Seek refuge in the US
Markets have suffered a significant risk-off move in the last month. US equities have fallen as much as -3.8%; European stocks are down -6% in euro terms and -8% in US dollar terms, and government bonds have been bid up while credit spreads have widened. Readers are surely wondering what to do now: Buy the dip, or sell everything before this turns into a full-on bear market? Hold steady, or adjust portfolios? To answer these questions, we have to consider what has changed, and what has not. Three recent shifts in the investment landscape stand out: 1. We are now in a strong US dollar environment. The DXY index has risen 7% in the last 3 months; 5% in just the last six weeks. 2. Commodity prices have slumped (especially the oil price). Brent crude is at US$91, having fallen -15% in the last four months. It is now at its lowest price for two years; a break below $90 would be a first since 2010. 3. Another euro crisis appears to be brewing. While the market has shown itself unimpressed by the European Central Bank’s actions, recent data releases have been alarming. Even Europe’s strongest link, Germany, is now posting poor growth data (with yesterday’s dismal industrial production number the latest example). The general risk-off environment can also be ascribed to weak data from China and Japan. In addition, the recent rush into treasuries was likely exacerbated by the September 3 approval of a US rule that requires banks to increase their holding of high quality liquid assets by year end (the shortfall is estimated at about $100bn). And, of course, the planned end of the Federal Reserve’s quantitative easing programme later this month has everyone a bit jittery. It is a long list that might lead investors to dramatically scale back their equity exposure and wait for the dust to settle.
But now we must consider what has not changed-namely, the continued improvement in the US economic outlook. Moreover, the effect of a lower oil price is to give US consumers an effective tax cut. Also, the decline in US long interest rates provides more support to the US housing market.
For all these reasons, we would suggest the following asset allocation approach. Shift portfolios toward US assets with the currency exposure unhedged. Focus the risky part of the portfolio on companies that rely mostly on US domestic demand, and are relatively less exposed to global growth (including Europe), Japan, China and commodity-producing emerging markets-in other words, just about everyone outside the US. Then balance that exposure with very long duration (20-30 year) US treasuries, to reduce volatility and hedge the risk that the US economy disappoints, or at least gets sucked into a global downturn (10-year US treasuries may be yielding just 2.4%, but the spread over German bunds is close to a 24 year high).