The major tactical risk to our allocation has materialised sooner than we expected. Markets have already started contemplating that the next move by the Fed is not down but up. We have thus reduced our equity overweight to 5 percentage points. This, however, is a purely tactical decision. We are not trying to time what seems to be a correction in the making. Instead the decision reflects the fact that the current allocation is no longer appropriate given our judgement of the macro outlook, market sentiment and our model.
In May, saw tentative signs of a rebound in US growth. Now, one month later, markets are convinced that this is the case, fuelling interest rate and inflation concerns. Although this raises the question of the magnitude of our recommended equity overweight, fundamentally, nothing has changed. Equities are still our most preferred asset class, and our overall recommendation is unchanged. Stay overweight equities! The magnitude of the equity overweight comes down to 1) flexibility with respect to the practical implementation of changes in allocation 2) your assessment of and willingness to bear risk and 3) confidence in your timing capabilities.
Quoting seasoned monetary policy maker and Fed vice chairman Donald Kohn. We are uncertain about where the economy has been, where it is now, and where it is going. Taking his cue, we think understanding the past, before contemplating the future, is of the essence. In that respect, we think the first chart on the next page says it all. Real US rates have risen as markets have readjusted their expectations for the US growth outlook on the back of stronger than expected activity data, while inflation expectations have been contained (and actual inflation has continued to decelerate).
The movements in the fixed income markets over the past couple of days are clearly out of whack. Movements in global equities, however, should be seen in relation to 1) the exceptional rally over the past 12 months and 2) the increased uncertainty about the future outlook for interest rates. However, the bottom line is this: Globally, monetary policy is not restrictive. It is probably still slightly loose. More importantly, overall financial conditions are definitely loose, given, among other things, the still low level of longterm real interest rates. This is due to a number of factors, but our judgement is, that most of these factors are cyclical, not structural. This means that long-term rates need to rise . and rise more than they have done so far as this expansion will not end before monetary conditions venture into tight territory. This process, however, and the factors driving it, should partly benefit equities. And coupled with the fact that we do not think that we are in the midst of a serious correction, we retain an equity overweight of 5 percentage points. We intend to increase the overweight again should we be wrong and this is indeed a serious correction. On the other hand, we will reduce it further some time in the future, if equities shrug off recent volatility and continue to rise.
We have long been overruling our model, as this has suggested that we should fund our equity overweight through an underweight in high yield, instead of government bonds. However, we are warming to the idea of an underweight in high yield, as, in our opinion, risks are becoming increasingly asymmetric for spreads. Alongside the great puzzle of this expansion, i.e. the level of long-term interest rates lies another - the unwillingness of the corporate sector to gear up. As always, we think there is more than one explanation for this, but we would highlight the following. In the aftermath of the excesses of the late 90s, and in pursuit of the all important - shareholder value - corporates all over the world have shored up their balance sheets. Furthermore, as globalisation accelerated, company managers of the Western world enjoyed an extreme level of bargaining power with respect to their most important source of cost; labour, while facing unprecedented competitive pressures, thereby facilitating profit growth through cost control.
This will not continue. First, we think the high yield gap is an extreme market misevaluation, which, like all others, can be exploited. This is exactly what the private equity industry is doing. Buying the inexpensive asset, equities, and selling the expensive asset, debt (or, spreads if you like). Second, although we have confidence in financial engineering, we are concerned with the amount of leverage in the credit markets (or, more specifically, the uncertainty surrounding this complexity and understanding of the swathe of new products) and third, we think macro fundamentals are moving against corporate high yield, as the cycle matures. In that connection, we found it very interesting to read a recent report detailing how the large investment banks are already establishing and expanding their distressed debt desks in anticipation of a proper turn in the credit cycle. It remains, however, a question of timing, and we do not think that we are there just yet. For now, we recommend being extremely careful with corporate high yield, especially in the US.
In sum, as the cycle matures and extreme misevaluations disappear, our job as asset allocaters becomes more difficult. The screaming buys are getting fewer by the day.
Read the entire newsletter (PDF: 26kb)