We have downgraded the Industrials sector in four regions this week – to neutral in the UK and Pan Europe and to underweight in the Eurozone and Japan. In the last four weeks, it has lost ground in every region. Since the inception of our models, the Industrials sector has had the lowest number of underweight recommendations out of all eleven sectors (including Small Caps) and this is normally an indicator that investors are concerned about the onset of a recession. Small Caps have also seen a big reduction in their recommended weight over the same period, which reinforces these fears. Taken together, Pan Europe and the Eurozone are the worst-affected regions. The US, China and Japan all affected but not as badly. The UK is somewhere between the US and Europe. The narrative that the US will escape, while the rest of the world suffers, is not borne out by recent investor behaviour.

One of our key indicators for US equities is flashing amber. The recommended weighting when compared with a portfolio of 10-year Treasuries and cash has fallen to a level where it historically continues down to zero more often than not. This could be accomplished by a correction in equities or a rally in bonds – very probably a mixture of both. However, we are more optimistic about the medium-term future. We don’t think this correction would indicate an upcoming US recession. It’s very difficult to have one, when the Federal budget deficit is over 6%. In our view, the correction in equities is a necessary pre-condition for putting a short-term floor under the Treasury market.

This is a companion piece to last week’s note about the US 10-year Treasury – Why Yields Could Go to 6%. We think we are in a new trading range of 4.3-5.3% and that the biggest single reason for the change is the administration’s plan for 6% budget deficits until the end of the decade. We think there is a significant risk that it will be self-defeating, and that it is too close for comfort to the Liz Truss plan in the UK. We also think that the Fed is happy for bond markets to preach the virtues of fiscal restraint to the administration and is unlikely to ease rates in the absence of a financial accident. The latter is, of course, the most likely outcome of such a dramatic rise in yields.

We think investors should re-acquaint themselves with the relationship between nominal GDP and 10-year Treasury yields. Over the last 60 years there has been a good relationship between yields and the three-year trend in nominal GDP growth. At the end of Q2 2023, yields were far too low in relation to this trend, much lower than they were in the 1970’s before Chairman Volcker tightened monetary policy in the 1980’s. This sent yields to the top of the range in relation to GDP in just four years. We think that Chairman Powell’s higher for longer stance, coupled with ongoing QT of $900 billion a year, will eventually be as influential in boosting Treasury yields above the trend rate of growth, possibly for a period of several years. We use a variety of forecasting techniques, all of which suggest yields in excess of 6.0% sometime in 2026, but maybe earlier.

We think that US equities may be vulnerable to a correction over the next two to three months. Our models suggest that the Technology sector may be about to underperform and that this could put pressure on other related sectors which have also performed strongly this year. We identify three separate trades which may be able to mitigate some of the impact: long-dated US Treasuries, large cap Japanese equities and Energy equities in the US and Europe. The rationale behind each idea is discussed in detail in the note, but the key point is that they are largely unrelated and therefore offer an interesting diversification strategy as well.

For some time, we have been interested in the behaviour of risk-seeking investors, which we model using a variant of our standard approach, called a pro-risk momentum model. We find that it can be used to time switches between cash and US equities, so that our model outperforms US equities on a standalone basis over the last 50 years. This is a result which most academic research regards as unachievable. In absolute terms, the quantum of outperformance is not material, but the risk-adjusted returns are clearly superior and the drawdowns are significantly smaller and shorter. We find that the same approach also works when combining US 10-year Treasuries with cash and a broad commodity index with cash.

We don’t know if there will be Lehman moment in China, but we are fairly confident that there is a major discontinuity coming soon: either a collapse of consumer and financial confidence or a series of stimulus measures, which will kick the can further down the road – a bit like the Eurozone crisis of 2011-12. We can’t forecast the outcome, but we can work out which companies and sectors in the US and Europe have the greatest revenue exposure. In general, more European companies have a modest 5% exposure to China, but if we take the threshold of concern as 10% of sales, the US has more exposure than Europe. The big exposure is US Technology where 65% of market capitalisation has more than 10% of sales in China, Hong Kong or Taiwan.

Our models suggest that the near-term outlook for crude oil and 10-year Treasury yields is higher, while the trade weighted dollar is lower. This is not the consensus view. More importantly, we think that the medium-term risk-case for Treasury yields and the US dollar is much worse than the consensus is prepared to consider. It is hard to imagine a world of high and rising yields, if you have spent your career in an era of falling yields. The same is true of the dollar but in reverse. Investors ought to make the effort to do so, lest they are unpleasantly surprised.

All EM equity indices comprise a mix of countries which once shared some important economic characteristics, but no longer do. The whole asset class is dominated by China, where the investment outlook is increasingly uncertain. Looking at over 20 different countries with vastly different growth profiles and levels of income no longer makes sense. Investors who wish to reduce the complexity of their portfolios should think about swapping their EM equity allocation for one to India on its own. It has outperformed its benchmark by a substantial margin over the last 5,10, and 20 years and will probably continue to do so given its superior demographic profile and productivity outlook.