How Broad Was My Rally

Friday, May 31st, 2024

Quality available at a discount in Europe

Many investors are still waiting and hoping for the rally in US equities to broaden out. We see no evidence of this in terms of size. Our US equity model has Small Caps almost exactly in line with their benchmark weight, and they have been in the neutral zone for most of the last two years. If anything, their outlook has deteriorated in recent weeks, as hopes for rate cuts continue to be disappointed. We also think that the idea of broadening out is dangerous if it means reducing the liquidity and quality of the portfolio this late in the cycle. There is one area where we think this may be an attractive strategy. There is plenty of quality available in large-cap European equities at a significant discount to US valuations. This could be one reason why the Eurozone and the UK both rank ahead of the US in our tactical allocation model.

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Treasure not Treasuries

Friday, April 26th, 2024

We are increasing our exposure to commodities

We believe US core CPI will remain above 3% for the whole of 2024 and that equities and bonds are likely to suffer in this environment. Diversification away from these asset classes is a good idea and commodities are the obvious choice. We have a long-only commodities model with 10 constituents which produces better returns and a similar Sharpe ratio to the S&P 500, despite the fact that it went nowhere between 2011 and 2021. (All commodity indices are still below their 2008 high.) We also have a simplified multi-asset model with three commodities – crude oil, gold and copper – capped at a total of 25% of the portfolio. This model beat our standard equity/bond model by an average of 400 bps a year between 1997 and 2007, the last time commodities enjoyed a major bull run. We think we could be about to repeat this part of the cycle and cite the recent uptick in M&A in the sector as evidence.

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Country Trumps Sector

Thursday, January 18th, 2024

Switching between equity regions will be a theme in 2024

Our models do not currently identify much opportunity for generating outperformance by switching between asset classes and most of our equity sector models are reducing their recommended active weight. We still think that above average exposure to cash and short-dated bonds is a good idea. However, they may be some opportunities for switching between equity regions, which will be affected by changing perceptions of political risk as we move through the year. The important thing is to stay nimble and remember that other people have opinions too. One example of this is in EM Equities, where India vs China is now priced for perfection, which doesn’t reflect the fact that India has a general election in April or May.

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False Sense of Security

Monday, July 10th, 2023

7-10 year Treasuries offer no hedge against equity declines

We are mystified by the ongoing strength of the long end of the US yield curve. We fully acknowledge our bias towards a higher-for-longer view of inflation. Even so, we don’t understand why investors are willing to put up with lower yields and higher volatility than they could get by investing in shorter-dated Treasuries. Over the last 18 months, 7-10 year US Treasuries have delivered absolutely no protection against a decline in US equities. In fact, they have a tendency to decline at the same time and this downside beta has been getting worse. The same relationship affects all Treasury maturities from 1-3, all the way out to 10-20, but the 7-10 year index has the worst beta.

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For the Unbelievers

Friday, June 2nd, 2023

Low risk, not high return, makes Japanese equities attractive

Our proprietary volatility index dropped out of the danger zone three weeks ago, having warned us back in May 2022 that something was going to break. This helps to explain why investors feel so comfortable with equity risk at the moment. All equity regions have levels of realised volatility below their 25-year median and only US Treasuries are still in the danger zone. The volatility of Japanese equity returns is in the 13th percentile of its 25-year history. Investors don’t have to believe the new (or is it the old) shareholder activism story. The risk-cost of entry into Japanese equities is low by historical standards and that is enough to make the risk-reward calculations work.

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New Commodities Model

Friday, March 17th, 2023

Better than equities, provided investors are selective

With equities looking overvalued and bonds still under pressure in the wake of a terrible year, investors are searching for new ways of generating attractive, risk-efficient returns. Commodities are one of the most widely-used alternative asset classes, but they have a reputation for high volatility, large drawdowns and periods of extended under-performance. At the index level, this is fair comment. Many investors are still scarred by their experience of boosting their exposure in the wake of the global financial crisis, only to exit at a lower level sometime in the next ten years. The key point to recognise is that some of the commodity contracts included in the overall index are unlikely to generate consistent returns over time. There are several possible reasons, which we discuss in the note, but the effect is that we have decided to exclude them from our Long Only model, in the same way that many global equity investors routinely avoid exposure to Japanese equities. Our Long Only model has no exposure to Livestock, Softs and most Grain contracts and focuses mainly on Energy, Industrial Metals and Precious Metals. On a standalone basis, it has produced total returns which are slightly better than US equities since inception in July 1997. If we allow the model to take short positions as well, we find that the returns are considerably better, with no loss of risk-efficiency and no significant increase in drawdown. The bottom line is that the right mix of commodities can produce attractive, risk-adjusted returns, provided investors are properly selective.

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Pivot to Asia

Friday, July 22nd, 2022

It may be the least-worst option

There is a leadership vacuum in global equity markets. The US, the Eurozone and the UK all have serious issues to confront, ranging from valuation excess and monetary tightening to political uncertainty and energy rationing. Japan and Emerging Asia share some of these problems but are not as badly affected. One is a low return, risk reduction trade, while the other offers high risk and high reward. Both strategies have a place in a well-diversified global equity portfolio.

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Adding REITs to the Mix

Friday, October 29th, 2021

Works well but the downside needs to be managed

There is lots of client interest in alternative asset classes, mainly because bonds no longer provide enough income and because they are structurally vulnerable to inflation. This week, we demonstrate this it is possible to generate superior long-term returns by adding REITs to an actively managed portfolio of equities and bonds. The key messages are (1) that the combined portfolio needs to be actively and systematically traded and (2) that exposure to REITs must be properly constrained in order to avoid the savage drawdowns that are characteristic of this asset class. We also note that US REITs have performed very strongly this year, so now may not be the time to start this strategy.

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Currency First is Second Best

Friday, October 15th, 2021

Even the strong dollar is not as important as you think

Clients often ask whether they should incorporate a currency view into their asset allocation process, to which the short answer is No. Although we don’t normally publish it, we have a model which prioritises currency selection over asset class selection. There are times when it outperforms our standard model (and now is one of them), but over the long run it produces lower returns, with higher volatility and deeper and longer drawdowns. Two conditions are required for the Currency-First model to outperform – a global bull market in risk assets and easy monetary policy in the US. Neither one, on its own, is sufficient. If you believe the latest FOMC minutes, our standard asset class model should start to outperform again, sometime in the first half of 2022.

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Three Quick Ideas

Friday, September 10th, 2021

End of summer lull makes us cautious about big calls

We are always wary of making big calls on the basis of thin summer markets, so here are three quick ideas. First, Japan produced an important technical buy signal just before Prime Minister Suga announced his resignation. It is very similar to the one at the start of the Abenomics rally in 2012. Second, the recommended weight of US equities to the rest of the world is at a 10-year high and it does not normally hold this level for more than a month. Third, we think European industrials are out of line with US Industrials and potentially vulnerable.

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