China’s problem may be Europe’s opportunity.
Our recommended weight for Chinese equities has just hit its all-time low since the beginning of this century. They have been in extreme underweight territory for their longest period ever. We think this is more than a temporary misunderstanding. It could represent the breakdown of the pro-China consensus that has dominated US investment thinking for over a decade. There may be parallels with what happened when the US became disillusioned with Russia 10 years ago. US investors who want international equity diversification will be forced to have another look at Europe.
But we don’t know when, why or how much
With very few exceptions, our main risk-appetite indicators are at or close to maximum risk-on. We see evidence of peaking behaviour in global equities vs global fixed income, in US Credit, and cyclicals vs defensives in the US, Japan and the UK. There is one indicator – Italian vs German government bonds – which is already past its peak. Most investors understand this and intend to use any correction as a buying opportunity. However, it still makes sense to take some risk off the table now, if only to put it back on at a lower price. We are also concerned that investors may be ignoring an uptick in geo-political risk.
Higher yields and lower volatility
Many investors, brought up on the Tequila crisis of 1994, or the Thai baht crisis of 1997, or others too numerous to mention, may be surprised to see EM Sovereign Bonds at the top of our euro asset allocation model and at #2 in the US$ version. Times have changed. The volatility of the EM bond portfolio (but not necessarily individual countries) is less than 7-10 year Treasuries and the yield is a lot higher. They deserve their ranking.
Listen to the market. It has lots of ideas.
Even if the macro outlook is uncertain, there are still several important messages that can be gleaned from the detail of our equity sector models. The three we highlight concern US Energy, Global Utilities and European Consumer Goods. Our models can never prove any investment thesis, but they can suggest interesting lines of enquiry.