Seek refuge in the US

Financial Mirror (Cyprus) - - FRONT PAGE - Mar­cuard’s Mar­ket up­date by GaveKal Drago­nomics

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).

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