of preference, our top picks in the current situation are Czechia, India, Russia and Mexico. The EM countries which have seen the biggest improvement since China fell into extreme underweight territory are Poland, Russia and India.

When this particular scare is over, US investors will have to confront the final issue. Do they feel comfortable with the fact that the US is now over 60% of global market capitalisation, the peak since global indices were compiled? This compares with 57% just before the onset of the pandemic and 46% ten years ago. If the answer is no, and if China is still out of favour, then there are only two places they can go to – Japan or Europe.

Both options would entail a shift away from growth towards value and both have similar average recommended weight over the last 10 years (+4% for Japan vs -3% for Europe), but the big issue is timing. Japan’s recommended weight is much more volatile. The standard deviation of the levels is 40% vs 25% for Europe. Japan is also a big underweight at the moment, compared with Europe, which is approaching a 10-year high. The same metric that is telling us to avoid China is also telling us to avoid Japan at the moment.

The bottom line is that China’s problem could be Europe’s opportunity. There are many other reasons for investing in Europe, but disillusionment with the pro-China consensus of the last decade may become an important factor.

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