Tuesday, September 2nd, 2014

Autumn Season

We start the Autumn season with our view on Fixed Income because that is where things have actually changed over the summer. Contrast this with the state of suspended animation that has hung over equity markets. Our US fixed income model has upgraded 7-10 years Treasuries to neutral. This may not sound very important, but it is the first time it has happened this year, and in our opinion, it represents a considered response to what the Fed has been saying – i.e. that the US labour market will soon have recovered enough for it not to be a constraint on rising interest rates.

If that is the case, then we should expect spreads in high yield and investment grade to widen and carry on widening for some time. This has already started in high yield, where our model is underweight. It may be just about to start in investment grade, where our model is still neutral. We should also expect the dollar to strengthen against all currencies, but particularly against the euro and the yen, and most of the merging market currencies. This will have not a direct effect on the returns of US dollar-denominated bonds issued by emerging markets. But because they represent a foreign currency obligation of the borrowers, it will make the overall cost of servicing these bonds more onerous, and eventually reverse the dramatic narrowing of spreads we saw in Q2.

In Fixed Income there has been a clear move away from risky assets, which can easily be related to what central banks are saying. This is not the case with equity markets, especially the US. Our sector model shows Technology as the runaway leader, with an overweight position which is almost twice the size of Healthcare which is the second place sector. The overweight position in Technology has been in a continual uptrend since late June. The Healthcare sector has been following the same pattern about four weeks behind and 35 percentage points lower. We have also upgraded US Growth to overweight vs US Value. The normal recommendation is neutral with a slight bias towards value.

In the face of this uncertainty about Fed intentions it looks as though US investors have doubled-up in equities at the same time as they have doubled-down in fixed income. In one sense it is logical. If you think the US recovery is slowing down and that earnings growth in “normal” sectors may struggle (particularly for international companies exposed to the Eurozone), there is a good case for investing in secular growth, which may be able to escape the pull of gravity for a while. The trouble is that this style is always dependent on multiple expansion at this stage of the cycle. And most investors can never tell what the peak multiple should be until they have past it.

We saw a similar pattern of behaviour in late 1999: reduction of risk in fixed income and increase of risk in US equities. We could also add that our international equity model is heavily overweight emerging market equities, just like 15 years ago. That does not mean we are definitely at the same stage of the investment cycle, or that the exit route will be the same, but the difference between the two main asset classes is important.

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