Drugs and Fear

  • The fear factor has signalled the end of the first wave of correction on Wall Street and of the second wave in European equity. The diagnosis is that the correction in the equity space will probably extend to the early part of next year. Don’t panic. Sell the rallies.
  • The loss of monetary visibility in America arises from the principal message delivered by financial markets this year. America’s monetary return-to-more-normal is accompanied by lower inflation expectations and lower longer-term risk-free rates. Although inflation will stay very low in the developed world this is not a world without growth. Growth leadership is changing.
  • The restoration of investor confidence in the EZ requires a policy reformulation centred upon a Franco-German trade-off between fiscal flexibility and commitment to structural reform. The deal is now visible but for the French government the hard part lies ahead.
  • Our investment rules signal that it is wise to remove to go from UW to N in the Oil & Gas sector because its relative valuation is approaching its lowest level on recent record.

Recommended sector and market asset allocation

The fear visible in market behaviour and in the pricing of options last week signalled a short-term market bottom. We have just witnessed the end of the first wave of correction on Wall Street and of the second wave in European equity. Europe’s equity markets have entered a phase of evident distress and high volatility. The diagnosis is that the correction in the equity space will probably extend to the early part of next year. Don’t panic. Sell the rallies. We would expect US equity to recover into November before the profit-takers outweigh the bottom-pickers. The S&P500 should probably be able to recover to the 1950 area.

We have witnessed a demonstration of the dependency created by the Fed’s monetary super-reflation. The expectation of the Fed raising rates in 2015 has been removed. The loss of monetary visibility in America arises from the principal message delivered by financial markets this year. America’s monetary return-to-more-normal does not mean higher bond yields. It is accompanied this year by lower inflation expectations and lower longer-term risk-free rates. Inflation will stay very low in the developed world for some considerable time due to excess supply of labour and commodities and excess capacity in many markets. However, this is not a world without growth. Growth leadership is changing. The contribution to corporate profitability from the global growth theme has begun to decline. The growth return-to-more-normal concerns domestic activities in the trans-Atlantic world, led by America. Anxiety about the outlook for the euro area has become so acute that we are entering the period in which positional risk is becoming a significant influence upon market behaviour. The restoration of investor confidence in the euro area requires a policy reformulation that is centred upon a Franco-German trade-off between fiscal flexibility and commitment to structural reform. The deal is now visible but for the French government the hard part lies ahead.

The relative composite valuation of the Oil & Gas sector is approaching its lowest level on recent record beyond two standard deviations from mean. Our investment rules signal that it is wise to remove our UW position to go to N. Large cap energy stocks are clearly cheap and investors have become under-exposed to the sector. A stabilisation of crude oil prices is now plausible.

Weightings and asset allocation for the MSCI Europe Universe



20/10/2014 Neutral weight in MSCI (%) 2-yr beta values
(vs MSCI)
Tactical sector rating Recommended allocatioln (%)
Consumer Discretionary 9.9 1.1 UW 9
Automobiles & Components 3.1 1.5 N 3
Consumer Durables & Apparel 2.4 1.0 UW 1
Consumer Services 1.0 1.0 OW 2
Media 2.1 0.9 N 2
Retailing 1.4 0.9 UW 1
Consumer Staples 13.5 0.7 OW 14
Food & Staples Retailing 1.2 1.0 UW 0
Fod Beverage & Tobacco 10.6 0.7 OW 13
Household & Personal Product 1.8 0.7 OW 2
Energy 8.9 1.0 N (UW) 9
Financials 22.8 1.2 OW 25
Banks 12.7 1.2 N 13
Diversified Financials 3.1 1.3 N 3
Insurance 5.9 1.1 OW 7
Real Estate 1.2 0.9 OW 2
healthcare 13.7 0.8 OW 16
Healthcare Equipment & Services 1.2 0.7 OW 2
Pharmaceuticals & Biotechnology 12.5 0.8 OW 14
Industrials 10.8 1.1 UW 8
Capital Goods 8.2 1.1 UW 5
Commercial Services & Suppy 1.2 0.8 UW 1
Transportation 1.4 1.1 OW 2
Information Technology 3.3 1.1 OW 4
Software & Services 1.4 0.9 UW 1
Technology & Hardware Equipment 1.0 1.4 OW 2
Semiconducors 0.8 1.1 OW 1
Materials 7.8 1.2 N 8
Telecommunication services 4.9 0.9 N 4
Utilities 4.3 0.8 N 4
Exposure to risk
(beta value)
  1.00    
Lquidity ratio   6% (5%)    
* 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