Tuesday, October 9th, 2012

Global Equity Models Commentary 09/10/2012

Market conditions

Europe is risky – not a surprising statement at the moment. But Eurozone investors sometimes do not appreciate how big the problem is. For US investors, the extra risk of investing in European equities is almost twice as high as the extra risk of investing in any other equity region (all compared with US Treasuries). Some of this is due to the volatility of the exchange rate, but by far the largest part is due to the underlying volatility of European (in particular) Eurozone equities. This is a blessing and a curse. The curse is that while the volatility remains, Europe will remain almost uninvestable. The blessing is that if the extra risk is reduced, the recovery could be surprisingly strong. The contrast with EM equities is interesting. EM equities are normally regarded as high risk, but at the moment this is not really true. The reason they have been out of favour is that returns have been poor.

Current positions

In the US dollar portfolio, Pan-European equities have the highest weight, but please remember that this includes the UK as well as the Eurozone. Second favourite is US with Japan and EM equities hardly registering on the scoreboard. In euro portfolio, it is the US market which is most preferred, with the UK and the Eurozone not far behind. In the sterling model, the Eurozone is slightly ahead of the UK and the US. It is clearly odd (and unsustainable) that the most risky equity region is the most preferred in the sterling and dollar portfolios, but is not at the top of the model denominated in its own currency. The answer lies in the recent strength of the euro against the other currencies, which has artificially inflated returns in sterling and dollar terms. Fundamental analysis would try to avoid this sort of conclusion by looking at hedged returns, but we don’t think this is sensible given the nature of the crisis. Whatever happens – good or bad – it it highly likely that the euro and the eurozone equity markets will move in the same direction at the same time.

Outlook

The conflicting effects of monetary policy and exchange rates make the relationships between Eurozone, UK and US equities difficult to manage at present. But they all have one thing in common. In all three models we see the potential for EM equities to increase their weighting in the coming weeks. In the sterling and dollar portfolios this would probably be at the expense of the holdings in Treasuries or Gilts. But in the euro portfolio the weighting of Bunds is already low, so it would have to be at the expense of one of the three main regions, most likely Eurozone equities, if the dollar stabilizes or rises against the euro. At present we see no sign that Japan will see a revival of interest anytime soon. We repeat the warning attached to the multi-asset model, that signal strength is poor and unreliable at present. On balance investors should be increasing their exposure to equity risk at present, but we would have no objection to hedging the downside risk.

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