Tuesday, June 16th, 2015

Peak District

At the heart of our asset allocation model there is a chart which tracks the probability that global equities will beat global bonds on risk-adjusted basis. Actually, there are two charts – one each for the US dollar and euro-denominated models, and they both track the progress of our recommended equity portfolios vs our recommended bond portfolios – not a fixed global equity index vs a fixed aggregate bond index. Because these portfolios are already optimised their conclusions cannot be dismissed on the basis that they are forced to hold underlying assets which no right-thinking fund manager would buy (e.g. Japanese equities for most of the last decade).

So we should pay attention when both models suggest that we may have reached a local peak in our weighting of equities relative to bonds. The fact that both models have turned suggests that the timing is not unduly influenced by foreign exchange markets, which is also important. The last significant change occurred in February 2015, when the equity score hit bottom relative to bonds and since then it has been one-way traffic reducing bonds and adding to equities (in particular the Eurozone and Japan) with only a small pause in March.. These turning points are quite rare and can never be reduced to a simple three-point explanation, but if forced we would point to the following factors: (1) the previous sell-off in bonds, which has finally revealed what passes for value in these yield-constrained times (2) the growing realisation that there is no good solution for Greece and (3) the appeal of the haven trade in fixed income and currencies if Greece goes bad.

What happens next depends on a set of political decisions, but our models suggest that the market response within Europe may not be as straight forward as investors expect. We start with the completely conventional conclusion from our Eurozone bond model that investors are selling peripheral bond markets and buying the core. There is no significant distinction between core countries such as Germany and the Netherlands, but our model clearly suggests that Spain has a worse risk-reward ratio than either Italy or Portugal. We put this down to the heightened probability that Podemos, the new radical party, will hold the balance of power after the general election in November. The unconventional conclusion comes from our country-based equity model. The weights have not moved very much yet, but we see deteriorating curves across all the core equity markets, especially Germany, Finland and the Netherlands and improving curves in peripheral countries such as Spain, Italy and Portugal. This suggests that equity investors may be positioning themselves for Grexit, and looking to benefit from the subsequent policy response from the ECB (“whatever it takes”). This would of course benefit peripheral bonds, but the upside in peripheral equities is potentially much greater.

This is clearly counter-intuitive, but not necessarily incompatible with a haven trade in favour of the US dollar and high-quality government bonds. If investors de-risk their asset allocation they may be able to take a little more risk with what is left of their equity portfolios. This applies on both sides of the Atlantic. We have no equivalent of the country-based approach for the US, but our sector model has significantly increased its exposure to Small Caps in recent weeks. In summary, if we are past the peak exposure to equities, it is probably time to increase the beta of what remains.

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