Tuesday, October 15th, 2013

Uneasy Calm

At Harlyn, we are always amazed at the precision with which economists can calculate the GDP lost because of natural or man-made disasters. As an example of attention-seeking behaviour it rivals that of a US Congressman with a difficult primary coming up in 2014. As a form of economic analysis it is almost worthless. No-one knows when a deal on the US budget will happen or what the “grand bargain” will look like. While we wait for news, here a few observations about how asset prices are actually behaving.

US stocks and bonds have been in no-man’s land for about three weeks. There is little sense of direction and the normal negative correlation of returns between them has been replaced by a weak positive correlation using short run data. Even though the crisis originates in the US, no-one believes the effects will be confined there, so European and UK equities and government bonds are behaving in a similar fashion in local currency terms.

However this has wildly different implications for asset allocation, because of the strain this crisis has placed on the currency markets. The dollar is weak against sterling and the euro. US investors who are unable to predict the outcome of the crisis are nonetheless happy to hold foreign currency equities, while they watch and wait. European investors do not have the same luxury. They are not being paid for the extra risk of holding US (or dollar-related) equities and if they are not actually selling at the moment, they certainly are not buying. Cashflows are going into fixed income investments denominated in euros, with a preference for investment grade corporate bonds. The strengthening euro forces Europe to derisk, while the US can keep the same level of equity exposure thanks to the declining dollar.

Until this week the sector models showed the same uneasy calm. There was very little movement in the rankings of the US, UK or Eurozone. All three regions had Consumer Discretionary and Industrials at the top with sectors like Consumer Staples and Energy close to the bottom. Even though investors knew that the Government shutdown was potentially toxic, they were unwilling to remove the pro-cyclical bet. This week that mood has started to change. Our European and UK sector models show clear evidence that the bullish stance is being reduced (including an increase in exposure to Utilities) but there is little sign of a similar move in the US. Either US investors have more faith in their politicians, or they understand that they will be bailed out by a weaker dollar boosting returns from international assets.

However there is group of investors who are clearly much more concerned by the impasse in Washington. The Financials sector in Japan has had one of the fastest turnaround from risk-on to risk-off that we have seen in the last 12 months. Anyone would think that the American Government owed them money.

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