Thursday, July 19th, 2018

Three Unrelated Ideas

Few of our models have produced a tradeable signal in recent weeks. Here are three ideas (two new and one worth repeating) which we think are interesting. At first sight, there is not much linkage between them but maybe they all reflect the rising risk of a trade war.

Since the end of March, the recommended weight of Japanese Equities relative to the rest of the world has hovered in a very narrow range, just above its benchmark weight. This sort of stability is very rare. It is OK for a region to have a large and stable over or underweight. In the neutral zone, stability is normally a sign that we are approaching a major move, but that nobody is sure of the direction. The longer the period of stability, the bigger the eventual move. This is where we were in Japan until two weeks ago. Last week, we fell below benchmark. This week we are in the verge of a downgrade to underweight. The risk of the country being caught in the cross-fire of a trade war between the US and China is obviously rising, even though it’s hard to find a new development which “caused” this move.

The good news is that Japan’s problems allow us to upgrade the Eurozone to neutral from underweight. Investors are still increasing their overweight on US equities, funding it mainly with a large underweight in Emerging Markets. At the beginning of this month we were concerned that they would soon need a new source of funding and that this would probably be the Eurozone. Now it looks as though Japan will fund the next leg up in US Equities, which means that the Eurozone should also be able to participate if there is any upside.

Our second idea concerns US High Yield, which has been our preferred fixed income category for the whole of 2018. We are still overweight, but the model has begun to reduce exposure and this week has broken down through some important moving averages. High Yield is also falling against each of its main comparators: US Treasuries; EM Sovereign Bonds and Investment Grade. Again, it’s hard to pin this on a news item, which arguably means that we should pay more attention, because it represents a considered, data-driven decision to move away from this asset class. We would the credit-cycle to be turning down at this stage of the economic cycle, but a trade war would negatively impact the credit quality of weaker industrial companies and the risk return for bond investors is always asymmetric.

The third idea is Healthcare. On current trends we will upgrade the sector to overweight in both the US and Europe by the end of this month. This is not a new trend, but it has clearly got stronger in the last two weeks. The sector started to rally in the UK back in March. The Eurozone followed in late April and the US and Pan-Europe (including the Swiss giants) in late May. There is no mystery why this is happening: rising corporate activity (Shire/Takeda & Novartis/Alcon), promising trials in key therapeutic areas (GSK, Biogen) and better earnings. The sector has been neglected for a long time. In Europe, our model has not had an overweight recommendation since late 2015. In the US, it is the same story apart from a four-month period around Q3 2017, which ended in a return to underweight. The idea fits well with last week’s note on defensives, because the sector has very low exposure to any trade-war related risks. We also believe that the sector would do well if the US and European markets were able to move higher over the summer.

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