Wednesday, November 21st, 2018

Straws in the Wind

At times like this, the vanity of the prediction game should be obvious to all investors. The solution is fewer, not better, forecasts. Investors should spend more time observing the present and less time gazing into crystal balls. Forecasts only matter if other investors believe them. Systematic, disciplined observation will tell us what investors are doing, not what their PR machines are saying. This is the unifying theme of this week’ note. What follows is a series of examples which illustrate this.

UK Equities: Despite some of the most dreadful headlines in the last 20 years relating to the outlook for the UK economy and the competence of the UK government, the recommended weight of UK equities relative to the global equity benchmark has hardly moved. The rating remains at Neutral as opposed to Underweight for the Eurozone. This is more than counter-intuitive. This is something which “should have happened” but didn’t. Either current holders have incredibly low expectations or there are no more sellers left.

EU Sector Strategy: The bottom of the table in our pan-European equity sector model is a crowded place. There are five sectors rated underweight, all of which are cyclical or growth-orientated. From the bottom up, they are Technology, Financials, Small Caps, Industrials and Materials. By contrast, recent flows into Utilities and Telecom suggest a new “safety at any price” mentality. These companies have the same operational, regulatory and balance sheet problems as three months ago, but their ranking has improved dramatically. Our conclusion is that investors are longer confident about the earnings outlook for Europe in 2019.

Eurozone Government Bonds: For most of the last six months, this model has been very boring. Italy was a big underweight and everything else was neutral. Last week we downgraded Greece to underweight, a fate which Spain has only just avoided, while Portugal has dropped out of the mid-ranked cluster. Fears of contagion are starting to ripple outwards. Whether this is enough to prevent the ECB from stopping the LTRO programme remains to be seen.

US High Yield: We still have a big overweight on this category relative to other fixed income but we think that the period of outperformance is ending. We have had the first signal to reduce our overweight; we expect confirmation in the next two weeks. At the index level this is hugely dependent on the outlook for oil prices, but in important sectors like Industrials, we already have confirmation. This has significant negative implications for US Equities, particularly those with high leverage or onerous refinancing requirements in 2019 and 2020.

US Technology: 13 weeks ago, we had confirmation of our signal to reduce exposure to this sector. Over the last 23 years, whenever the Technology sector has had an extended run with a large overweight position, it has usually been followed by a collapse to an extreme underweight position. This would also be consistent with the performance of the sector in all other regions during the course of 2018. The long-term chart in the US suggests that this pattern will be maintained and that comparisons with the Tech-Bust of 2000 are justified.

US Equities: If the largest sector in the index is set to underperform, it is very difficult to see how the asset class as a whole can produce a positive absolute return. There is no need to try to forecast the downside. If investors are not going to be paid for the risk of owning US Equities, they should sell. At the moment it is still possible to characterize this as an episode of PE compression, rather than falling earnings, but every bear market starts like this.

Buy Duration: Over the last two months, 7-10 US Treasuries is the only asset class which has enjoyed a consistent and sustained increase in exposure in our US asset allocation model. We don’t need to forecast a significant reduction in yields to justify this move. All we need is rising volatility and falling returns in other asset classes, which is already the case. However, if the other signals referred to above are maintained, the path of least resistance is for yields to fall.

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