Friday, October 25th, 2019

Equal and Opposite Signals

According to Google, there are two possible authors of the saying, “I thought I was indecisive, but now I’m not so sure” – Alan Partridge and Tommy Cooper. Both were great comedians in their day and both would appreciate the irony of the joint-attribution. We know how they felt. The basic problem is that our models do not have enough evidence to commit to an increased position in either equities or fixed income.

All of our macro models are stuck in a narrow range between resistance and support. We are underweight equities – less than we were, but not as much as we could be. Our equity sector models have low conviction signals and most of the lead indicators are going sideways rather than up or down. There is no clear shift from cyclicals to defensives or vice versa. Our fixed income models have hardly changed their recommended weights for credit vs duration for the last three months. So, we are reduced to talking about things which may happen, but not imminently.

The most obvious candidate is Emerging Markets. Since June, the main portfolio has had a big position in EM Sovereign Bonds, denominated in US dollars, not local currency. In our view, this is a natural reflection of the increased maturity and liquidity of these markets as well as the desperate search for yield. Holding these assets via an ETF also makes them accessible to new investors, while basic portfolio theory makes them less volatile than an individual country bond. Over the long-term we expect them to produce better risk-adjusted returns than the rest of the fixed income universe. But last month they achieved their highest weighting in the fixed income model since the middle of 2009. There is still no sign of a decisive break of trend, but it is probably too late for investors to be adding to this position. They don’t need a crisis; they could just underperform because they run out of buyers.

In the equity model, we have a significant underweight on EM Equities. It is nowhere near its historic lows, but the region suffered badly after President Trump’s trade bombshell in May and has been at the bottom of the equity rankings since then – alongside the UK. Since early August it has built a solid support level, which has allowed the moving average (MAV) time to catch up. On present trends we would expect a crossover sometime in late November / early December. On a regional basis, we would expect this to be led by Asia, rather than Latin America or EMEA.

This is all very tentative, but the process of exhausting the selling pressure, attracting support and then building a rally is the natural cycle of investment. We have just seen a worked example of this cycle in Japanese Equities, which were deep in underweight territory when they broke up through their MAV in July and have since rallied strongly. Emerging Markets may soon be the only equity region which is rated underweight but above its MAV and this may signal a rally. We also expect EM Bonds to drop below their MAV on the way down from a 10-year high, which may be the prelude to a correction. Conclusion: We may soon have roughly equal and opposite signals in EM Equities and EM Bonds. The initial switching opportunity would be for EM specialists, but it may develop wider significance.

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