Probability-based investment modelling for professional and institutional investors
We see lots of commentary suggesting that the value style is going to outperform the growth style in Europe and the US. We also see this being used as a reason for rebalancing global equity portfolios away from the US and towards Europe. We disagree with both ideas and also with the big idea behind them, which is that government yield curves are going to shift higher and/or steepen at the same time. Indeed, the recent behaviour of US Financials suggests that investors are becoming concerned about the yield curve inverting over the medium term. We also think that the new emphasis on ESG guidelines makes the value/growth trade much more complex than it used to be.
US investors are significantly more positive about the Energy sector than their European counterparts. There could be many explanations, but we are increasingly concerned that there is a buyer’s strike in Europe. This could have unintended consequences – first of all for the implementation of a low-carbon style on a global basis, and second on the outlook for inflation in 2023 and beyond. Changes in our investment style in Europe may have moved too far in advance of changes in our lifestyle.
The recent outperformance of Small Caps is starting to generate headlines, but we think there is more to come, especially in Europe. We don’t see any need to take profits, nor do we think that Small Cap outperformance is a reliable indicator of an upcoming peak in the equity index. We do accept that it may be too late to start a big overweight position, So, if you are looking for the next big thing, you may want to consider Energy.
Elections don’t change things, except when they do. The combination of the Saudi oil cut and Democrat control of the Senate could usher in a period of materially higher oil prices. The Senate victory also means that social media companies may be threatened with more regulation and even a possible break-up. But does the new administration have the political capital to take on Big Pharma at the same time? The outlook for the Healthcare sector may be more hopeful than the Blue Wave doomsters suggested.
Generating an adequate income from euro-denominated bonds is next to impossible, so investors should abandon the attempt. They should embrace currency risk – not try to hedge it away. They should enjoy the fact that US dollar yields are structurally higher than those in the Eurozone. This means owning long-dated Treasuries and dollar-denominated EM sovereign bonds. Finally, they should consider the source currency of their equity dividends and take another look at the Energy sector.
Three interesting ideas emerge from our regular reports. First, the volatility shock will almost certainly be as bad as 2008. Second, we believe that a long Technology /short Energy trade will have a positive pay-off no matter whether equity markets rise or fall. Third, our models are increasing exposure to EM Equities. We recognise this is a contrarian trade, but it is well-supported by our process and doesn’t depend on one or two countries.
Nobody likes the Energy sector. On a global basis the current sell-off is as bad as all the other major declines, apart from 2014. The difference is that oil prices are much more stable now than they were then. The medium-term challenges (ESG agenda, electric cars, balance sheet distress) are all well-known, but we would be really surprised if the sector wasn’t rated overweight again within the next two years – any maybe sooner.
High Yield has peaked in our fixed income models and has fallen sharply against Investment Grade. We have checked our cross-asset sector models and it isn’t caused by a problem in Energy. It looks like a straightforward loss of confidence in the outlook for Industrial High Yield. This is potentially ominous for Equities as well, but we haven’t generated a sell signal just yet.