Clients often ask whether they should incorporate a currency view into their asset allocation process, to which the short answer is No. Although we don’t normally publish it, we have a model which prioritises currency selection over asset class selection. There are times when it outperforms our standard model (and now is one of them), but over the long run it produces lower returns, with higher volatility and deeper and longer drawdowns. Two conditions are required for the Currency-First model to outperform – a global bull market in risk assets and easy monetary policy in the US. Neither one, on its own, is sufficient. If you believe the latest FOMC minutes, our standard asset class model should start to outperform again, sometime in the first half of 2022.

We are always wary of making big calls on the basis of thin summer markets, so here are three quick ideas. First, Japan produced an important technical buy signal just before Prime Minister Suga announced his resignation. It is very similar to the one at the start of the Abenomics rally in 2012. Second, the recommended weight of US equities to the rest of the world is at a 10-year high and it does not normally hold this level for more than a month. Third, we think European industrials are out of line with US Industrials and potentially vulnerable.

Our recommended exposure to Chinese equities is effectively zero, but EM Equities (of which China is by far the largest part) are critical to the success of any global balanced portfolio. So, we have looked at individual Chinese sectors to see which ones have been the most successful diversifiers compared to their US counterpart. The good news is that it is easy to identify those which fail the test badly: Financials, Industrials, Telecom and Small Caps. The bad news is that only Technology has offered successful diversification over the whole of our test period, but now is not a good entry point. There may also be opportunities in Consumer Staples and Healthcare, but, again, we prefer to wait for a better entry point.

We think it is time to take China out of the main EM equity indices. Some of the arguments made for its inclusion are no longer valid. It doesn’t make sense to have separate benchmarks for companies listed in China and Hong Kong. Separate indices for China plus Hong Kong and the rest of Emerging Markets would increase flexibility for all investors, not just those who no longer wish to have passive exposure to the current regime in China. Once we make the split, we can see that EM ex China has already begun an interesting rally.

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.

The global Healthcare sector has begun to rally hard after hitting an all-time low in terms of its recommended weight relative to benchmark. It had previously been ignored because it doesn’t fit well into the current debate about growth vs value. We think it is time for another look, chiefly because the risk of price controls on US prescription drugs is much lower than previously feared. There is no time for Congress to consider this legislation before the run-up to the mid-term elections, and politicians may find that public opinion has changed after the success of anti-Covid vaccines.

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.

Perhaps the most obvious symbol of the changes under way is the fact that Europe, not the US, has been our preferred equity region since late May. This isn’t the result of one single trend or a dramatic headline. It has happened gradually, as marginal buying shifted from the US to Europe. It is the same with the shift from industrial to consumer cyclicals. No-one doubts the coming industrial recovery, but our charts suggest it is already in the price, so investors are starting to look for the next big idea.

Successful diversification using publicly-traded alternative asset classes, like commodities, REITs and TIPS is possible. We can select from a family of systematically-managed portfolios, which allow us to capture the upside of diversification and avoid most of the downside. However, the big takeaway from this process is that multi-asset diversification itself has been largely redundant since the end of the financial crisis, thanks to the actions of the Federal Reserve. Since that time there have been two false dawns, when it looked as though the concept was about to make a comeback and we may be on the verge of another one now. If it turns out to a real dawn, we have the regime management skills to exploit it. If not, we should be able to get out without too much harm.