Po­si­tion­ing for a US re­ces­sion

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

Since the end of last year we have been wor­ried about an “un­ex­pected” slow-down, or even re­ces­sion, in the world’s de­vel­oped economies. In or­der to mon­i­tor the sit­u­a­tion on a daily ba­sis, we built a new in­di­ca­tor of US eco­nomic ac­tiv­ity which con­tains 17 com­po­nents rang­ing from lum­ber prices and high-yield bond spreads to the in­ven­tory-to-sales ra­tio. It was nec­es­sary to con­struct such an in­di­ca­tor be­cause six years of ex­treme mon­e­tary pol­icy in the US (and other de­vel­oped mar­kets) has stripped eco­nomic data of any real mean­ing.

Un­der­stand­ing this dif­fu­sion in­dex is straight­for­ward. When the read­ing is pos­i­tive, in­vestors have lit­tle to worry about and should treat “dips” as a buy­ing op­por­tu­nity. When the read­ing is neg­a­tive a US re­ces­sion is a pos­si­bil­ity. Should the read­ing fall be­low -5 then it is time to get wor­ried — on each oc­ca­sion since 1981 that the in­di­ca­tor recorded such a level a US re­ces­sion fol­lowed in fairly short or­der. At this point, our ad­vice would gen­er­ally be to buy the de­fen­sive


cycli­cal team with a fo­cus on long-dated US bonds as a hedge. This is cer­tainly not a time to buy eq­ui­ties on dips.

To­day, the in­di­ca­tor reads -5 which points to a con­trac­tion in the US, and more gen­er­ally the OECD. Such an out­come con­trasts sharply with of­fi­cial US GDP data, which re­mains fairly strong. This dis­crep­ancy is best ex­plained by of­fer­ing spe­cific port­fo­lio con­struc­tion ad­vice in the event of a de­vel­oped mar­ket con­trac­tion. The as­sump­tion is sim­ply that the US econ­omy con­tin­ues to slow. Hence, the aim is to out­line an “anti-frag­ile” port­fo­lio which will re­sist what­ever brick­bats are hurled at it.

Dur­ing pe­ri­ods when the US econ­omy has slowed, es­pe­cially if it was “un­ex­pected” by of­fi­cial econ­o­mists, then eq­ui­ties have usu­ally taken a beat­ing while bonds have done well. For this rea­son, the chart shows the S&P 500 di­vided by the price of a 30-year zero-coupon trea­sury. A few re­sults are im­me­di­ately clear: - Eq­ui­ties should be owned when the in­di­ca­tor is pos­i­tive. - Bonds should be held when the in­di­ca­tor is neg­a­tive. - The ra­tio of eq­ui­ties to bonds (blue line) has since 1981 bot­tomed at about 50 on at least six oc­ca­sions. Hence, even in pe­ri­ods when fun­da­men­tals were not favourable to eq­ui­ties (2003 and 2012) the in­di­ca­tor iden­ti­fied stock mar­ket in­vest­ment as a de­cent bet.

To­day, the ra­tio be­tween the S&P 500 and long-dated US zeros stands at 75. This sug­gests that shares will be­come a buy in the com­ing months if they un­der­per­form bonds by a chunky 33%. The con­di­tion could also be met if US eq­ui­ties re­main un­changed, but 30-year trea­sury yields de­cline from their cur­rent 3% to about 2%. Al­ter­na­tively, shares could fall sharply, or some com­bi­na­tion in be­tween.

Notwith­stand­ing the con­tin­ued rel­a­tive strength of head­line US eco­nomic data, note that the OECD lead­ing in­di­ca­tor for the US is neg­a­tive on a YoY ba­sis, while re­gional in­di­ca­tors con­tinue to crater. The key in­vest­ment con­clu­sion from the re­ces­sion in­di­ca­tor is that eq­uity po­si­tions, which face risks from wors­en­ing eco­nomic fun­da­men­tals, should be hedged us­ing bonds or up­ping the cash com­po­nent.

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