Tuesday, December 17th, 2013

Sting in the Tail

The year ends as it began, with uncertainty about the Federal Reserve’s intentions. As usual we eschew all opportunities to forecast what would like to happen at this week’s FOMC meeting, and concentrate instead on investor behaviour to see if this contains any clues as to the future. We observe three things.

Falling equity markets: All major equity markets are down on a month-to-date basis, with international equities reacting much worse than US equities. Once again this is accompanied by a fall in US Treasuries, highlighting the positive correlation across asset classes and equity regions that we have previously written about. On a rolling 26 week basis every major equity market apart from Japan has a positive correlation of over of 40% (and climbing) with US Treasuries.

Weird currency reaction: The behaviour of foreign exchange markets is frankly perverse. Despite the fact that probability of Fed tapering in January has increased in recent weeks, the Euro and Sterling are both poised to break out on the upside against dollar and yen.

No significant changes in sector rotation: So far, there has been no signal in any of our regional sector models that equity investors expect different sectors to take up market leadership. It is a bit early to expect this, because we still don’t know what the FOMC will say. But if they do indicate that a January taper is the preferred option, we may see the first significant rotation during the holiday season. This would leave many investors playing catch-up when they return to their desks in January.

The combination of these three trends leads to some odd conclusions. US investors prefer Eurozone and UK equities because of the currency strength, even though European investors believe we have got to the point where further currency strength causes an erosion of competitiveness. UK and European investors prefer US equities because of their ultra-low volatility, even though this volatility would clearly be impacted by a decision to start the taper.

Disturbance in equity bond relationships

We also detect a disturbance in the normal relationship between risk and return for equities vs bonds. Usually we expect the excess return of equities vs bonds to be inversely correlated with the excess volatility of equities vs bonds. In other words if equities become more risky relative to bonds we expect their returns to fall relative to bonds. The relationship is persistently negative (about 90% of all observations) in all regions, but if we look at the short-dated samples (26 weeks our less) for US and UK equities vs their domestic bond markets, we note that the relationship is positive.

This suggests that investors are becoming insensitive to risk (as regards their allocation between equities and bonds). The average of all sample periods is still negative (the right way round) so there is no need to panic. Nonetheless this should be regarded as a warning signal indicating the potential for a short sharp sell-off in equities. Do not under-estimate the potential for 2013 to have a sting in its tail.

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