Tuesday, October 20th, 2015

What Next After the Rally

Two weeks ago we wrote a note called Bear Squeeze in which we argued that it was rare for international and domestic institutional investors to be so negative about equities across so many countries and that anyone with a short position in Emerging Market equities, particularly Asia ex Japan or Eastern Europe should think about covering it immediately. Since then EM equities as a whole have risen by 12%, compared with 8% for the US, 7% for Europe and 9% for Japan (all in local currency).

One of the themes we did not have time to discuss was the idea that a rally in emerging markets was a precondition for a rally in developed markets. There are several strands to this argument. First the Fed decided not to raise rates in September in order to avoid putting more pressure on the exchange rates and economic performance of these countries. Second the slowdown in China and other non-US countries was one of the most frequently cited factors for reduced guidance in the run-up to the US Q3 results season. There is now some evidence that this has fed through into weaker exports and an inventory adjustment in the US. Third the Fed did not want US$ strength to put greater pressure on commodity prices, which were then at or close to multi-year lows.

This whole chain of reasoning would have been regarded as misconceived and the Fed’s decision as a failure if the currency and equity markets had not responded, which they duly did. So where are we now? Our models suggest (1) that even after such a strong rally, the forward-looking indicators for EM equity performance vs developed markets are still not positive – merely less negative than they were and (2) that the forward-looking indicators for equities vs bonds have hardly improved at all. This is applies not just to EM and US equities vs US Treasuries but to all equity markets relative to their domestic bonds markets – the local for local models whose scope we have expanded over the last month. Further progress by emerging and/or developed equity markets is not impossible, but we think that the most likely path is for the rally to peter out sometime this week or next and for equities to give back some of their recent gains.

If this happens it will be very hard for emerging and developed markets not to move in tandem. There may be one exception to this link. Japan has been something of a special situation in the run-up to the Post Bank IPO. Although there is little direct evidence, some of the selling pressure last month may have been caused by pre-IPO hedging. If the IPO (which was oversubscribed 5.6x according to the FT) trades well in the aftermarket, this may kindle a new wave of interest by retail investors in Japan who have mistrusted their local equity market (with good reason) ever since 1989.

Japan apart, the logical conclusion is that investors should look to increase their exposure to fixed income. For dollar investors we prefer investment grade or Treasuries and we would be happy to take some duration risk as well. For euro investors we suggest sovereign bonds in the periphery, although there is a small risk of disappointment if the ECB talks down the possibility of further QE. We would even be happy for investors to increase their cash reserves and wait for a better entry level into risk assets.

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