Tuesday, April 8th, 2014

Straws in the Wind

A minor information vacuum has developed in recent weeks. Apart from the sell-off in US growth stocks, there have been few attention-grabbing developments. This gives us space to talk about some of the less important indicators, which can be interesting when times are quiet. The issues we want to focus on are (1) the level of active weight in our sector models (2) the outlook for non-government fixed income and (3) what’s going in the periphery of the Eurozone.For readers who can’t bear the suspense, our conclusion will be that current developments could indicate a period of significant rotation amongst asset classes and sectors, but that the Eurozone may be less affected than other regions.

Active weight: We track the active weight of our regional equity models on a weekly basis (measured as the variance of our recommended weights from benchmark). Over the last four weeks this figure has fallen sharply in the US, the UK, Japan and Pan-Europe. Active weight in the US is down from a two-year high to the middle of the range. In the UK, it has hit a new two-year low. In Japan and Pan-Europe, the moves are not as dramatic in terms of previous levels, but are a clear reversal of previous upwards or sideways trends. We always interpret this development as an indication that equities are looking for new leadership at the sector level. It is often, but not always, the precursor of a significant change in market direction. In the Eurozone, active weight has gone up, a development which demands an explanation – more later.

Non-government fixed income: In all three of our asset allocation models, we observe a clear topping out in the probability curve for investment-grade corporate debt. We have long suggested that the correct response to rising medium-term government yields was to add credit risk in corporate bonds, rather than going short duration in govvies. It looks as though this trade is coming to an end, partly because it is now possible to play the same game in Emerging Market Sovereign bonds, which have shot to the top of our US asset allocation model in the last two months. To us, this is another sign that markets are looking for new leadership.

Eurozone periphery: The thematic link between the first two points is the Eurozone periphery. The successive bull markets in Irish, Spanish, Portuguese and finally Greek government bonds should help to persuade nervous investors that once high-yield government bond markets are seen to have bottomed the subsequent rally can last a long time. New leadership, once established, can be very rewarding. Even now the Eurozone country bond model (which is overweight the periphery) is still adding to its active weight. This is turn supports the high active weight in our Eurozone equity model, which is overweight Financials and Utilities, two of the sectors which have the strongest thematic links to the periphery.

Conclusion: We think the reduction in the active weight of our sector models is evidence (1) that equity markets in the US and elsewhere are looking for new leadership; (2) that there is potential for significant rotation between asset classes. (3) We think this rotation has already begun in fixed income markets. (4) We think that the Eurozone is least vulnerable to these developments, unless the rehabilitation of the periphery is threatened.

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