US investment adding to risk appetite.
After some turbulence in markets last week, the upswing in risk markets has returned. The difference between these last few days and the norm for the last few years is the strength of USD as risk market rise. Volatility has once again increased, but only marginally and mostly in FX markets in the Emerging World. Despite the upswing, and a 6.6% gain on the FTSE 100 since end-2012, fear is a dominant emotion in sterling markets while positioning in mainland Europe suggests that most believe the worst is now behind us.
Our FX models point towards a period of stronger EUR, most particularly against GBP and also JPY. Sterling has been undermined to a large extent by the potential of a ratings downgrade and the stream of poor economic numbers that raise the spectre of another recession. Options markets and technical data point to higher EURGBP as the best way to trade GBP weakness. Thus sterling DCIs with EUR as the conversion currency have become a preference over GBP/USD contracts for the first time in months.
Against this backdrop we have moved our tactical positioning. After last week's disappointing news on monetary policy expansion in Japan we have reduced exposure to Japanese equities following those robust gains from mid-December onwards. It is entirely possible that a more expansive policy will be introduced after 1 April, once the new governor of the Bank of Japan is in place. But between then and now, it is better to take some profits for clients with a conservative outlook Only for more risk-taking portfolios has that risk exposure been retained.
Additionally, with the US fiscal cliff behind us, but automatic spending cuts due on 1 March, there is a risk that the US equity market will give back some of its recent gains ahead of the deadline for implementation of cuts. It is quite clear that President Obama does not fully appreciate the extent to which US welfare and retirement budgets are unfunded on a long-term basis. This fact alone makes the likelihood of a near-term resolution, as opposed to a quick fix, much less likely. Thus our US equity weightings for conservative clients have been paired back to under-weights.
Lastly for cautious clients, the risk of a further upward shift in US bond yields requires effective risk management of Emerging Markets debt positions. As a result, we have taken down our exposure to EM corporate debt as this sector is vulnerable to a sell-off in USD benchmark bonds. The opinion is to move that funding to bond markets in developed markets that are not EUR, GBP or USD denominated.
For our more adventurous, or risk-taking clients, the emphasis has been on finding better means of making good returns. As described here last week, earnings results have been favourable in developed markets, but have been materially better in Emerging Markets. This is particularly so in Latin America (and also Greater China in Asia). Our view has been to add to Latin American equity positions across the board and to take advantage of an expected fall in USD against EM FX and lower inflation in the first half of 2013.
Increased allocation to local currency bonds in Emerging Markets is the preferred route as these offer more upside potential than USD bonds. Spreads in the latter asset class have tightened to such an extent against USD benchmark bonds that they are now over-valued.
China's recovery is gathering momentum. Asian markets have enjoyed a terrific run over the last 6 months as signs of global growth and a rebound in the book-to-bill ratio from 75% to 92% between October and December have buoyed the outlook for export-orientated stocks. Korean markets, particularly equities, have struggled since Japan embarked on a weak yen monetary policy, but the major export nations of Asia have all performed.
Vietnam in the Frontier Market bucket has had the added benefit of big decline in inflation and interest rates in the first half of 2012. The Ho Chi Minh index has gained almost 16% this month, although a widening of the current account surplus and an uptick to inflation should add some caution to enthusiasm for Frontier Markets.
Nevertheless, the numbers coming out of China are now considerably better than was so nine months ago when fears of a slip in growth to 5-6% caused fears of a growth recession that would undermine the entire de-coupling story of Asian resilience. What is encouraging is that the recovery in China's growth and performance indicators has occurred without a stimulus package of large magnitude or aggressive cuts in central bank policy rates. This is a positive for the longer term since the stimulus measures of 2008 led to increased debt-servicing burdens on China's municipalities and also left doubts over bank balance sheet risk in mainland China. Our view continues to see investment in China's equity market as a positive opportunity. Equally, investment in mining and cyclical recovery themes (e.g. those attached to infrastructure build outs, urbanization and consumer spending) are attractive too.
On the China theme, one development which should get attention is the news of London potentially entering into swap agreements with the PRC to aid the development of the renminbi offshore market in the UK. The CNH offshore market is relatively small compared to its onshore CNY relative, and mostly centred in Hong Kong, but the possibility of listing in London may well add to the attractiveness of debt issuance in larger global markets.
Lastly, our theme of the last few months has been the cyclical recovery in capital spending in the US which will benefit global emerging markets, particularly export orientated markets. The latest US durable goods figures come out this evening and the direction given will be a good portend of direction for Emerging Markets over the next few weeks.
2013 CPI Financial. All rights reserved.
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