The Clock and the Cracks

  • Investors are waiting for the FOMC and the vote in Scotland. Whatever the vote the investment world has discovered a political risk premium that will persist. There is little evidence that the Fed has changed its timetable for monetary re-entry. However, the investment world has failed to keep up.
  • We argue that this third quarter holds the decisive investment messages of 2014. The significance of the profit-taking in credit is validated by the return of volatility to forex markets. It implies vulnerability in the commodity-emerging space. It is the prelude to profit-taking in equity in Q4.
  • The EZ’s singularity is not the trend in its interest rate markets but the reduction of investment risk attached to corporate credit.

Recommended sector and market asset allocation

Investors are waiting for the FOMC and the vote in Scotland. Whatever the vote the investment world has discovered a political risk premium that will persist. There is little evidence that the Fed has changed its timetable for monetary re-entry. However, the investment world, distracted by the disturbances in Europe’s markets, has failed to keep up. The parenthesis of declining US$- denominated bond yields of the last six months has been closed.

We argue that this third quarter holds the decisive investment messages of 2014. The general theme is contained in our argument that Jackson Hole 2014 marks the advent of a stronger US$. This quarter is characterised, above all, by profit-taking and reversal of trend in the credit space, at least that part denominated in US$ that includes most of the emerging world. Credit leads equity. The profit-taking in credit in Q3 is the prelude to profit-taking in equity in Q4. Our assumption is that the year-end profit-taking in equity will be the beginning of the correction that must be associated with the transition to higher US$ interest rates. History tells us that a strong US$ implies commodity vulnerability. Commodity under-performance has returned with a vengeance. A stronger US$ also implies vulnerability for financial assets in the emerging world. The weakness of emerging currencies this quarter has been more widespread but less pronounced than was the case at the time of last year’s rise in US$ bond yields: it is consistent with the anticipation of higher US$ short rates that will cause upheaval in the international business of carry trades.

We are coming out of Q3 2014 with a major turning point in the reference debt markets of euroland. Euro rates have reached their lower boundary. Moreover, the ECB’s commitment to provide continuous buyer-of-last-resort support for EZ non-financial private credit and for many categories of private asset held by EZ Banks reduces the investment risk attached to corporate credit throughout the euro system. EZ corporate credit is the new “high yield”. Within European equity the pain trade continues. The characteristic trends of the previous decade – in particular, the systematic divergence between global goods producers and domestic service providers – have been arrested. And yet, the investment community is incapable of embracing this message because the difficulties of Europe’s economies remain too apparent.

Weightings and asset allocation for the MSCI Europe Universe



15/09/2014 Neutral weight in MSCI (%) 2-yr beta values
(vs MSCI)
Tactical sector rating Recommended allocation (%)
Consumer Discretionary 9.9 1.1 N 10
Automobiles & Components 3.1 1.5 N 3
Consumer Durables & Apparel 2.4 1.1 UW 2
Consumer Services 0.9 0.9 OW 2
Media 2.0 0.9 N 2
Retailing 1.4 0.9 UW 1
Consumer Staples 13.3 0.7 N 13
Food & Staples Retailing 1.2 1.0 UW 1
Fod Beverage & Tobacco 10.4 0.7 N 10
Household & Personal Product 1.7 0.7 OW 2
Energy 9.3 0.9 UW 7
Financials 22.7 1.3 OW 25
Banks 12.6 1.3 N 13
Diversified Financials 3.1 1.4 N 3
Insurance 5.8 1.2 N 7
Real Estate 1.1 0.9 OW 2
healthcare 13.4 0.8 OW 16
Healthcare Equipment & Services 1.2 0.6 OW 2
Pharmaceuticals & Biotechnology 12.3 0.8 OW 14
Industrials 11.1 1.1 UW 9
Capital Goods 8.3 1.1 UW 6
Commercial Services & Suppy 1.2 0.8 UW 1
Transportation 1.5 1.0 OW 2
Information Technology 3.3 1.1 OW 4
Software & Services 1.5 0.9 UW 1
Technology & Hardware Equipment 1.0 1.3 OW 2
Semiconducors 0.9 1.1 OW 2
Materials 7.8 1.2 N 8
Telecommunication services 4.9 0.9 N 5
Utilities 4.3 0.9 N 4
Exposure to risk
(beta value)
  1.02    
Lquidity ratio   2%    
* The exposure to risk is measured by the weighted average of 2-y betas.
We manage the liquidity ratio within a 0-10% rank.
Source: Kepler Cheuvreux