Have equities found their low?

Yvan Berthoux - 08 November 2018

Global equity markets appear to be recovering from their second seizure of the year, but there is a wide dispersion of views on the market outlook. Canvassing our contacts, we have found a variety of responses to the latest equity setback. Is this the moment to jump out of overweight US equities or is  it still smart to buy the dips? Does the rebound in the US Dollar signify greater international enthusiasm for US assets or is it a substitute for US equity gains? Our macro-framework suggests that long positions in Japanese Yen and US Dollars, and in US equities relative to the rest of the world, should be maintained. 

Have global equities found their lows? Here are some of the reactions we have observed to this burning question:  

  1. A significant number of market participants think that US equities could fall further to catch up with the world ex-US equities after having recorded a sustained divergence (figure 1, left frame)
  2. Others simply think that now represents a good time to buy the dips as equities appear to be cheap based on various metrics of value investing
  3. Brent Johnson’s interesting Dollar Milkshake Theory favours the US Dollar and US equities with US receiving capital flows due to rising interest rates while the rest of the world falls apart as the monetary system is intolerant to a strong US Dollar.

For several months, we have been warning investors that the market was facing a few challenges coming. We noticed previously that the slowdown in real economic activity in many developed countries (UK, Euro Area, China), elevated uncertainty, falling excess liquidity and central banks’ negative QE  impulse were all going to act as headwinds for risky assets, and especially equities around the globe. Consequently, we have been trying to find defensive strategies, safe-haven assets and to deleverage sensitivity to a sudden rise in price volatility to absorb this highly uncertain period and wait for better opportunities at a later date.

As a result, we saw that our classic safe-haven – the Japanese Yen – has well-supported during this recent period of volatility. For instance, figure 1 (right frame) shows the strong relationship between AUDJPY, one of our barometers of risk-on/risk-off environment, and the world ex-US (RoW) equities (represented by the VEU ETF). Even though the relationship between carry currencies and US equities (SP500) broke down after the crisis, it still exists for EM and RoW equities. Therefore, the Yen should continue to outperform RoW assets, in the event of further downside risk.

For investors who prefer to remain exposed to the US Dollar, it is interesting to observe the yearly performance of the greenback (USD REER) overlaid with the relative performance of US equities (SPY) versus RoW (VEU) equities. Figure 2 shows that for the past 10 years, which corresponds to the start of the two ETF times series, the US stock market has outperformed the world in periods of rising US Dollar. We notice that the two series mean revert, with the US Dollar ranging from -10 to 10 percent in annual change while the US vs. RoW relative performance ranges from -20 to 20 percent. This suggests that we could build up an equity position based on a fundamental view on the US Dollar (assuming, of course, that the relationship holds good.)  

At this stage, there is still more room for the US Dollar to appreciate in the medium term (YoY gain on the USD REER is currently of 2.3 per cent), however the SPY/VEU ratio is currently trading at 15.8, the high of its -20/+20 range. What is really more important? Further upside room on the USD, or still higher valuations of US equities relative to the World?

Using our macro framework, especially in this period of elevated market complacency, our preferred tactical allocation is to be long JPY, USD and US equities relative to the rest of the world.  

Figure 1

Data Source: Eikon Reuters

Figure 2

Data Source: Eikon Reuters, DataStream

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