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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