Psigma buys into US Treasuries because bond markets have fallen too far and too quickly

3rd September 2013

Bond markets fell “too far and too quickly” this summer prompting multi-manager Psigma to buy into US Treasuries for the first time since 2011.

In a note to investors, Tom Becket, chief investment officer of Psigma Investment Management argues the fixed interest markets have priced interest rate hikes prematurely. He says the dollar/sterling rate is oversold offering another reason for UK investors to be interested and says the move will provide diversification.

Beckit says markets presented a difficult second quarter for asset allocators. But he says the last week or so has seen a resumption of diversification working “efficiently and effectively”.

He says: “Perceived low-risk assets, such as core government bonds, gold and investment grade credit have all performed robustly, renewing their credibility as assets to hold when markets are tough. This breakdown in correlations is certainly helpful to all those who, like us, pursue diversification in portfolios. Let’s hope it stays that way.”

The note adds: “In July we took profits from both our US and Agriculture allocations, through the sales of Legg Mason US Equity Income and First State Agribusiness. This meant that our recommended cash allocation on a balanced portfolio was a lofty 10%. Our cash weighting is now 7.5% on balanced portfolios.”

In a typically lyrical introduction to the note, Becket says the traditional sign of summer is the sight of a swallow but, he notes ruefully, not anymore.

“Now it is emails from stressed investment operatives explaining the volatility of financial markets. After a month of calm in July, August has been very bumpy, with nerves rising over the strength of the global economic recovery, a potential change in the Federal Reserve’s policy and capital flight from emerging market economies.

“They say that one swallow doesn’t make a summer; well a raft of mini-crises certainly ruins ours. When one adds uncertainty over corporate earnings, the likely outbreak of a worldwide geopolitical event in Syria and seemingly endless flashpoints in the Eurozone to the mix, it is understandable that markets have swooned in the summer sun.”

Beckit says his firm entered August as diversified as it has ever been while also defensively positioned.

“We are still extremely diversified, particularly in our Alternatives allocation. We recognise that holding a high cash weighting is very sensitive at a time of record low interest rates, so we are actively seeking good opportunities to use that cash in the months ahead; increases to EM assets, European equities and a return to Agriculture which has been hit very hard in recent weeks are all under consideration.”

Beckit says that the global economic recovery has become even more confusing over the last few months.

He says: “The US, which was reassuringly strong, has seen some questionable data over the last few weeks, particularly from the housing market. Europe is improving and the UK is undeniably strong at this point in time, which will help compensate for the US slowdown.

“Chinese growth has been more resolute over recent weeks than the Bears were roaring it would be, whilst useful leading indicators, such as Korean exports, have started to gather momentum. Japan has slowed from early Q2 and clearly more help is needed there, which we expect from the Abe administration when the Diet re-opens in September. In short, the economic recovery remains “boring, below-par, bumpy and brittle” but there are still enough positive signs for our forecast that the global economy could return back towards trend growth at some point in 2014.”

However he says there are several important developments and risks to keep an eye on which we include in full below.

Change in US Monetary Policy: The waves of summer volatility were first triggered by the US Federal Reserve’s hints in May that they would start to “taper” their bond purchases (QE) at September’s policy meeting. This in effect “let the cat out of the bag” and global financial markets quickly moved to price in a new trajectory of policy; bonds fell, yields rose, equities wobbled and money started to flow from the EMs and back to the US dollar. However, there surely now have to be some doubts over whether the Fed will actually start to wind up QE in September, particularly given the rise in mortgage rates and slowdown in housing activity. This “will they, won’t they” discussion has become the investment world’s most boring but sadly important debate. Our weakly held view is that they will taper in September, as to backtrack now would undermine confidence even further. However, markets have definitely moved too quickly to price in rate hikes, which we don’t see happening until 2016 at the earliest. This loose monetary policy is vital to keep the economy moving, credit flowing, mortgage rates under control and confidence high. If the Federal Reserve mess this up and communicate their path unconvincingly then we could be in for a rocky few years. The fact that it seems that Larry Summers, a supposed anti-QE economist is about to take over at the Fed, muddies the water yet further. The “great” debate continues…

The Great Deceleration in Emerging Markets –We have been surprised by how poorly EM assets have performed on a relative and absolute basis over the last year. This has led to plenty of opportunities for long term investors, but patience will be required. Over the last week, my team and I have held 5 conference calls with our EM managers to try and ascertain whether what we are seeing in ASEAN and India is a “mini re-run” of what we saw in the Asian Financial Crisis of 1997. Thus far, we have been relieved to hear that nobody believes that it is. However, it would be naïve to suggest that the capital flight we are seeing from markets like India and Indonesia is anything but negative. Drastic action is required by the affected Asian central banks. We should note that we have no exposure to ASEAN or Indian equity markets. As long as the recent events are not the prelude to a major crisis, which at this point we don’t believe is the case, then EM assets are broadly cheap and have great potential to recover. Our central view is that investors have swung the sentiment pendulum to negative too aggressively. However, we will be watching on-going developments hawkishly and are ready to act accordingly. It is worth noting that our investments in China have recently recovered very well from their distressed valuation levels at the end of Q2 as the country has amazingly become considered a “safe haven”!

The Syria Crisis – We always say that it is very hard to prepare investment strategies for events like the unfolding human tragedy in Syria. We also cannot add a huge amount of insight to what you will have all heard and read in the media. However, diversification is helping soften the blows that are being caused to markets by the threat of a military strike, as gold, the US Dollar, US Treasury bonds, the oil price and energy company shares have all gained strongly over recent days. If the Syria crisis spirals out of control, which is possible, and creates further shockwaves in the Arab world, then holding the aforementioned assets will be very sensible.

The Never-ending Eurozone Story – Amazingly, Europe has fallen to 5th in the list of worries that is plaguing investor sentiment, but it is not something we should totally dis-regard, given the political issues in Italy, the fact that another bailout is required in Greece, perennial debt issues in Portugal and a structural lack of growth in France. However, we are more positive on the wider Eurozone growth outlook, as there seems to be a tacit approval of austerity reduction and we believe that Frau Merkel and her coalition will get the victory they desire at next month’s elections. While we are not as optimistic as some, who believe that Merkel’s win will open the German liquidity taps to flow to the Med, we are more positive than the many Bears who claim that there is no hope for the Eurozone. Things are gradually getting better, if admittedly from a low base, and we are seeking to increase our exposure to Eurozone equities that are undoubtedly cheap relative to the US.

Equity Valuations/ Corporate Earnings – There are definitely question marks appearing about the relaxed attitude of analysts towards US corporate earnings as this year progresses. The last reporting season was “patchy”, with only really the financial sector surprising to the upside. Analysts are still expecting earnings growth of close to 10% in Q4, which we find difficult tomarry to the global economic situation. US equities to us look expensive, with the S&P 500 trading on 15xs P/E. We are also concerned about the incessant flow to “safe” US equities and the uniformly optimistic consensus. Globally, the corporate results season was solid, if unspectacular. From a valuation perspective, Europe is much cheaper than the US on 11xs P/E and we believe that earnings in the region should recover in the coming years. Broadly the samerationale applies to Japan, where we believe that investors are too obsessed with the currency and ignoring the long term earnings growth potential of Japan inc. There is an obvious valuation opportunity in EM equities, as companies across the emerging world are trading at a material discount to the US and other developed markets, ignoring the possible growth of these companies’ earnings. Our views are contrarian, but we feel confident that value, both from a regional and a sectoral standpoint, will start to work powerfully in the coming years.

The note concludes that “as long as our economic prognosis is not wildly errant, then our base case remains that 2014 should be a positive year for equities and (after the recent sell-off) other risk assets, such as high yield credit. Assets that have been hit very hard, such as EM bonds, are also under close review.

“In the short term we are more cautious and our asset allocations reflect this. This near term anxiety is somewhat assuaged by the number of attractive long term opportunities we can find, particularly in EMs, Europe and Japan, but this is not a time to be a hero.”

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