From one extreme to another

Asset allocation strategy - 11/6/2018

The October market correction was impressive but it was also remarkable for not being triggered by some event.

Instead, a decline in the overall environment gave a sudden sharp knock to market sentiment:

  • the previous surge in US long bond yields probably made investors lose their bearings, causing valuations to fall, and especially for growth stocks
  • major central bank liquidity started to contract. The Fed’s balance sheet has been shrinking more rapidly since October 1st, the ECB has slowed its balance sheet expansion, before stopping altogether at the end of 2018, and Japan’s new monetary stance has also been helping its central bank to slow asset purchasing
  • persistent US-China tensions have led to fears of a return to cold war conditions, concerns that were underpinned by further renminbi slippage against the US dollar in October
  • third quarter US company results have so far easily outstripped expectations but companies have generally been more low key over the future. At the same time, markets have been highly sensitive to results, with particularly strong dispersion over earnings expectations.

And technically, the correction was amplified by heavy VIX shorts and rapid readjustments by controlled volatility and long-short equity funds.

In our view, the market purge was overdone. True, global financial conditions have declined due to tighter monetary policies and contracting liquidity but the fundamental environment is still sound. Of course, Europe and China have perhaps seen their economies slow more than investors expected. And at the same time, today’s buoyant US economy is largely technical and has been driven by Donald Trump's fiscal stimulus; its effects will soon start to wane. 

No cyclical downturn in view

There are, however, still no pointers suggesting the end of the cycle is nigh: inflation is still benign, corporate margins remain healthy and interest expense is manageable. Moreover, tighter financial conditions following the market correction have taken financial condition indices back down to their historic mean. As a result, it is tricky at this stage to assume that the October crisis could set off economic weakness. In other words, we could be in for a slowdown rather than a cyclical downturn and the market impact is not the same.      

Key points
  • Slightly overweight US and European equities
  • Back to neutral on emerging country equities
  • Increased exposure to US Treasuries

Note also that Beijing has in recent months introduced various economic stimulus measures so we cannot rule out some pleasant surprises in coming weeks. Finally, even if protectionism is still a high risk, US-China talks might resume once the US midterms are over.

We had tactically trimmed equity exposure over the summer on concerns that markets were over-complacent. At the end of October, we tactically increased US, European and emerging market equity weightings because markets had gone from one extreme to another, apparently ignoring the possibility that there might be some good news before the end of the year. We have also raised US Treasury exposure but are now very wary of core European government debt. US 10-year Treasuries are looking attractive again with a yield close to 3.2%, high enough to protect against any concerns over an economic slowdown.

    Our convictions for Novembre Changes compared to the previous month
EQUITIES
US
Europe
  Euro
  United Kingdom
Japan
Emerging countries
FIXED INCOME
US
Euro
Investment Grade
High Yield
Money market
DIVERSIFICATION    
Convertible bonds
Dollar
Next headline events
  • Next ECB meeting: December 13
  • Next Fed meeting: December 18 & 19
  • Next BoJ meeting: December 19 & 20

 

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