Tuesday, September 22nd, 2015

Upside Down

Clients sometimes ask which asset classes we would choose if were only allowed to invest in two and all we could do is alter the balance of the portfolio between them. Our answer is always EM equities and US Treasuries (the most and the least risky). The combination of these two indices creates our best performing model looking at risk-adjusted returns and also performance relative to benchmark. Its signals are not always perfect – nothing ever is – but it has generated a gross total return of 1100% since inception in January 1996.

We mention it this week because the Fed has explicitly made the link between EM equities and US monetary policy. At one level this is problem because it means that central bankers may try to game a model that was previously free from official interference. It another level it may help us to predict what the Fed is going to do and how to think about timing.

At the moment the model is almost completely negative on EM equities. It recommends an exposure of less than 1% (vs 99% US Treasuries) meaning that their risk-adjusted return relative to Treasuries can’t get much worse. As far as the model is concerned the situation is very close to hopeless – which is part of the reason why the Fed became concerned. Nothing is hopeless for ever, so it is worth asking what would change this prognosis and when. The answer is, course, that returns from US Treasuries could fall, which is exactly what would happen if the probability of a US rate rise in October or December started to increase.

And now the logic becomes circular. The FOMC’s principal reasons for postponing were the turmoil in Chinese equities and the weakness of economic growth in EM. Its actions immediately remove some of the downside. We think that time may do the rest. In our previous note, Crowding Out, we argued that the Chinese authorities would be able to support the Shanghai Composite at a level of 3,000 or above and that the key ingredients for success were (1) a large quantity of foreign reserves (2) unwavering official determination and (3) a medium-term exit strategy. We stick to this view and suggest that it will be consensus by the date of the next FOMC meeting on October 28th

EM growth is still clearly under pressure. However the risk of a catastrophic downturn is lower if the Fed is prepared to act as central banker to the world, and the oil shock is no longer new. It is one year old this month. Already we notice that the performance of certain EM countries (e.g. Philippines, Malaysia, Mexico, Eastern Europe and of course India) has begun to improve relative to a global equity index.

Officially our view is that it is too early to go back into EM equities and it will take longer than a few weeks to recover from the damage of the last nine months. But if EM equities stabilise, this increases the likelihood of a hike by the FOMC, which reduces the safe-haven appeal of US Treasuries and drives investors back into developed market equities. The logic is a bit tortuous, but we think it is sound. When our EM vs Treasuries model starts to increase exposure to equities (even if it is still very low) that will be the moment to start buying developed market equities. If the Chinese support operation works, that could be sooner than you think.

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