Wednesday, October 28th, 2015

Difficult Question. Don’t Answer

Every conversation with clients over the last two weeks has revolved around one question, “Is this rally in equities for real?” The short answer is we can’t be certain, because there is no killer fact which will prove or disprove the rally. Our models continue to recommend an underweight position in equities in every region, but they are slightly less underweight than they were. To get to an overweight recommendation in equities vs fixed income we would need either (i) a collapse in Treasuries and other government bonds or (ii) a new all-time high in US and UK equities and new highs for this cycle in the Eurozone and Japan. None of this seems very likely to us; so we are sceptical that the rally can go much further. Equities have offered poor risk-adjusted returns for the last six months, and we expect rational investors to react accordingly.

The problem is that other actors seem to be behaving irrationally – or at least outside their normal pattern. The ECB is dropping constant hints that it is prepared to intervene in financial markets and appears to be angling for a weaker euro. The trouble is that no-one is quite sure why, because the current run of economic data just isn’t that bad. There is a suspicion that this may have more to do with a new period of elevated political risk in Europe, with a hung parliament in Portugal and elections due in Spain by the end of the year. If the ECB moves from words to action, there may be unintended consequences. The scale of the intervention is almost certain to depress the euro vs the dollar, and should be good for the Eurozone economy. But it would put also pressure on US earnings forecasts, which is hardly bullish for US equities.

An ECB intervention may encourage euro investors to buy European equities, but the last time the euro depreciated in this fashion we noticed significant flows into US Treasuries, as they sought to pick up extra yield and a currency gain while avoiding the risk of owning equities. The mechanics of intervention may also lead euro investors to acquire more sovereign bonds in the euro periphery. Indeed our models suggest this has already started. Our point here is that ECB intervention does not automatically benefit Eurozone equities at the expense of other asset classes, and that it is very difficult to manufacture a high-conviction call on global equities out of this scenario.

So what should a US investor do if the ECB (or the Bank of Japan) intervenes? Obviously, any purchases of euro or Japanese equities must be fully-hedged, but the currency hedge doesn’t automatically make overseas equities attractive in risk-adjusted terms. If investors do not feel comfortable adding to either equities or bonds, now may be a good time to look at alternatives. Our models suggest that gold and real estate both offer a useful diversification when compared with a 50/50 portfolio of US equities and bonds. Both gold and real estate had very low recommended weights up until early Q3, but since then they have recovered to a neutral rating and both have upward sloping probability curves, suggesting further progress is possible.

The tactical question concerning equities vs bonds is very difficult at present. So maybe investors should find a question they can answer and look at a different set of assets.

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