Super Mario fails the markets again.
Another rally peters out on deteriorating sentiment and fear becomes the dominant theme. But still the S&P500 measure of equity market volatility is stuck in a range of only 15-22 per cent. The last three times the VIX traded in this range the next move was up and quickly, with detrimental implications for those holding risk assets. We are in a period when reducing portfolio sensitivity to market movements and sentiment is the most important contribution to investment decisions.
Two worrying US data points sent markets against the buffers last week. Non-farm payrolls data on Friday was poor, below expectations and a reminder that US private sector recovery has been well down on previous recoveries. This offsets the fact that US corporates are relatively healthy from a balance sheet perspective. Second, the manufacturing sector's PMI showed the sharpest fall in new orders and exports since the low-point of the financial crisis. Given recent declines in China's PMI this shouldn't be completely surprising, but the scale of decline from 60 to 49.7 on the headline measure is a concern for export-led markets.
The ECB then compounded fears by saying it isn't ready to flood the markets with new money. The ECB's monetary policy announcement came 45 minutes after the Bank of England decided to extend its quantitative easing program. ECB President Mario Draghi offered a mere 25bps in rate cuts and the view that there was downside risk to the European economy. It's fair to call this an understatement. Subsequent comments in the financial media that there is little more to come in terms of rate cuts or quantitative easing don't help.
In the absence of serious monetary intervention, European markets are left with only sentiment enhancing policy-initiatives from the political circuit to keep the bears at bay. That is why copper has consistently out-performed gold over the last few months. Gold will only move materially higher when the ECB moves from conventional measures to unconventional measures of the kind being employed across the English Channel. Until then it makes complete sense to be out of European equities, its currency and debt priced in EUR. US dollars remain the currency of choice.
On a global basis, our asset allocation models have been updated for July and show a deteriorating outlook for equities in developed markets and we thus recommend a slight over-weight in Emerging Markets. Equities outside the G7 are expensive relative to developed markets on a valuation basis but the momentum behind credit growth, the abundance of liquidity, earnings revisions and the slope of yield curves make for a more attractive investment proposition than developed markets.
In terms of other signals, our models still point to under-weighting US equities versus fixed income, but the underweight is becoming less as credit spreads have tightened. Our core view, that small cap equities or high yield debt should continue to remain the preferred expression in US market, is still vindicated by low risk-free interest rates and high dividend yields. For UK equities, the weighting of bonds and equities is now equal as longer-dated bond yields have now descended to the extent that equity dividend yields are now almost at a 300bps premium to equities.
The mix of Emerging v Developed Markets is still skewed in favour of Emerging Markets, and Asia Pacific / MENA in particular. Earnings revisions are becoming more positive in equities with money supply growth rates still constructive. In fixed income, as with equities, we still recommend reducing beta. In fixed income this comes through only having exposure to the high grade market and at short maturities. We also favour hard currency debt over local FX.
Our pick BRICs, in equities terms, remain Russia and China as valuations and growth potential. However, Russia's equity market has a beta of 1.3, meaning its downside risk aligned are more than proportionate to declines in the MSCI Emerging Markets index. China comes with a beta of 1.0 by comparison, thus making it slightly less sensitive but with the prospect of significant cuts in Peoples' Bank of China monetary policy.
Out-going Chinese Premier Wen Jiabao made his singular policy statement yesterday again; government policy should only be loosened when growth is around the 7.5 per cent trend range. Interest rates and the supply of credit are government policy in China. With inflation dropping in China to just above two per cent in June, and PMI data appearing soft, the time for more sops to the market is now. For this reason alone, investors should consider investing long-term in the Chinese market.
2012 CPI Financial. All rights reserved.
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