Who will blink first?

The S&P 500 and the US10 years' yield rate continued their wild ride against the expectations of the most, especially for what concerns the S&P. Up to today the US equity markets shrug off any actual or prospect of a rate increase. The 10yr 3% threshold seemed insurmountable for a while, but also this level is history now. It is worth wondering until when this complacency will last. While Treasuries will probably continue increase their yield, we are wondering if the equity market while remain bullet proof for long. Who will blink first then?

While most active managers and commentators have been suggesting to differentiate out of US equity assets for a while, markets keep on discounting an earnings growth well above average (average price/earnings ratio is 17 vs 14.5 historical average) and the economic indicators suggest that an economic downturn is nowhere close. That said, current valuations should already discount the present GDP growth of about 4% leaving little room for fantasising about further growth acceleration. As said, markets seems not seeing that rates are increasing ...

Politics count

The post Global Financial Crisis growth of the S&P seemed exhausted with the end of President Obama administration. The unexpected victory of Donald Trump fueled the so-called "Trump trade", growth of the equity market of almost 40%, based on the expectations of the approval of a massive corporate tax cut. Once this, somewhat unexpectedly although welcomed, passed the vote of both houses, the S&P 500 had a first faux pas losing 10% at the end of January. From the 2600 level, the index recovered all the lost ground back to the 2900 level and more.

Here politics come into play. On the 6th of November, midterm elections will be held in the US. The present administration could lose the control of one of the two houses and, with this, the ability to swiftly pass its economic decisions.

The balance sheet of the FED is also shrinking. In the future, liquidity will continue to shrink making any leveraged investment riskier but also "resharpening" FED's ammunition for economic downturns. Additionally, it is worth considering that the present expansion period has been the longest in recent history.

So, what could be the trigger of a downturn in the US equity market? We obviously don't know but, watching the present situation from a disciplined point of view we can observe that many defensive asset class like gold are behaving like this will sometimes happen in the future. On the other hand, as said, the leading economic indicators are still very far from indicating a risk of recession.

On the monetary side, we will have a more unobstructed view on future policies after tonight FOMC statements. It is likely that the Committee will modify its DOT PLOT forecast allowing a better interpretation if its intentions.

From the portfolio management perspective, we continue to favour 3 approaches as variation to our usual asset allocation:

1) keep cash or near cash. This dry powder will guarantee us shooting power on the targets that now we consider too expensive, both in the equity and bonds markets

2) Long-term equity investments uncorrelated to major markets. These are specific long-term investments, mostly aimed to profit from the M&A activity that is likely to increase in this phase of the cycle.

3) Tactical index long/short investing. This provides temporary over/under exposure to specific markets/asset classes.

We avoid buying:

- emerging market bonds

- long corporate bonds

Please contact us directly should you be interested in more details of the current asset allocation.

Best regards

Federico Polese

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