Wednesday, July 19th, 2017

No Case for Emerging Markets Yet

The problem for fans of Emerging Markets is that since the beginning of 2017, European equity markets have produced EM rates of return combined with DM levels of volatility and liquidity. The reasons for this are no great mystery. A robust recovery in the Eurozone, market-friendly election results, better progress on bank capital adequacy and a strong currency have all combined to boost returns.

For the first three factors cited above, there is no reason to think that they will go into reverse in the near future, but the currency could become a problem. Since January 2015, EURUSD has traded in a well-defined range of 1.05-1.15. One of the reasons why this year’s returns look so good in dollar terms is that they are inflated by over 9% as the single currency has gone from the bottom to the top of the range since January. However, from now on the situation gets more difficult; either the euro strengthens in which case European investors could start to take profits (as they did at the beginning of this week) or the currency stabilises/retraces in which case dollar returns will no longer benefit from this tailwind.

This could be the moment when investors start rotating into Emerging Market equities, but we have our doubts. None of the BRICS looks particularly attractive to us. South Africa and Brazil are mired in political scandals alleging corruption at the highest levels of government, and also have very disappointing growth rates. Russia’s fiscal deficit continues to widen and weak GDP growth is unlikely to improve unless the oil price rises to $60/bbl, which we also think is unlikely. For the last two months, these three countries have consistently been ranked in the bottom six out of over 40 global equity markets which we follow.

Neither India or China has a growth problem, but both have structural reform issues which could periodically affect the risk appetite of local investors. In India, two recent examples are the abolition of high denomination bank notes and the introduction of the nationwide goods and services tax. In China, regulators have yet to embark on a serious clean-up of bank balance sheets and some of the wealth management products offered to local investors are little more than Ponzi schemes. Ten years on from the start of the global financial crisis, we know it is possible to have a healthy economy and sick financial markets. The right reforms, properly communicated, and well-executed would lead to a rally in both countries, but for now they remain on or close to our negative watch-list.

This leaves us looking a second-tier emerging markets like Mexico, Korea, Turkey and Poland. Korea is large enough to make a difference to global portfolios, but not all index providers classify it as an emerging market, and it comes with a large geo-political risk called Kim Jong-Un. Mexico is well-understood by US investors, but the peso is always vulnerable to the US political cycle. Like the Eurozone, currency appreciation is a big part of this year’s excess returns. Turkey looks good now precisely because it looked so terrible a year ago, and can never be a core holding, while Poland is really a European, not an EM, story. If the three factors we cited at the beginning of this note remain supportive, we don’t see why investors would want to change a winning formula. The Eurozone and its near neighbours, apart from the UK, are producing better risk-adjusted returns than Emerging Markets.

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Wednesday, July 12th, 2017

Financial Rotation

Over the last two weeks several clients have asked whether we can find any evidence of a broad rotation into Financials in response to a co-ordinated tightening of monetary policy by central banks around the world. We are naturally sceptical of this idea, because this is the sort shock to financials markets they have been trying to avoid for the last five years. It is, however, possible that they may each have decided for their own specific reasons to move in the same general direction at the same time but at a different pace, and that they may not want to advertise this in advance. Rather than constructing elaborate theories, we prefer to look at the evidence.

During this time, our equity sector models have increased their exposure to Financials everywhere, apart from China. In the US, we have upgraded the sector from neutral to overweight; in the UK and Pan-European models we are challenging the sector’s highest exposure over the last four years, and in the Eurozone, we have just broken through it. It all sounds very impressive, but the alternative facts are that in the US and Japan we are well below the highest recent exposures, set in March and February of this year respectively. The strength of Pan-Europe is primarily down to an explosive move in the Eurozone. This has happened before, but it has nearly always been followed by an immediate and complete retracement. In other words, the ECB has form when it comes to miscommunicating monetary policy, as do investors in over-discounting it.

We have also looked at the most important stocks to see if we can identify any patterns. In the US, the recent strength has been led by the universal banks like JP Morgan Chase and Citigroup, rather than the investment banks like Goldman Sachs, Morgan Stanley and Bank of America, which did so well in Q4 of 2016. However, none of the banks has a higher recommended weighting now than it did three months ago. In Financials as a whole, only Bank of New York and All State are doing better than they were at the end of Q1.

In Europe, there are several banks with a higher recommended weight than three months ago. The most important are BBVA, Caixa, Commerzbank, Intesa Sao Paolo, and Unicredit. We think this a result of the successful recapitalisation of smaller banks in Italy and Spain, rather than an indicator of future ECB policy. Looking at the rest of the Financials sector only Allianz, Deutsche Boerse, Munich Re, and Sampo are more highly rated than at the end of Q1. In the UK, none of the banks, including HSBC, are more highly rated, but the life insurers like Legal and General, Standard Life and Prudential are.

Our conclusions are as follows. (1) In the US, enough banks have higher exposures than a month ago to support the idea that investors are once again anticipating a steeper yield curve, but it is definitely second time around, and the move will not be as powerful as it was from Q4 2016 to Q1 2017. (2) In the Eurozone, the main driver of recent outperformance has been the recapitalisation of the smaller Italian banks, and the consequent reduction of systemic risk. (3) In the UK, the strength of the financials sector comes from other financials, not banks, and we don’t see a clear link with UK monetary policy. Overall, we have no problem with an overweight recommendation on the sector, we just don’t expect it to get much bigger.

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Wednesday, July 5th, 2017

Lucky Dip

For the last month, our global equity vs all fixed income models have been indicating that an equity correction could occur at any moment. The same is true for our US equities vs US Treasuries model, and most of the BRICS are in trouble against their local government bond markets. The Eurozone and Japan are less threatening, but could be vulnerable. So far, so consensus, but what happens next is not. Most of our clients have been told by most of their brokers that they should “buy the dip”.

We disagree and to the extent that we do agree, we will probably be recommending a different bounce. Because we are dealing with a future correction whose timing, scale and consequences are unknown at the moment, our normal probability-based charts are no good to us, so we shall rely on some simple long term total return charts covering the major equity indices in local currency.

Let us start with the US. It is always possible that we get a 10% correction followed by a strong rally, with significant new all-time highs. But we are late in the profit cycle and big new highs would probably increase the speed at which the FOMC shrank its own balance sheet. If investors think that a significant new high is unlikely after a correction, what is the point of adding to US equity exposure, 10% beneath it? They would have to be very confident of their ability to time the next high and get out before it.

Our first chart compares the total returns of US and Eurozone equities in local currency, over the last three equity cycles. One of the few bullish points for global equities at the moment, is that the top of the last two cycles has been marked by a period of excessive optimism for the Eurozone, which takes the index above the US before it crashes to earth. Euro-euphoria has clearly begun but it may have further to run and may last to the Italian elections scheduled for Q1 2018. If there is a dip in global equities in the near future we would consider using it to buy Eurozone, not US equities, on the basis that the upside is not capped at current levels.

The next two charts show the Emerging Markets in dollars, and Japanese Equities in yen, both vs the US. The problem with Emerging Markets is that they had a huge run from 2003 to 2007, and have done nothing since then. None of our short term charts suggest that EM as a group would react well to a sell-off by US equities. If there is a dip and then a bounce, the returns are unlikely to be attractive on a risk-adjusted basis and there is a real danger of hitting significant long-term resistance just above the current level. By contrast, Japan has just hit a new high for the last three equity cycles, beating the levels set in 2007 and 2015. Of course, it’s not the all-time high, but therein lies the attraction. Most Western investors would regard as fanciful the idea that Japan could generate returns like those from Emerging Markets between 2003-07. That is roughly what they thought about EM before it happened.

So if there is a dip in global equities, we would use the opportunity to buy Eurozone equities, as the short-term trade. If the correction looks like the precursor to a more significant downturn, or if it doesn’t happen until after the Eurozone has closed the gap with the US, we would increase exposure to Japan. Our tactical models are trending in this direction, but this is a longer term call, which depends on the government finally delivering on its programme of improved corporate governance.

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Thursday, June 29th, 2017

The Hurdle: Excess Volatility & how Central Banks Respond to it

Every asset allocation process has at its heart a set of numbers which describe the relationship between risk and return. There are many different approaches (don’t worry, we are not going to survey them) but they all have this idea in common. Our approach is based on the concept of excess volatility, which we define as the volatility of equities minus the volatility of the risk-free asset, i.e. government bonds. This is the amount by which equity returns must beat bond returns in order to be risk-efficient – the hurdle rate. We aim for a recovery ratio of at least 100%. We don’t always achieve it, but we find that the discipline helps us achieve much smaller drawdowns than other processes. In practice, this means that when the excess volatility of equity is very high, e.g. Q4 2008, we have almost no equities in the portfolio, and when it is very low we are happy to run with a very high exposure.

That’s the theory – why talk about it now? The answer is that two weeks ago excess volatility in the US hit a new 22-year low. Although the bond index we use doesn’t go back that far, we believe that this reading would also be lower than anything from the 1980’s or 1970’s. There has been a small bounce in the last two weeks, but we are effectively the lowest we have ever been. For equity investors, risk conditions have never been more benign, which is, of course, bad news, because the overwhelming probability is that they will start to get worse – possibly quite soon. Before we all start looking for the exit, we should remember two things. (1) We may have reached the trough, but there will need to be multiple policy mistakes to get anywhere near the peaks of 2000 and 2012, let alone 2008. (2) On its own, excess volatility is not a good timing indicator – the previous troughs in 2004 and 2013 were not associated with major tops in the equity market.

However, using this analysis, there is absolutely no justification for the FOMC continuing to stabilise US financial markets in any way. They have achieved their policy objectives. In fact, if they had a metric which targeted risk conditions, it would show that they needed to inject risk into the system, almost as a way of vaccinating intermediaries against future infection. We get exactly the same conclusion from our Eurozone chart, which has also hit a 20-year low. The difference is that Eurozone chart has fallen further and faster. The current reading is much lower than anything since the financial crisis, whereas the US has had two previous episodes of low excess volatility since then. We think this analysis (or something like it) played a significant part in the ECB’s change of direction this week.

Excess volatility in UK is deep into the first quartile, but is not exceptional. It was lower than the current level for several months in 2005 and 1996-97. In Japan, we have only recently entered the first quartile (March 2017). We think these charts help to explain why the moves to withdraw QE are being led by the Fed, with the ECB in second place and the BoE and the BoJ a long way behind. Excess volatility will almost certainly rise – basically because central banks can’t, and don’t want to, push it any lower. As risk conditions deteriorate, our model, and many others like it, will gradually start to disinvest from equities, even though the actions of central banks may depress the returns from government bonds. Let’s hope they don’t get too enthusiastic.

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