Welcome to the New Year! Many things happened while you were concentrating on something more important than other people’s pensions. Some could easily have been extrapolated from trends already in place during Q4, but some are new, either as turning points, or as levels which indicate that a problem could become critical. By design, this is a short document and we are happy to explain any of the points in more detail if clients wish to get in touch directly.

Equities vs bonds: Looking at global equities vs global bonds, we are at maximum underweight on equities. It doesn’t matter which reporting currency (dollars, sterling or euros) or which safe asset we use, we get the same result. The same is true when we look at all developed markets on an individual country basis in local currency (i.e. Topix vs JGBs or Dax vs Bunds). Apart from the obvious explanation that returns from equities are falling, these models all have to deal a significant rise in equity volatility relative to bond volatility and a reversal in the direction of bond yields.

By way of comparison, we hit this level in late 2007, long before there was widespread understanding of the problems in the US mortgage market. There have been other episodes since then which did not end in disaster, but we always needed help from one or more central banks to get us off the rocks.

Global Equities: Before the holidays we indicated that the US was likely to be downgraded from overweight to neutral and that we had no problem if clients wished to get ahead of this curve. The downgrade duly happened and we are now close to a second, down to underweight. It is rare for a major equity region to go from over to underweight in one move without some attempt at a rally, but the current one in the US has not broken any downtrend relative to other regions.

The big winner is Emerging Markets, which is now upgraded to overweight. This is very broad rally, in which former leaders and former laggards have participated. At the country level, Pakistan is the only EM on either the laggards’ or the negative watch list, while New Zealand and Spain and are the only developed markets on the leaders’ or positive watch list.

The Eurozone is still our least favourite region, but the UK has jumped from fourth the second. We have long suspected that every investor who was scared about Brexit has already sold, but we also note that the UK has virtually no exposure to Technology, the epicentre of recent market tremors, and has always been a defensive market when global equities fall.

Fixed Income: 7-10 year US Treasuries are our most favoured category in all fixed income models, followed by EM sovereign dollar-denominated bonds. In all models there has been a clear switch away from credit and back to duration. EM sovereigns offer an interesting combination of both and their credit quality has improved (at least relative to expectations) now that the dollar has stopped rising.

Equity Sectors: Most equity sector models are very defensive, although there one sector in each model (e.g. Healthcare in the Eurozone or Consumer Goods in the US and UK, which is not participating as it has in previous similar episodes.) There are also a number of sectors close to multi-year highs or lows. If these levels are broken significantly, it will be important.

Industrials: In the UK, the sector is close to a 12-year low and in the EU it’s a 15-year low. The UK sector has become the main focus for all Brexit-related disaster scenarios. In the rest of Europe, there is increasing concern about the scale and speed of the slowdown in industrial output. The first may be a buying opportunity, the second probably isn’t. Note also that the US sector is on the verge of a downgrade to underweight, which is nearly always a signal that the US is in or approaching a bear market.

Healthcare: Our recommended exposure to this sector is at multi-year highs in the US, UK and Pan Europe. The new wave of M&A will probably help to keep the pot boiling for a while. We don’t expect to increase our exposure. We may even reduce it slightly, but in the first instance this would just mean that the margin of outperformance had declined, not that the outperformance itself was in question.

Energy: In the US, the recommended exposure is close to the lows we saw in 2014-2016 and early 2018. Nothing is forever in the Energy sector so we don’t rule out the possibility of tactical buying opportunities, particularly as the new pipelines out of the Permian basin come on stream later this year. Elsewhere, the sector is mainly ranked in the top-5, because investors like the US dollar exposure.

Technology: The US sector is on the neutral / underweight boundary, at a level where it has attracted support in the past. However, in every other region where the sector was rated #1 at some stage during 2017-2018 (i.e. all of them) the decline has not stopped until the sector has fallen to #11, very often hitting new lows for this economic cycle. Of course, the US may be different, but there still many large stocks trading at a significant premium to the rest of the index.

Financials: In most regions, this sector is ranked solidly in the middle of the table, which is what we would expect at this stage of the cycle (after the policy stimulus and before the bad debt write-offs). The exception is the Eurozone, where it is still ranked #10. There has been a significant rally off a level close to the all-time low in the middle of 2018, but the leading indicators suggest that this is running out of steam. We are still nervous about the market implications of an extended run at the bottom of the table.

Conclusions: In the short term, we expect risk assets to remain under pressure because there has been a significant increase in the volatility of all financial assets as well as the differential between high and low risk assets. This means that investors require a higher return than previously in order to justify the extra risk of investing.

VAR and risk parity models will continue to reduce their exposure to equities vs fixed income, to corporate vs government securities and to cyclical vs defensive equities. In the end we will need a convincing and co-ordinated stimulus (fiscal and monetary) to change the risk-reduction dynamic. At the moment, that looks like a big ask.

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