Tuesday, July 22nd, 2014

Strike Two

There was a brief wobble in US equity markets last Thursday, as investors tried to understand what had happened to flight MH 17. This was followed by a complete recovery on Friday. All told the S&P 500 lost and gained about 25 points – hardly an earth-tremor, certainly not an earthquake. There was some residual nervousness on Monday as investors wondered whether the US would add to the sanctions it had already imposed, but today the market has gone back to worrying about the US results season. We think there may well be additional sanctions, but they will probably come later as a result of Russia’s continued meddling in Eastern Ukraine, and not as a keen-jerk response to a tragic accident.

At the top-line level, the MH 17 outrage is simply not big enough to move the dial in terms of the allocation between risk and non-risk assets. Nor has it had a material impact on energy prices. However there are some interesting trends in regional asset allocation which give us a clue as to what may happen if we ever get to Strike Three.

  1. US Equities vs US Treasuries: No change, the model has a heavily overweight position in US equities, which increased slightly last week. The probability curve is upward-sloping which suggests that we are likely to add to our equity position.
  2. US Equities vs International Equities: Increased exposure to US equities. We were overweight International Equities relative to the US and we still are, but the overweight has been reduced. The total reduction is about half of our previous overweight.
  3. Within International Equities: We remain heavily Overweight Emerging Markets with an unchanged position. We have increased our exposure to Japan relative to International Equities and relative to portfolio as a whole. Essentially all of the reduction in our International Equity position is funded by the UK and the Eurozone, with the greater part coming from the Eurozone.
  4. Individual Regions vs the US: Japan is up vs the US and has an improving probability curve. The Eurozone has fallen sharply and has a probability curve which is deteriorating very badly.

We should be wary of extrapolating recent reactions onto unknown (and hopefully imaginary) future crises. But the lessons are as follows

  1. Unless there is a dramatic spike on the price of oil, Japan should be unaffected by another crisis in the Ukraine and would be a beneficiary on a relative basis. Her main test is reform of corporation tax, and that comes in Q4.
  2. The Eurozone is already suffering from weak growth and fresh worries about the health of the peripheral banks and bond markets. It is also closest to the conflict zone and most vulnerable to disruption in the flows of trade and energy. The UK is too closely connected to the Eurozone to hold up on its own.
  3. Emerging markets should come through relatively unscathed, unless there is also a major sell-off in US equities. This implies a bias towards Asia and away from EMEA, but that is exactly the trade we favoured before last Thursday.

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