Wednesday, August 19th, 2015

The Burden of Proof

This is our first note since the summer break. The last one before we went away focussed on the attractiveness of individual countries relative to the world equity index ex the US. Our conclusion at the time was that if investors didn’t like the currency they shouldn’t invest in the equity market of that country either. The problem with this approach is that it can allow currencies to have too much influence over asset allocation decisions. Most institutional investors have fixed maximum and minimum limits on their ability to invest outside their home currency and cannot rely on a process which could be distorted by short term noise emanating from the FX market.

As an antidote to this we also look at the balance of risk and return on a local vs local basis. In the same way that we compare US equities to US Treasuries in dollars, we look at Chinese equities vs Chinese government bonds in renminbi and Russian equities vs Russian bonds in roubles. For the sake of brevity we only include the major emerging markets and regard the Eurozone as one country, so our sample is as follows
• Americas: US, Canada, Mexico, Brazil
• EMEA: UK, Eurozone, Switzerland, Russia, South Africa
• Asia: Japan, China, Korea, India, Australia

As usual we plot the results in four quadrants: (1) high and rising appetite for equities compared to local government bonds, (2) high and falling, (3) low and falling, and (4) low and rising. The key points are as follows. Only Switzerland is in the high and rising quadrant – an important anomaly which we will return to in later notes. Only India is in the low and rising quadrant, also an important result which distinguishes it from the other large emerging markets. Japan is the only representative of the second quadrant (i.e. good – but not as good as it was). Every other country: UK, Eurozone, China, Russia, Australia, Canada, Mexico, Brazil, Korea and South Africa is in the fourth quadrant.

And what about the US? At the moment it is in the second quadrant (same as Japan) but it is near the boundary with the third quadrant and it would only take two bad weeks for equites or two good weeks for bonds to cross the line. If we were just looking at the US in isolation, our recommendation on equities vs treasuries would be “neutral, but watch carefully”. However the fact that 11 out 13 other countries have witnessed a significant reduction in risk appetite is enough to alter the burden of proof. For us, the question is not whether US equities will generate superior risk-adjusted returns, but why do investors think that the US will be unaffected by a worldwide shift away from equity risk.

As usual we do not have a fully developed set of forecasts to support this view, because if we did it would be too late. To the question, what has changed, the answer is China. The collapse of the Chinese stock market, the declines in industrial commodities and the change in exchange rate policy are consistent with the idea that Chinese growth will be significantly lower than official forecasts. We are just beginning to explore what this means for the global economy and for the US. For instance, if China starts “exporting deflation” a 2.2% nominal yield on the US 10-year bond may look quite attractive.

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