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.

For some time, we have been discussing with clients the possibility of dividing up the equity universe in a different way, to give us more flexibility with our regional equity allocation. To do this, we would have to split the US into two. There are many ways in which this could be done, but it is really hard (actually impossible) to come up with financial metrics or thematic approaches which would give us a consistently applicable framework, without lots of anomalies. So, we opted for a really simple definition: the top 10 stocks, from time to time, vs the rest. These typically account for just over 40% of the market capitalisation of the S&P500. We find clear evidence that this group behaves differently from the rest of the US, often having an overweight position, when the rest of the US is underweight. As far as the current situation is concerned, we suggest that the right way to fund an increased exposure to Nasdaq, FAANG or Megacaps, is not to sell European stocks, but the rest of US equities.

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 13^th 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.

These are confusing times in financial markets, with little direction in any of the main asset classes. This week, we focus only on the high-conviction ideas generated by our models covering asset allocation, commodities, equity sectors, individual countries, credit and different maturities in government bonds. In general, there are more negative, than positive, high-conviction ideas. These include topping signals in many Eurozone countries such as France, Italy, Germany and Spain and for the Eurozone as a whole. We have high-conviction negative signals in Financials across all regions, apart from China, and other pre-recession signals in sectors like US Industrials and UK Materials. The positive signal in asset allocation is for US equities, but the level of conviction is lower than the negative call on the Eurozone, and is heavily dependent on the positive view of US Communications going forward. We like Europe, ex Eurozone, particularly Switzerland and Denmark, and detect signs that India may be bottoming, though the rest of EM Equities are highly unattractive.

EM Equities are in deep trouble and we see no early turning-point, mainly because China is also suffering. The strong outperformance promised after the end of lockdown has not materialised, but more importantly, our models suggest that the local equity market itself is not functioning as it should. Two relatively obscure indicators: active weight and persistence of winning and losing sectors are either at, or very close to, 20-year lows. This suggests that investors are struggling to construct portfolios, which deliver an appropriate balance between risk and return. This is not a problem China has suffered from until recently and if it continues, international investors may have to regard this as a secular trend, not a cyclical aberration. If EM and China are not attractive destinations for international capital, other regions must benefit on a relative basis - and the most obvious is Europe.

Most institutional investors are not allowed to use leverage in their portfolios, which is a pity, because one of our models, which switches between a 100% leveraged portfolio of US equities and cash, has outperformed the S&P500 since inception in 1996. It has exactly the same as inputs and rules as all our other asset allocation models and it produces better absolute and risk-adjusted returns than 100% equity exposure, with a smaller drawdown. It also beats our equity/bond model, but is not as risk-efficient. This disproves the theory that investors cannot use timing to beat the market. They can, if they have a margin account, and know how to use it. For most of the last 30 years, this result could be dismissed as a curiosity because a mixed equity/bond portfolio did so well. In particular, bonds rose when equities fell. But if equity and bond returns stay positively correlated – as they currently are – for an extended period of time, institutional investors may need to explore the opportunities created by cash and leverage strategies.

The top-down consensus is rightly gloomy about the outlook for earnings estimates and equity benchmarks in the US. The problem is that the market shares this analysis and still refuses to go down. We need an additional catalyst to shake us out of the current trading range. A mild US recession is not the main risk to balanced portfolios, provided bonds rise while equities fall. What we worry about is a bear market in everything, if the current regime of positive correlation between equities and bonds continues. There are ways to mitigate this, by lowering the beta in your equity portfolio, increasing exposure to Europe (and anywhere else that may benefit from a weak dollar) and increased exposure to cash and money market funds.

We have written before about the importance of dogs which don’t bark in the night. Three things did not happen last week. The dollar did not surge in response to stress in financial markets. Equity investors did not dump cyclical or high-beta sectors in favour of defensive sectors. There was no shift towards EM Equities in response to a banking crisis in developed markets. Simple explanations are often wrong, but maybe investors think that the dollar is structurally over-valued, that there isn’t going to be a recession in the US or Europe and that the great globalisation trade of the last 30 years is over. They could be wrong, but their opinions are important.

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.