Lesson one, fixed income is not offering many clear signals. There is no sustained relative momentum anywhere along the US Treasury curve. Investment Grade and EM Bonds are not adding to returns or diversifying risk. High Yield continues to do both, which is lesson two. Three, we still like the Technology-related sectors in US equities, but not as much as previously and we are much more selective within them. Four, Japanese equities are uninvestible until we know who the new Prime Minster is and maybe not even then. Five, we are already defensive in our Eurozone equity models and becoming more so in our bond model, all of which is consistent with a rising threat of recession. Six, the UK is our preferred equity region, with its recommended weight approaching a 20-year high. There is a chance it may escape from 25 years of underperformance.

Our multi-asset models have significantly reduced their exposure to global equities. The US dollar version is already neutral; we expect the euro version to get there in the near future. We have long argued that there would be period of seasonal weakness in equities in Q3 and this has arrived bang on schedule. The narrative behind it is of secondary importance, but current fears about a US slowdown should be enough to persuade investors not to rotate into Small Caps. The trade which works is to de-risk equity portfolios by reducing exposure to cyclical sectors and increasing it in defensives like Utilities, Healthcare, Telecom and even Consumer Staples. We have been recommending this since early June. It’s something all investors can do, even if they are nervous about moving into fixed income, when US 10-year Treasuries yield less than 4%.

There is suddenly a lot of enthusiasm for US Small Caps, based on the idea that the Fed is about to start cutting rates and that this will lead to underperformance by the Technology sector and a broadening out of the US rally. We think the logic connecting these ideas is flaky, at best. But our main objection to this strategy is that macro themes are best played in large liquid stocks, not illiquid Small Caps. It’s much easier to cut the position if the investment thesis is wrong. If you want to exploit the US rate-cutting cycle, we suggest EM Equities, which have just been upgraded to overweight in our global equity model. They are much less affected by the threat of rising US unemployment, which is the main reason why the Fed might start cutting in September.

Sometimes it helps to look at the world from another perspective. Most institutional investment regard risk as a cost, something which must be used efficiently. But there is another approach, which views volatility as something which enables high returns, which should be accepted, provided that the asset can be sold when losses are worse than those which are predicted from the distribution of returns. This view is typically associated with retail investors and the benchmark asset for comparison purposes is normally cash. If we use this approach, based on data for the last four quarters, we find that the probability of incurring unacceptable losses in US Equities is less than 3%. Sure, it’s a short data set, but with numbers like this, FOMO can be rational.

All our equity sector models in developed markets are switching out of cyclicals and into defensives. At a global level, the peak exposure to cyclicals vs defensives occurred in late April and since then the gap between these two groups has been closing every week. We can’t be sure about the explanation, but our models frequently detect these changes before the consensus settles on a narrative. We do know that the current episode is the seocnd longest continuous net exposure to cyclicals in the 29-year history of the model and that the indicator can swing as far the other way in favour of defensives. Right now, we think the numbers are more important than the narrative.

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.

Over the last month, two large equity markets, which have been out of fashion for many years, have suddenly surged up our rankings. There is no natural linkage between the UK and China, but both may be benefitting from a view that the authorities are making progress in tackling the big issues relating to their economies: the real estate crisis in China and stagflation in the UK. In China, we don’t think this is the end of the housing crisis, but we do think that recent announcements will successfully insulate the banking industry from any further contagion. China can once again be evaluated on the basis of its growth prospects, and not its balance sheet.  In the UK, recent data paint a picture of accelerating non-inflationary growth, which should be rewarded with falling interest rates. The real causes of the lack of enthusiasm for UK equities are more structural and relate in part to the biases of UK domestic investors. Behind the scenes, the Government is working hard to change these attitudes and these efforts will come to a peak with the planned sale of some its stake in NatWest Bank to UK retail investors, later this summer.

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.

Our standard probability approach suggests that the probability of US core CPI falling below 3% in 2024 - let alone down to 2% - is effectively zero. We think the central point of the forecast range should be between 3.5-4.0%. There parts of the US economy which are exhibiting disinflationary trends, but the cost of shelter, especially Owners’ Equivalent Rent, is likely to remain elevated for several quarters. The Fed needs a major policy rethink about how it manages market expectations on the outlook for core CPI, and on how it addresses the rising cost of home ownership in its overall policy mix.