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Why I'm Most Negative on US

Updated: May 17, 2022

The last two equity bear markets - in 2001/2 and 2008/9 - saw rolling three year returns from global equities at their trough hit -45 and -42 percent, respectively. Anticipating such dramatic declines can help add value to portfolios, enabling shifts to more defensive positioning. Markets, however, are notoriously hard to predict. So how can one do this? The answer is to keep it simple and to make asset allocation shifts gradually and progressively.

"It is always hard to get timing right"

The decision-making framework for asset allocation should be based on business cycle analysis. There are clear correlations between the phase of the cycle and the performance of various financial asset classes.

Business cycles in the real world are not as neat as their textbook cousins, but they exist and have a pattern that can be discerned. This pattern pertains to whether economies are expanding or contracting, which can, in our view be most simply and easily measured by whether unemployment rates are rising or falling. When unemployment rates are at low levels, as is the case now, rising wage pressures eventually feed through to higher inflation, which central banks address by tightening monetary policy.

Indeed, it is monetary policy that is really the key driver of financial asset prices.

The indirect effect of rising interest rates, at least on equities, is to make borrowing more expensive, which in turn causes a slowdown in spending, whether by consumers or companies. The slowdown hits corporate profits and thus share prices.

The direct effect of higher interest rates is to make cash more attractive in a relative sense and thus other financial assets be their bonds or equities less attractive.

Valuation is also important but should be used in conjunction with analysis of the business cycle. It is hard to know where valuations of various asset classes should peak and trough and anyone cycle; valuations at the end of the tech bubble of the 1990s were driven by wild expectations for new technology companies, while those before the great financial crisis 10 years ago were a function of what appeared to be low valuations for banks.

In both cases, however, and many before them, unemployment, monetary policy and yield curves provided good signals.

We began reducing our funds’ equity targets in the second half of 2016, first from overweight to neutral, then further underweight since. We have done this in anticipation of some sort of global downturn towards the end of next year or possibly the beginning of 2021 that would be preceded by an equity bear market.

The market we have reduced the most as the US and indeed we now hold no US equities at all.

The reason for being most negative on the US is twofold. Firstly, the business cycle in the US is most advanced, as evidenced by higher inflation than elsewhere and thus more tightening in monetary policy. Secondly, valuations in the US are now looking stretched relative to global valuations as a whole. The price to book ratio of US equities is now more than twice the ex-US average.

It has been a little surprising that US equities have continued to perform so well in a relative sense over the last year or two, but it is always hard to get timing precisely right.

We also have a zero position in safe-haven government bonds, such as Gilts and Treasurys. Both inflation and real yields are now very low in a long-term historical context, which makes safe-haven bonds expensive. Our position is a little trickier than that in US equities as we suspect safe-haven bonds will hold up well in a recession. Indeed, growth fears over the last few months have seen them perform very well.

But, if you buy 10 year Treasurys on a real yield of 0.5% your real return to maturity on a per annum basis is only going to be 0.5%, and possibly worse if inflation is higher than expected. This does not, in our humble opinion, make them attractive investments.

Published in The Wealth Net

The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.

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