Tuesday, April 14th, 2015

Anglo-Saxon Angst

This week we focus on the challenges faced by the two main Anglo-Saxon markets. Since January, both the US and the UK have seen a significant reduction in our recommended weight relative to the rest of the world. So what happens if they continue underperform the rest of the world, as they did in the first quarter?

In the UK, election uncertainty and the prospect of some fiscal tightening whichever coalition is in power are enough to account for the recent underperformance. The removal of this uncertainty would be a positive, but not nearly as positive as continuing QE in the Eurozone or the reform programme in Japan. So it is hard to see it outperforming these two regions. The UK also has the highest correlation with the US market at present and is most likely to be affected if the US continues to underperform.

The story behind US underperformance is more complex. We are now at a point where the negative impact of dollar strength on US earnings outweighs the attraction of currency appreciation for non-US investors. When the dollar began its rally, US capital markets sucked in foreign capital because there was little evidence of economic growth anywhere else. This changed as the Eurozone and Japanese recoveries gathered pace in Q1 2015. Investors in these countries already had a position in US assets and had no need to buy more, while the improved performance of their domestic equity markets offered another way of profiting from dollar strength.

An overweight recommendation on Eurozone and Japanese equities is now the consensus call, but there is a limit to how much can be invested in these two regions. Our conversations with Eurozone investors suggest that their benchmark weight for Japan is significantly below its actual share of global market capitalisation. We guess that a similar pattern applies in reverse for Japanese investors. If the US continues to underperform, investors are going to have to find another home for their money. If it’s not the UK (for the reasons above) Emerging Markets are the only possible destination.

Our models highlight two significant developments. First, for EM equities as a whole, the recommended weight bottomed in early March and has risen for four consecutive weeks. It’s not huge, but it’s a start. Second there are some countries where we see a material improvement in the gradient of the probability curve, which is our most forward-looking indicator. Some of the index strength is a result of the feeding frenzy in China, but this does not explain the recent bounces in countries such as Russia, Hungary, Poland, Peru and Brazil – admittedly from very oversold levels.

Our official recommendation is still underweight, but we have already begun to reduce the scale of that bet. At the moment we prefer to look at individual countries rather than the asset class as a whole. Our high-quality favourites are the Philippines and India. Our analysis also suggests that the risk/reward ratio is changing in in previous basket cases such as Russia and Hungary. Other countries where there are tentative signs of improvement or bottoming out include Poland, Mexico, Malaysia – and Austria, if you regard it as a play on Eastern Europe as well as a member of the Eurozone.

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