Wednesday, September 17th, 2014

Open Kimono

In addition to our asset allocation and sector rotation models, Harlyn also runs a country-based product, which comprises forty-four countries ranging from Pakistan to the US. We tend not to market it as widely as the others because it reflects an approach to international diversification which has fallen out of fashion. Few investors now operate on a global basis with country as opposed to sector or style as their primary selection tool. We use the model to add colour to our basic calls on equity regions. We can rank emerging market regions and countries in order of preference and we use it to structure our European exposure: Eurozone, UK, or Europe ex both (i.e. Switzerland and Sweden).

Normally we find that Europe and Emerging Markets each have countries at the top and bottom of the list. The current situation is therefore highly unusual. Every single developed European country is in the bottom half of the table, and the bottom quartile only has two (out of eleven) which are not from Western Europe. The only emerging countries which are not in the top half of the table are Russia, Hungary and Poland (thanks to the Ukraine). The top five countries currently are India, Thailand, Taiwan, Philippines and Mexico, in that order. Not only does the market agree with our call to overweight emerging markets and underweight Europe, it does so virtually without exception.

This state of affairs could continue for several weeks, but is unlikely to generate any headlines – which is where Japan comes in. Investors know what they think about Europe and Emerging Markets, but they are not sure about Japan. In the middle of June, it was in 42nd position in our World ex US model, with only Austria behind it. Now it is 16th, with a score which is halfway between the leaders from emerging markets and the laggards of Europe.

The reason for the rally was that investors began to believe that there really would be progress on corporate tax reform, following a series of announcements and government-inspired news stories. In the last two weeks we have noted clear signs that that momentum is beginning to falter. (The gradient of the probability curve is not as steep or as convex as it was.) Part of the reason is that investors have had no update on the tax reform package. We did a google search and found nothing of any consequence since June, apart from an IMF working paper in August, on which the government has not commented.

In June, we were warned that there would not be much detail before December 2014, and in fairness to Mr. Abe, he did announce a major cabinet reshuffle at the beginning of September. But none of this will matter if investors run out of patience. Our country model suggests that they will need to take a view on Japan a lot sooner than December. If they are not offered a reason to buy, the chances are that they will sell. This would be a pity. For once there is an interesting bull story, but the government needs to provide support for it. As Jamie Dimon would say, “It’s time for open kimono.”

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