Tuesday, May 13th, 2014

Sell-By Date

The background to this exercise is that fixed income has outperformed equities (US$ total returns YTD) and that US equities have been the worst performing asset (apart from Japan) out of the nine we include in our asset allocation model. This would still be true if we also included REITs and commodities. So part of the answer is that we have already experienced a relative correction, especially when we take risk into account.

Make no mistake; we have not abandoned our view that there is likely to be a correction in equity markets in Q2. All our equity / bond charts recommend a reduction in equity exposure compared with the beginning of the quarter and the beginning of the year. There is also internal evidence that equity investors are preparing for a correction (e.g. the poor performance of US Small Caps, the recent preference for defensive sectors such as Energy and Utilities). However several clients have asked what would make us change our mind and how long we are prepared to keep our correction call open. US equities are flirting with new highs as we write; so it is clearly a reasonable question.

In response to a similar question at the recent Senate hearing, Janet Yellen responded that US equities and other risk assets were valued in line with historical norms; so there was no need to consider a pre-emptive move to counter a threat to financial stability. We agree in the sense that valuations have clearly been higher in the recent past, but the outcome from this following this logic to extremes has normally been disastrous. However we don’t set interest rates in the US, so our opinion is clearly not that important. Mario Draghi also intimated that the ECB would consider a rate cut at the next meeting in June.

The joint volatility of all the assets in our model is currently 9.4% (26 week trailing). This compares with a long run median of 13.7% and a low of 6.8% back in February 2007. If central banks are prepared to stay even looser for even longer, there is no reason for financial markets to become stressed, and therefore volatility could decline further. It is difficult to have an equity correction without an increase in volatility.

The other risk is that investors decide to throttle back on some of the aggressive strategies they have been pursuing in fixed income markets. The momentum of returns from US high yield has already begun to falter, and we see signs that investors have stopped adding to their overweight position in Eurozone peripheral bonds. If this happens, we investors may revert to equities on the basis that they hadn’t corrected and were therefore “safe”. The most likely beneficiary of this would be emerging market equities, which would fit well with the increasing interest in emerging market bonds.

As for the Sell-By Date for our call, the simplest answer is 30th June; this gives us a free look at the next meetings of the FOMC and the ECB. In the meantime we will have to put up with a situation where our charts highlight the risk of a correction, but never quite confirm the fact that it is happening. It’s frustrating, it’s inconclusive, but that’s life.

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