Monday, August 17, 2009

Asset Allocation: Kissing the risk-recovery goodbye

Equity markets rallied sharply during the Q2 earnings season of the past weeks and surpassed their early June highs significantly. However, by now they look exhausted and burned-out. Strategically I have been recommending a defensive asset allocation (Asset Allocation: Defensive stance on June 22) but have proposed to lighten up all positions on a tactical basis on July 14 (Market Update: Temporary counter-movement) with the aim of getting back in on cheaper levels. Now, I realign my tactical outlook with the cautious strategic stance as the recovery in risky assets is ending:

Government bonds:
Long duration
Equities: underweight, especially in cyclicals/consumer durables/financials&commodities
Currencies: overweight USD & JPY. Neutral on CHF. Underweight EUR, GBP and commodity-currencies.
Credit: Neutral to moderately underweight credit overall. Within credit overweight higher-rated non-cyclicals (for example utilities) across the curve vs. lower-rated cyclicals.
Commodities: Underweight, mainly energy and base metals but also Gold.
Cash: Overweight

The positive market developments during the Q2 earnings season of the past several weeks was largely down to the positive earnings surprises and the consensus shifting in favor of a marked brightening of the fundamental economic outlook. GDP expectations for Q309 as well as 2010 in general have seen a material upward shift. Additionally, as written here, sentiment towards equity markets has turned largely bullish. For example, according to the American Association of Individual Investors, most US retail investors have become bullish again, for the first time since May 2008. Furthermore, according to ChartCraft's Investors Intelligence, bullish institutional investors outnumber bearish ones by 2:1 and the percentage of bears is back to the lows prevailing in October 2007 (i.e. just when the S&P500 made its all-time high)!
This high level of investor enthusiasm lets me think that by now the positive news is more than adequately priced in. Yes, Q309 should show a markedly positive number in terms of US GDP growth, however, as I have written already previously (Q3 growth likely to surprise positively but not final sales) this should be mainly down to the reduction in the negative contributions from auto manufacturing and residential investment as well as a decline in the pace of inventory liquidation. Furthermore, net exports are likely to contribute positively. Final demand on the other side, does not promise to stage a significant rebound. For one, the positive development of net exports masks that both, imports and exports are falling (just imports are falling more). Furthermore, as US retail sales showed again last week, consumption remains weak. Finally, such weak developments of consumption coupled with the current extremely low level of capacity utilisation will keep business investment depressed.
Additionally, the positive earnings surprises evident for Q2 are more down to cost-cutting than a brighter fundamental backdrop given that revenue surprises painted a much less positive picture. Cost-cutting, however, will further depress future demand growth.

Oil: Upward trend broken, stochastics turn lower from overbought levels
Finally, the market technical picture has been deteriorating over the past days. This is especially evident in some commodity markets as for example oil. The chart above shows that oil has broken through its former upward trend on Friday. Furthermore, stochastics are in overbought territory but have started to fall, also signalling that we are likely at the start of a more pronounced downward-movement.

Overall, I think that markets have discounted a too bright growth outlook, sentiment has become overly bullish and technically markets are starting to fall back from overbought levels. Therefore, I expect a longer-lasting and deeper downturn in risky assets which will also be mirrored by a widening of credit spreads as well as by a sharper downturn in commodity prices. I propose a defensive asset allocation from a strategic as well as a tactical horizon.

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