Tuesday, March 18th, 2014

It’s An Ill Wind

One of the great joys of working in the financial markets is that you can watch daytime TV and still claim to be doing your job. Few things are more addictive than tuning into CNN or BBC World and watching a reporter talk to camera while the tanks roar past, or the bombers fly overhead, or the riot police charge. But it is numbers, not headlines, which drive capital markets.

As we argued in our note two weeks ago, (Crimea-Free Zone: 4th March 2014) the reduction in our recommended weighting for US equities was important because it was based on prices which pre-date the Russian invasion of Crimea. At the time it was a relatively modest signal, and it is much more powerful now. But, we believe it would have happened even without a new government in the Ukraine. Ever since the FOMC decided to start the taper, bond returns and equity volatility have been rising and equity momentum has stalled. Every week the risk-adjusted returns from equities have declined.

We would normally expect any flow out from equities to be absorbed by Treasuries, but the geo-politics makes the call more complicated than that. Treasuries are owned by many overseas investors, including some who may be on the receiving end of US sanctions. Other fixed income assets like US High Yield and Investment Grade Corporate bonds have been in a bull market for most of the last nine months. This was accompanied by a surge in new issuance, which means that investors can rebalance their portfolios without buying in the secondary market. There is nothing wrong with owning these assets in the current circumstances, but prices are unlikely to rise in the face of abundant supply.

If investors want to buy something which will go up, they have to look at assets which went down a lot previously. If we rule out all equities, that leaves only two – gold and emerging market bonds. Our US asset allocation model does not invest in gold, but it is allowed to buy Emerging Market bonds provided they are denominated in hard currency. Everyone knows about the balance of payment crisis in Q2 of 2013, but the transformation since then has been remarkable. At the end of Q3 the annualised volatility of the relevant IBOXX index was running at over 12%; now it has fallen to less than 7%. Then, the running return was a negative 20%; now it is 5% positive.

It is easy to argue that these returns are vulnerable to a slowdown in China or the equivalent. This may well be true. But once a bond market has begun to be rehabilitated, the process can last a long time and be resilient in the face of poor newsflow. The peripheral countries of the Eurozone are a good example of how this works. In October 2012, our model ranked Spanish bonds at 10 out of 11 Eurozone countries in terms of their risk-adjusted returns. By February 2013, they were in the top 3, and have remained there ever since. More recently, Greek bonds were ranked 11th in July 2013. By November, they were ranked 2nd and are currently on top of the table. It’s an ill wind that blows nobody any good. It’s a rare crisis that does not highlight at least one good opportunity.

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