The first thing to point out is that while our stress Indicator is an extremely useful input into our decision-making process, we do not respond to changes in the level of the indicator in a pre-determined or mechanistic manner. We therefore would not be automatic buyers of equities as a result of a fall in the level of the Indicator.
The Draghi plan – a bond purchasing scheme aimed at bringing down the yields on distressed short-dated debt – is another useful step in the long journey towards an eventual solution to the European debt crisis. As has been the case with so much of the intervention that we have seen over the past few years, it is only addressing a symptom of the crisis and not dealing with the causes (i.e. low growth and a debt mountain) but it further reduces the chances of systemic meltdown and it is, at the least, a useful time buyer.
In the US – in what is a clear change of policy – the message from the Fed was unambiguous: “If the outlook for the labour market does not improve substantially, the [Federal Open Market] Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.”
In other words, the Fed has indicated that its support for the market will be unlimited either by size or duration. Interest rates will be kept lower for longer, to at least mid-2015 rather than the end of 2014. Given that any rise in interest rates will clearly lag any pick up in economic policy, the prospects for policy normalisation seem even further away.
The old adage of “Don’t fight the Fed” certainly is as relevant today as ever and, given the fact that QE3 gave the market much more than it was expecting, it would appear that US risk assets are somewhat underpinned for the time being.
Given the speed at which the US is now printing money, the attraction of growing US assets, particularly bonds, will be seriously reduced by the likely depreciation of the dollar and a pick-up in the inflation rate going forward.
For this reason we were happy to remove our overweight dollar position across the models.
Given that the Fed has pleasantly surprised the markets and that Europe has taken important steps towards an eventual solution over the quarter, why then we are persisting with our equity underweight?
- The summer rally has been low volume, and low volume rallies usually end in tears. We have enjoyed a substantial rally from the March 2009 lows and the US, and to a lesser extent the UK, are knocking on the door of the previous all time highs. Given the low volume nature of the summer rally, many technical analysts are warning that this is a dangerous combination and that there is an increasing likelihood of a setback of some significance between now and Christmas.
- There is also a tendency in the US for major tops to occur a month of two either side of a Presidential Election. At some stage the markets must surely pay more attention to the post US Election deficit problems or fiscal cliff as it is referred to. We are looking at either tax hikes or savage spending cuts in the New Year.
When positive signs are a negative
Perhaps the most important sign that we are nearer to a setback than many feel is that, after a summer of caution, investors are now starting to turn bullish, feeling that the markets are totally underwritten by Ben Bernanke.
Such thoughts have historically proved dangerous. Given that we are investment managers who seek to provide consistent risk-adjusted returns, we feel no compulsion to chase markets which are now becoming very overbought.
Despite our equity underweight we are catching a fair amount of the present rally due to our investments in other assets such as gold.
The longer-term attractions of equities remain and indeed have been enhanced by the developments in Europe and the US over the month but for the time being we are happy to have some insurance against a setback and will maintain our present cash levels in the expectation of one occurring in Q4.