Tuesday, July 14th, 2015

Decision Dependent

Markets hate uncertainty and there has been lots of it around in the last few weeks. Many trees have been killed in the attempt to explain the deal between Greece and the Eurozone, but few investors believe that their understanding of the consequences has been much enhanced. Likewise the actions of the Chinese exchange regulators and the intentions of FOMC have been much examined, but the questions remain essentially the same as they were two, three and four weeks ago.

It is therefore not surprising that our regional sector models have started to exhibit a shift away from cyclical/aggressive sectors in favour of more defensive ones. This is consistent with the shift away from global equities towards global fixed income which began in early June, and which we wrote about last week (Coincidences Can Be Dangerous, 7th July 2015). The fact that both developments have happened more or less simultaneously is an important indicator that investors are becoming more risk-averse. We leave it to other commentators to argue whether this is justified or not. Our job is simply to observe it in real-time and to highlight it as soon as we see it. Of course it may reverse, depending on decisions taken in Washington, Brussels and Beijing, and if it does, we will say so. In the meantime it may help to review each region to see which is most affected by this shift.

The biggest shift towards defensives is in Japan. This may surprise some investors, but in recent client calls we have consistently emphasised that this was the equity market most at risk from a disorderly decline in Chinese equities. (Australia is not far behind, but a lot of damage had already been done by earlier evidence of slower GDP growth). In the four weeks since the Shanghai Composite peaked Healthcare has gone from #8 to #3 in the sector ranking. Consumer Staples has up from #5 to #1 and Telecom from #10 to #8. By contrast Consumer Discretionary has fallen from #1 to #4, Technology from #4 to #6 and Materials from #6 to #9.

In Pan-Europe, the move is not quite as powerful, but clearly visible nonetheless. This is partly because the safe havens for Eurozone and UK investors are not quite the same. (e.g. Healthcare is a haven in the Eurozone but not the UK). Nonetheless Healthcare is now #3, having been #6 four weeks previously; and Staples are up from #7 to #5. On the other side, Technology is down from #4 to #7 and Industrials from #3 to #6.

Until two weeks ago, the USA had not really joined in with this trend, but since then Technology has fallen from #4 to #6, with Industrials and Materials both down by one place to #7 and #9 respectively. Telecoms and Staples are both up one place to #8 and #5, with Utilities still at #10, but poised to overtake Materials very soon. The US also contains the one major exception to this pattern. Consumer Discretionary remains #1 and has seen its weighting increased thanks to the decline in oil prices which has seen Energy firmly rooted to the bottom of the table.

Conclusion: Neither the asset allocation call or the cyclical to defensive rotation are decisive on their own, but a self-reinforcing pattern may have begun.

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