Tuesday, August 25th, 2015

What Happens Next?

Last week we rhetorically asked why some investors thought that the US would be unaffected by a worldwide shift away from equity risk. Now that we know it isn’t, we need to construct a mental map of what could happen next, using our models where we can. Our first step is to rule out developments which are extremely unlikely to happen. This category includes a spontaneous recovery by EM equities. Whatever metric we look at (vs local bonds or global equities) the risk/reward ratio has been deteriorating consistently since Q2, and there have been no significant exceptions. The same goes for EM bonds, which show no improvement relative to any of the other fixed income categories. Our final near-impossibility is a sustained rally in commodities, which have had the worst risk/reward characteristics of any asset class for most of the last three years.

Our second step is to divide the future into quadrants using two axes: nice vs nasty and likely vs unlikely. In the nice but unlikely category is greater clarity on the future fiscal arrangements of the Eurozone. Spain and Portugal are lagging in our Eurozone sovereign bond model and we think this is caused by rising uncertainty about their elections later this year. Another set of Greek elections in September does not help. Also nice but unlikely is an acceleration in US earnings growth, which would provide more valuation support for US equities. Current estimates call for 11% growth in 2016 followed by 13% in 2017. We have never believed these numbers, but we also note that the Tech sector is struggling to stay at neutral in our US sector model. These estimates cannot be fulfilled without a full contribution from the largest sector in the index.

In the nasty but unlikely quadrant we place a rise in government bond yields in developed markets. Regardless of what central banks announce, it is hard to see the Chinese devaluation as anything but a deflationary shock. This applies particularly to the US, where nominal yields of 2.0% may suddenly look quite attractive again. This should also mean that there is not much likelihood of significant stress on the balance sheets of banks in the developed world. Financials remain in the top three sectors in our US and European equity models and in our US investment grade and high yield models.

The opposite is true for banks in emerging markets. We regard further distress as nasty and likely. China has reportedly injected $100bn from its foreign exchange reserves into systemically important banks. China has the reserves to do this. There are many countries which don’t. Also in the nasty but likely quadrant is a Fed rate rise – but not necessarily in September. In the final analysis the main reason why it wouldn’t happen is that the crisis in China and other emerging markets is much worse than we now believe. So the doves should be careful what they wish for.

We struggled to think of something nice and likely, and eventually realised that a fall in equity markets gives the M&A boom in the US and the UK the chance for one last hurrah. By contrast with some of the potential negatives around, it’s not much, but it does give investors a reason to stay in Anglo-Saxon equity markets even as they disinvest from EM equities and possibly the rest of Europe. It is also the big difference between US/UK equities and most other asset classes. There is still a buyer waiting in the wings.

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