Tuesday, June 30th, 2015

Known knowns

Financial markets seem to have forgotten their lines. When negotiations between the Greek government and the Troika eventually broke down there was supposed to be a sell-off in the Financials sector (both equity and bonds) and an extended period of weakness in the euro. Monday’s 2.6% decline in the Pan-European sector was painful but it hardly qualifies as a catastrophe and on the basis of world as it was last Friday we have taken the decision to upgrade it to overweight. Likewise the 1.9% decline in the euro vs the dollar in early morning trade had been completely wiped out by 4.00 in the afternoon and the currency went on to close 0.7% up at the end of the day in New York.

Of course, this crisis is not over yet and these developments may still occur at some point in the near future, but the market response so far illustrates one of the core principles behind our work, which is the inability of forecasters to identify the victims of an accident, even when it is widely predicted. This latest example has some interesting consequences. We see no material flight to safety in either the US dollar or US Treasuries. Our main asset allocation models have marginally increased their exposure to fixed income, but the main beneficiary has been corporate not sovereign bonds. Within equities we see a small increase in our exposure to the UK and an even smaller move out of the Eurozone. The biggest change over the last two weeks is the decline in Emerging Markets, which is the result of some proper volatility in China.

We believe that the best way of working out what is likely to happen in fast-moving markets, is to pay attention to the risk and return signals they generate and to ignore most of the theorising which analysts and commentators are prone to. If this means saying that we don’t know the answer to many of the questions being asked, then so be it. Here is a list of things we know that we know, even if it is shorter than we would like.

• We have upgraded Pan-European financials to overweight. In February 2015 we recommended a 25% underweight, which is now a 30% overweight. The closer Greece gets to the point of no return, the higher our weighting becomes. This should remind investors that the Swiss, UK and Nordic systems are largely immune from the fall-out and should benefit from the ECB’s policy response.

• Over the last two months we have also upgraded the Financials sector in Japanese equities and in US High Yield and Investment Grade credit, and we are close to an upgrade in both the US and UK equity models. These upgrades have all happened while the Grexit crisis escalates.

• Our Eurozone sovereign bond model identifies Spain as the country most at risk from the crisis in Greece. Italy and Portugal are also at risk, but the situation in Spain is worse. These two countries improved their ranking significantly last week when it was hoped there would be a deal, but Spain stayed rooted to the bottom of the table next to Greece.

• The country most likely to disrupt international markets is China which is #1 in our country equity ranking. Our models suggest that Japan and the rest of Asia may suffer badly if the recent sell-off turns into an extended bear market.

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