Tuesday, September 15th, 2015

After Thursday

The world does not need another preview piece analysing what the Fed should do and how markets might react. For the last four weeks the recommended weights in our sector and country models have been going sideways. The same is true for our regional equity and fixed income models. It’s as if investors have put everything on hold until after this Thursday. Logic therefore suggests that where we do see a change of trend or a continuing uptrend or downtrend, that it is (a) important and (b) not Fed dependent. Here are three that we have noticed recently.

We begin with Eurozone equities, where Italy has moved to #2 in our country ranking, up from #5 at the beginning of August. The Renzi government has attracted favourable comment for the scope and speed of its reform programme, and GDP growth has accelerated for the first time in many years. Some of this is due to the devaluation of the euro, but there are plenty of other Eurozone countries which have not seen the same acceleration. The combination of stable government (by Italian standards), popular reform programme and weak currency is unlikely to be affected by this week’s Fed decision. The other key point is the difference between Italy and Spain which languishes at #10. Many investors argue that Spain has faster growth and that the reform credentials of the Rajoy government are just as good. We agree, but the crucial difference is the prospect of a stable government in Spain after this year’s parliamentary elections and the referendum on Catalonian independence. The Fed will not alter the balance of these political risks.

Our second trend relates to Eurozone investment grade credit, which is now our clear favourite in the euro fixed-income space. Normally this trade would be heavily dependent on a decision by the Fed, but this time could be different. Since the Greek government “agreed” to the Troika’s rescue package, there has been little differentiation between the risk-adjusted returns of sovereign bonds within the Eurozone, and the relative rankings have gone sideways. We think that investors are now playing the recovery of the periphery by buying bonds issued by domestic financials rather than the sovereign bonds. Provided the ECB maintains its commitment to QE (and it may even expand the programme) the slow and steady recapitalisation of the banking sector should continue, and spreads should narrow.

Our final trend concerns US equity sectors. For most of the last two years (and currently for an unbroken run of 58 weeks) Healthcare has been in the top three sectors in our US model. It is currently ranked #2 and may well remain in the top three for several weeks longer. However the recommended overweight relative to the index has fallen sharply over the last eight weeks and is now at its lowest level since August 2014. There are many possible explanations: a pause in M&A activity over the summer and concern over some heady biotech valuations would be on most people’s list, to which we add a third: the prospect of Obamacare becoming a political football during next year’s Presidential campaign. It’s difficult to see how a Fed decision could affect these sector-specific risk factors one way or another, and it is interesting to note that the sector has started to lag at a time when defensive growth would normally be expected to do well.

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