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Dec 2013
John P. Cuthbert BA, MA, MSc, JP Cuthbert Consulting Ltd, Independent Financial Economist john@jpcuthbertconsulting.co.uk
Looking Ahead into 2014 Heading into 2014, this time round investors look more optimistic than pessimistic. This optimism is well represented, I would argue, by BoAMLs global view that sees the US environment shifting from High Liquidity/Low Growth to High Growth/Low Liquidity or Absolute Strategys view of regime Change. If BoAML are right, High Growth/Low Liquidity would indeed mark a substantial sea-change. And a sea-change that is well prefigured.
There is also a considerable weight of sentiment behind Europe and Yen equities, but less enthusiasm for Resources, Commodities (particularly Gold), and GEMs, though fund flows appear to be recovering. Investors have also been exiting Sovereign Bonds, but not in Great Rotation volumes. Looking at these dispositions and how crowded they are, we continue to hold fast to the view that too many investors continue to misunderstand at least four things: the underlying economic fundamentals; the scope and importance of policy and policy effectiveness (most noticeably with regard to Fed Tapering); the dynamics of the commingled relationship between underlying economic fundamentals and asset prices; and, finally, how the key is not strategic certainty since this is not obtainable (the dynamics are just too intractable), but to trust to portfolio and tactical flexibility. Indeed, as we have said so many times, so long as many investing voices persistently characterize the current investment environment as one thing or another (Bull, Bear, New Normal or take-off, and, for that matter as High Growth/Low Liquidity), theres little room for the nuance of detail that we think is key to understanding market dynamics. In short, although a year of DM growth acceleration, EM economic stabilization, and continued monetary policy accommodation looks as likely to us as it does to Morgan Stanleys 2014 Global Outlook, the translation into market effects is much more complicated. For our part, our Quantitative forecasts suggest that many of the key consensus trades are heading for considerable difficulty. In our view, this difficulty is the natural consequence of two things: First, the valuation compression of 2013; and second, the intractability of transitioning from an emergency policy environment to a standard mid cycle with MP normalization. Our view is that this is unlikely to be pulled off without policy error, that policy accommodation is and should be as much a part of fundamentals as earnings, so long as deleveraging is in place and deflationary risks remain present. Obviously, the US is to the forefront of such concerns, but in our view, both Japan and the Euro-Zone are equally notable tests as to whether our radical observation of emergency policy as part of the fundamentals fabric holds any water. We have no faith that Abenomics can be truly made to work, or indeed that ultimately the Euro-zone can avoid a type of deflationary trap or Japanification, as MS call it. 2014 will tell us a great deal about the tractability of these deep concerns We of course recognize in our Outlook for 2014 that regime change in US monetary policy, and the re-pricing of expectations about the sustainability of growth in China, the Emerging Markets, Europe, and Japan will remain to the van, as they should. Our cavil is that market views and portfolio positioning on these concerns is misplaced. Indeed our key ideas, in these regards (though note our forecast horizon is 6 months), follow in bullet-point next
We do, of course, also recognize that policy certainty on US interest rate direction could (eventually) drastically change the US growth dynamic unleashing substantial pent up demand for capex and consumer spending. That would eventually boost growth and markets, though on our reckoning that would be a 2015 event at the earliest. In this regard, for us the key is the behavior of US capital spending. After all, what markets want (and CFOs too), and perhaps desperately need, is policy certainty. If they dont get that they will remain stuck in a transitional see -saw type of environment. Euro Growth will be topsy-turvy, but EPS will impress because of the extent of operational leverage, particularly in the Banks Japan equities are due a further tactical bounce, but for H1 as a whole they are going to be a shocker as further stimulus gives way to Third Arrow policy uncertainty and a Sales Tax shock induced growth slowdown. China growth looks fragile to us, and the key is continued liquidity support from the PBOC. That said, in the longer-run, we see better growth stability if the shadow banking system fades and the link between monetary policy and growth sustainability with it; Commodities will be back as China, EM, and global growth stabilizes More EM growth/policy differentiation, but some surprisingly large winnersas the emphasis shifts towards EMs that are growth dependent on DMs rather than the other way round as it has been for so many years In the following pages we look at each of these issues through the prism of our quantitative forecast models. These Models consist of several classes of proprietary methods, as follows: Tactical mean-Reversion: This is the short-run model. It measures the performance trend as it fluctuates around a selected moving average. The essential point is that the model has been constructed so as to create key thresholds (upper and lower limits) relative to the moving average of the underlying performance trend. These thresholds roughly correspond to Overbought and Oversold conditions, and so give investment signals. Risk Forecast Model: The main risk model employs a stochastic technique to forecast the rolling risk trend over a forward 6-month period. Information Ratio Model: This is the long-run performance trend or forward curve model. It employs a special case moving average (called the Information Ratio), which we favour because, statistically, its properties tend to follow the commands of the Central Limit Theorem (it is expressed in standard deviations). In other words, at standard deviation limits, the probability of mean-reversion or change in trend direction is extremely high. Expected Return Model: Mean-reversion processes are path-dependent so we employ an independent check on the possible performance path using an Expected Return engine that generates weekly return forecasts over an 8-12 week horizon. It is based on the rsks/return stochastic properties of the Mean-Reversion Tactical Model.
20
FTSE World vs. Global Govt Bonds Tactical mean reversion drift model
10
normal
% active return
0
-10
normal lower
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superdetren
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In our view, this statistical change in behavior reflects an attempt to transition to a different type of asset pricing environment. In this new regime, tail risk is at much lower levels (see chart overleaf), reflecting lower anxiety about structural problems, but markets are drifting because they are searching for more certainty on trend direction. And that direction is intimately related to Fed Policy, Interest Rates, and Duration.
Just how important tail risk is to this new environment can be seen in the following chart..
48 43 38 33 28 23 trend 18 13 8 3 -2
To 20/12/2002 To 07/03/2003 To 23/05/2003 To 08/08/2003 To 24/10/2003 To 09/01/2004 To 26/03/2004 To 11/06/2004 To 27/08/2004 To 12/11/2004 To 28/01/2005 To 15/04/2005 To 01/07/2005 To 16/09/2005 To 02/12/2005 To 17/02/2006 To 05/05/2006 To 21/07/2006 To 06/10/2006 To 22/12/2006 To 09/03/2007 To 25/05/2007 To 10/08/2007 To 26/10/2007 To 11/01/2008 To 28/03/2008 To 13/06/2008 To 29/08/2008 To 14/11/2008 To 30/01/2009 To 17/04/2009 To 3/07/2009 To 18/09/2009 To 04/12/2009 To 19/02/2010 To 7/05/2010 To 23/07/2010 To 8/10/2010 To 24/12/2010 To 11/3/2011 To 27/05/2011 To 12/08/2011 To 28/10/2011 To 13/01/2012 To 30/03/2012 To 15/06/2012 To 31/08/2012 To16/11/2012 To 1/2/2013 To 19/4/2013 To 5/7/2013 To 20/9/2013 To 6/12/2013 To 31/1/2014 To 18/4/2014
Global Equities vs. Global Govt Bonds tail risk trend and risk forecast
forecast
Tail risk fell from a highly elevated to a cycle low and is stabilising at typical mid-cycle levels
The risk model presented above is a substantial forecasting innovation, and the models horizon is 6 months forward. Moreover, the models signals have been powerful predictors of negative and positive total returns for equities and bonds, and it has not failed to predict one significant turn in trend risk direction in and out of sample since 1978. 2013 was a case in point. Right now the signal from the Risk Model is long-run supportive for risk assets, ultimately implying further gains for equities in particular. However, the signal from the Global Equities vs. Global Sovereigns Risk Model shown above has been a little different from the signal for the pure Global Equities Model, indicating the importance of the co-varying relationship with Bonds. In the pure Global Equities Volatility Model, risk rose for awhile in 2013 and has only been contracting since Bernankes Autumn clarifications. Looking into 2014, the Model nonetheless predicts further amelioration in equity market risk conditions...
10
% active return
0 -5
-10
-15
superdetren
-20
As marked by the ringed circles, each of the last two equity market thrusts have topped out well below the normal mean-reversion threshold. The model suggests, even if equity investors are becoming more bullish (actually Goldman Sachs report that the consensus has been revising down expectations on US Growth from Q3 into Q4), they have been palpably reluctant to seriously chase prices higher. Under-pinning this behavior has been a modest correction in the Cyclical leaders (Industrials, Tech), and a substantial correction in US Mid/Smaller Cap stocks (see overleaf). The synchronicity of many of these positions either at a BUY threshold (actually UK Mid-250 and US Tech began to rally before the Feds taper call), suggests a broad based rally before the next set back. Tactically, the current mean-reversion level for Global Equities constitutes a substantial BUY signal, but the preceding analysis suggests that Risk-On rallies will tend to be smaller in magnitude (c. 4.5% in GBP terms from 13/12/13), but with real strength in Mid and Small Cap.
-8 0 2 4
-6
-4
-2
-16
-14
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-5 0 5
-20
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% active return
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% active return
Russell Mid-Cap vs Russell Large-Cap 52W MA : Tactical mean reversion drift (12W 2nd cycle)
Russell 2000 vs S&P 500 52W MA : mean reversion drift (12W 2nd cycle)
To 20/12/2002 To 14/02/2003 To 11/04/2003 To 06/06/2003 To 01/08/2003 To 26/09/2003 To 21/11/2003 To 16/01/2004 To 12/03/2004 To 07/05/2004 To 02/07/2004 To 27/08/2004 To 22/10/2004 To 17/12/2004 To 11/02/2005 To 08/04/2005 To 03/06/2005 To 29/07/2005 To 23/09/2005 To 18/11/2005 To 13/01/2006 To 10/03/2006 To 05/05/2006 To 30/06/2006 To 25/08/2006 To 20/10/2006 To 15/12/2006 To 09/02/2007 To 06/04/2007 To 01/06/2007 To 27/07/2007 To 21/09/2007 To 16/11/2007 To 11/01/2008 To 07/03/2008 To 02/05/2008 To 27/06/2008 To 22/08/2008 To 17/10/2008 To 12/12/2008 To 06/02/2009 To 03/04/2009 To 29/05/2009 To 24/07/2009 To 18/09/2009 To 13/11/2009 To 8/1/2010 To 5/03/2010 To 30/04/2010 To25/06/2010 To 20/08/2010 To 15/10/2010 To 10/12/2010 To 4/2/2011 To 1/4/2011 To 27/05/2011 To 22/07/2011 To 16/09/2011 To 11/11/2011 To 06/01/2012 To 2/03/2012 To 27/04/2012 To 22/06/2012 To 17/07/2012 To 12/10/2012 To 7/12/2012 To 2/2/2013 To 29/3/2013 To 24/5/2013 To 19/7/2013 To 30/8/2013 To 08/11/2013
To 20/12/2002 To 14/02/2003 To 11/04/2003 To 06/06/2003 To 01/08/2003 To 26/09/2003 To 21/11/2003 To 16/01/2004 To 12/03/2004 To 07/05/2004 To 02/07/2004 To 27/08/2004 To 22/10/2004 To 17/12/2004 To 11/02/2005 To 08/04/2005 To 03/06/2005 To 29/07/2005 To 23/09/2005 To 18/11/2005 To 13/01/2006 To 10/03/2006 To 05/05/2006 To 30/06/2006 To 25/08/2006 To 20/10/2006 To 15/12/2006 To 09/02/2007 To 06/04/2007 To 01/06/2007 To 27/07/2007 To 21/09/2007 To 16/11/2007 To 11/01/2008 To 07/03/2008 To 02/05/2008 To 27/06/2008 To 22/08/2008 To 17/10/2008 To 12/12/2008 To 06/02/2009 To 03/04/2009 To 29/05/2009 To 24/07/2009 To 18/09/2009 To 13/11/2009 To 8/1/2010 To 5/03/2010 To 30/04/2010 To25/06/2010 To 20/08/2010 To 15/10/2010 To 10/12/2010 To 4/2/2011 To 1/4/2011 To 27/05/2011 To 22/07/2011 To 16/09/2011 To 11/11/2011 To 06/01/2012 To 2/03/2012 To 27/04/2012 To 22/06/2012 To 17/07/2012 To 12/10/2012 To 7/12/2012 To 8/2/2013 To 5/4/2013 To 31/5/2013 To 26/7/2013 To 30/8/2013 To 15/11/2013
Normal upper
Normal upper
superdetren
superdetren
forecast
standard deviations
0 To 20/12/2002 To 21/03/2003 To 20/06/2003 To 19/09/2003 To 19/12/2003 To 19/03/2004 To 18/06/2004 To 17/09/2004 To 17/12/2004 To 18/03/2005 To 17/06/2005 To 16/09/2005 To 16/12/2005 To 17/03/2006 To 16/06/2006 To 15/09/2006 To 15/12/2006 To 16/03/2007 To 15/06/2007 To 14/09/2007 To 14/12/2007 To 14/03/2008 To 13/06/2008 To 12/09/2008 To 12/12/2008 To 13/03/2009 To 12/06/2009 To 11/09/2009 To 11/12/2009 To 12/03/2010 To 11/06/2010 To 10/9/2010 To 10/12/2010 To 11/3/2011 To 10/06/2011 To 9/09/2011 To 9/12/2011 To 9/03/2012 To 8/06/2012 To 7/09/2012 To 7/12/2012 To 8/3/2013 To 07/6/2013 To 30/8/2013 To 6/12/2013 To 14/2/2014 To 16/5/2014
-1
-2
IR (52W)
IR (36W) projected
-3
In fact, in our performance trend or forward curve model above (it shows as the information ratio, a special case trend moving average), the red line is the predictive trend path for equities through to early June 2014 (which is generated by a unique proprietary process), and in the predicted trend there are several sell-offs and rallies. This outlook is not quite consistent with some (e.g. Ned Davis or Marc Faber) who are predicting a 16-20% sell-off for the S&P 500. Our best estimate from the model above is -5% in early January, and then some basing before a further sell-off, with equities essentially down until a spring March/April bottom followed by a sharp rally (see last spike in the chart).
10
% active return
normal upper
-5
superdetren
-10
And on the 6 month longer-run outlook (IR Model overleaf) there is further to go before a floor is reached (probably at 3.2-3.3%). Some have argued that longer-dated Treasuries already price tapering. This may be true for the T30s, but we are conscious that the historic average premium between T30s and T10s has been 26bps, and with T30s at a 3.9% yield, that suggests that T10s (which are at 2.9%) are hugely vulnerable to substantial changes in growth and interest rate expectations. But note that the tail of the longer-run forward curve (IR) model above for US T10s is up, and that suggests to us that Tapering once again has discernible economic effects that induce the Fed to backtrack in H1, or at least for markets to price such an outcome From the lows, US T10s could rally back to 3%, and as the IR trend line or forward performance curve in the chart overleaf approaches the zero return boundary horizon (as it does in the red forecast trend from the lows), the likelihood of positive returns from Treasuries for H1 as a whole increases. 11
standard deviations
-1.5 -0.5 0.5 1.5 2.5 -2 0 1 2 3 -1
standard deviations
0 1 2 3
.. For now, US Dividend Aristocrats, which have been strong market out-performers, also look set to take a hit before they too eventually can find a floor ..
-4
-3
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-1
IR (52W)
S&P Hi-Yield Dividend Aristocrats vs. FTSE World USD Information Ratio & Forecast IR
IR (52W)
IR (36W) projected
IR (36W) projected
To 20/12/2002 To 21/03/2003 To 20/06/2003 To 19/09/2003 To 19/12/2003 To 19/03/2004 To 18/06/2004 To 17/09/2004 To 17/12/2004 To 18/03/2005 To 17/06/2005 To 16/09/2005 To 16/12/2005 To 17/03/2006 To 16/06/2006 To 15/09/2006 To 15/12/2006 To 16/03/2007 To 15/06/2007 To 14/09/2007 To 14/12/2007 To 14/03/2008 To 13/06/2008 To 12/09/2008 To 12/12/2008 To 13/03/2009 To 12/06/2009 To 11/09/2009 To 11/12/2009 To 12/03/2010 To 11/06/2010 To 10/9/2010 To 10/12/2010 To 11/3/2011 To 10/06/2011 To 9/09/2011 To 9/12/2011 To 9/03/2012 To 8/06/2012 To 7/09/2012 To 7/12/2012 To 8/3/2013 To 07/6/2013 To 30/8/2013 To 6/12/2013 To 14/2/2014 To 16/5/2014
To 20/12/2002 To 14/02/2003 To 11/04/2003 To 06/06/2003 To 01/08/2003 To 26/09/2003 To 21/11/2003 To 16/01/2004 To 12/03/2004 To 07/05/2004 To 02/07/2004 To 27/08/2004 To 22/10/2004 To 17/12/2004 To 11/02/2005 To 08/04/2005 To 03/06/2005 To 29/07/2005 To 23/09/2005 To 18/11/2005 To 13/01/2006 To 10/03/2006 To 05/05/2006 To 30/06/2006 To 25/08/2006 To 20/10/2006 To 15/12/2006 To 09/02/2007 To 06/04/2007 To 01/06/2007 To 27/07/2007 To 21/09/2007 To 16/11/2007 To 11/01/2008 To 07/03/2008 To 02/05/2008 To 27/06/2008 To 22/08/2008 To 17/10/2008 To 12/12/2008 To 06/02/2009 To 03/04/2009 To 29/05/2009 To 24/07/2009 To 18/09/2009 To 13/11/2009 To 8/1/2010 To 5/03/2010 To 30/04/2010 To25/06/2010 To 20/08/2010 To 15/10/2010 To 10/12/2010 To 4/2/2011 To 1/4/2011 To 27/05/2011 To 22/07/2011 To 16/09/2011 To 11/11/2011 To 06/01/2012 To 2/03/2012 To 27/04/2012 To 22/06/2012 To 17/07/2012 To 12/10/2012 To 7/12/2012 To 1/2/2013 To 29/3/2013 To 24/5/2013 To 19/7/2013 To 30/8/2014 To 30/8/2013 To 3/1/2014 To 7/2/2014 To 4/4/2014 To 30/5/2014
forecast
forecast
The third asset group that indicates that Tapering is Tightening is the forward forecast on US Banks. Banks have been an enormous beneficiary from emergency monetary policy, but the trend forecast (which amounts to a considerable level of under-performance, perhaps in the order of -20%), suggests that short rates do not remain anchored with obvious consequences for net interest margins.
US Banks vs. Global Govt Bonds USD Information Ratio & Forecast IR
standard deviations
forecast
0 To 20/12/2002 To 21/03/2003 To 20/06/2003 To 19/09/2003 To 19/12/2003 To 19/03/2004 To 18/06/2004 To 17/09/2004 To 17/12/2004 To 18/03/2005 To 17/06/2005 To 16/09/2005 To 16/12/2005 To 17/03/2006 To 16/06/2006 To 15/09/2006 To 15/12/2006 To 16/03/2007 To 15/06/2007 To 14/09/2007 To 14/12/2007 To 14/03/2008 To 13/06/2008 To 12/09/2008 To 12/12/2008 To 13/03/2009 To 12/06/2009 To 11/09/2009 To 11/12/2009 To 12/03/2010 To 11/06/2010 To 10/9/2010 To 10/12/2010 To 11/3/2011 To 10/06/2011 To 9/09/2011 To 9/12/2011 To 9/03/2012 To 8/06/2012 To 7/09/2012 To 7/12/2012 To 8/3/2013 To 07/6/2013 To 30/8/2013 To 6/12/2013 To 14/2/2014 To 16/5/2014
-1
-2
IR (52W)
-3
IR (36W) projected
Of course, rises in short rates are hardly consistent with our mini-cycle slowdown thesis, so perhaps all that can be taken away here is significant surprise in US interest-rate expectations going forward.
13
forecast
standard deviations
0 To 20/12/2002 To 21/03/2003 To 20/06/2003 To 19/09/2003 To 19/12/2003 To 19/03/2004 To 18/06/2004 To 17/09/2004 To 17/12/2004 To 18/03/2005 To 17/06/2005 To 16/09/2005 To 16/12/2005 To 17/03/2006 To 16/06/2006 To 15/09/2006 To 15/12/2006 To 16/03/2007 To 15/06/2007 To 14/09/2007 To 14/12/2007 To 14/03/2008 To 13/06/2008 To 12/09/2008 To 12/12/2008 To 13/03/2009 To 12/06/2009 To 11/09/2009 To 11/12/2009 To 12/03/2010 To 11/06/2010 To 10/9/2010 To 10/12/2010 To 11/3/2011 To 10/06/2011 To 9/09/2011 To 9/12/2011 To 9/03/2012 To 8/06/2012 To 7/09/2012 To 7/12/2012 To 8/3/2013 To 07/6/2013 To 6/9/2013 To 6/12/2013 To 14/2/2014 To 16/5/2014
-1
-2
IR (52W)
-3
IR (36W) projected
Global Industrials (see overleaf) also look well set as a relative out-performer, and although this is not a class that is typically duration sensitive, the level of forecast out-performance in the chart overleaf tells us a great deal about the rebound in global manufacturing, which looks set to strengthen into Q1 2014 consistent with Global manufacturing PMIs..
-3 0 1 2 3
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MSCI Industrials vs MSCI Consumer Staples information ratio trend & IR forecast
trend
To 20/12/2002 To 21/03/2003 To 20/06/2003 To 19/09/2003 To 19/12/2003 To 19/03/2004 To 18/06/2004 To 17/09/2004 To 17/12/2004 To 18/03/2005 To 17/06/2005 To 16/09/2005 To 16/12/2005 To 17/03/2006 To 16/06/2006 To 15/09/2006 To 15/12/2006 To 16/03/2007 To 15/06/2007 To 14/09/2007 To 14/12/2007 To 14/03/2008 To 13/06/2008 To 12/09/2008 To 12/12/2008 To 13/03/2009 To 12/06/2009 To 11/09/2009 To 11/12/2009 To 12/03/2010 To 11/06/2010 To 10/9/2010 To 10/12/2010 To 11/3/2011 To 10/06/2011 To 9/09/2011 To 9/12/2011 To 9/03/2012 To 8/06/2012 To 7/09/2012 To 7/12/2012 To 8/3/2013 To 07/6/2013 To 30/8/2013 To 6/12/2013 To 14/2/2014 To 16/5/2014
IR (52W)
forecast
15
1.5
0.5
% standard deviation
0 To 20/12/2002 To 21/03/2003 To 20/06/2003 To 19/09/2003 To 19/12/2003 To 19/03/2004 To 18/06/2004 To 17/09/2004 To 17/12/2004 To 18/03/2005 To 17/06/2005 To 16/09/2005 To 16/12/2005 To 17/03/2006 To 16/06/2006 To 15/09/2006 To 15/12/2006 To 16/03/2007 To 15/06/2007 To 14/09/2007 To 14/12/2007 To 14/03/2008 To 13/06/2008 To 12/09/2008 To 12/12/2008 To 13/03/2009 To 12/06/2009 To 11/09/2009 To 11/12/2009 To 12/03/2010 To 11/06/2010 To 10/9/2010 To 10/12/2010 To 11/3/2011 To 10/06/2011 To 9/09/2011 To 9/12/2011 To 9/03/2012 To 8/06/2012 To 7/09/2012 To 7/12/2012 To 8/3/2013 To 07/6/2013 To 30/8/2013 To 6/12/2013 To 14/2/2014 To 16/5/2014
-0.5
-1
-1.5
-2
-2.5
IR (52W)
IR (36W) projected
This is a curious forecast because it flies in the face of conventional reasoning. As the Fed Tapers, the USD should strengthen, and USD strength should be bad for EMs as it largely has been since the Fed began its Taper-talk.. There are perhaps other ways of explaining the signal, most notably that global growth proves to be stronger than domestic growth (thats exactly what global manufactur ing PMIs are currently saying). Or perhaps it would be more obvious to confine the long-EM equity signal above to curiosity or estimate error . That is our concern too. But in actual fact, not only is the above signal measurably outside the bounds of estimates error, it is supported by the presence of the same signal in our models for Copper, Korea equity, and Gold.
...
% standard deviation 0 1 2 3 4 -4 -3 -2 -1
1.5 2.5 1 2 0.5
% standard deviation
-1.5
-0.5
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To 20/12/2002 To 21/03/2003 To 20/06/2003 To 19/09/2003 To 19/12/2003 To 19/03/2004 To 18/06/2004 To 17/09/2004 To 17/12/2004 To 18/03/2005 To 17/06/2005 To 16/09/2005 To 16/12/2005 To 17/03/2006 To 16/06/2006 To 15/09/2006 To 15/12/2006 To 16/03/2007 To 15/06/2007 To 14/09/2007 To 14/12/2007 To 14/03/2008 To 13/06/2008 To 12/09/2008 To 12/12/2008 To 13/03/2009 To 12/06/2009 To 11/09/2009 To 11/12/2009 To 12/03/2010 To 11/06/2010 To 10/9/2010 To 10/12/2010 To 11/3/2011 To 10/06/2011 To 9/09/2011 To 9/12/2011 To 9/03/2012 To 8/06/2012 To 7/09/2012 To 7/12/2012 To 8/3/2013 To 07/6/2013 To 30/8/2013 To 6/12/2013 To 14/2/2014 To 16/5/2014
To 20/12/2002 To 21/03/2003 To 20/06/2003 To 19/09/2003 To 19/12/2003 To 19/03/2004 To 18/06/2004 To 17/09/2004 To 17/12/2004 To 18/03/2005 To 17/06/2005 To 16/09/2005 To 16/12/2005 To 17/03/2006 To 16/06/2006 To 15/09/2006 To 15/12/2006 To 16/03/2007 To 15/06/2007 To 14/09/2007 To 14/12/2007 To 14/03/2008 To 13/06/2008 To 12/09/2008 To 12/12/2008 To 13/03/2009 To 12/06/2009 To 11/09/2009 To 11/12/2009 To 12/03/2010 To 11/06/2010 To 10/9/2010 To 10/12/2010 To 11/3/2011 To 10/06/2011 To 9/09/2011 To 9/12/2011 To 9/03/2012 To 8/06/2012 To 7/09/2012 To 7/12/2012 To 8/3/2013 To 07/6/2013 To 30/8/2013 To 6/12/2013 To 14/2/2014 To 16/5/2014
IR (36W) projected
17
% standard deviation
Normal upper
0 To 20/12/2002 To 21/03/2003 To 20/06/2003 To 19/09/2003 To 19/12/2003 To 19/03/2004 To 18/06/2004 To 17/09/2004 To 17/12/2004 To 18/03/2005 To 17/06/2005 To 16/09/2005 To 16/12/2005 To 17/03/2006 To 16/06/2006 To 15/09/2006 To 15/12/2006 To 16/03/2007 To 15/06/2007 To 14/09/2007 To 14/12/2007 To 14/03/2008 To 13/06/2008 To 12/09/2008 To 12/12/2008 To 13/03/2009 To 12/06/2009 To 11/09/2009 To 11/12/2009 To 12/03/2010 To 11/06/2010 To 10/9/2010 To 10/12/2010 To 11/3/2011 To 10/06/2011 To 9/09/2011 To 9/12/2011 To 9/03/2012 To 8/06/2012 To 7/09/2012 To 7/12/2012 To 8/3/2013 To 07/6/2013 To 30/8/2013 To 6/12/2013 To 14/2/2014 To 16/5/2014
-1
-2
-3
-4
IR (52W)
IR (36W) projected
Now, of course, Golds behavior is itself more than a little curious (although we have been a recent bear because of rising real interest rate expectations), but one thing we know is that Golds relationship with the USD is a good example of a numeraire effect. Since Gold is largely priced in Dollars and devaluation in the USD is straightforwardly a re-valuation in Gold (or indeed anything else priced in USD, like Copper), then the primary explanation for the positive Gold signal above is a reversal in the US Dollars performance direction. So whats our take on the USD? Wait for it
% standard deviation
0 To 20/12/2002 To 21/03/2003 To 20/06/2003 To 19/09/2003 To 19/12/2003 To 19/03/2004 To 18/06/2004 To 17/09/2004 To 17/12/2004 To 18/03/2005 To 17/06/2005 To 16/09/2005 To 16/12/2005 To 17/03/2006 To 16/06/2006 To 15/09/2006 To 15/12/2006 To 16/03/2007 To 15/06/2007 To 14/09/2007 To 14/12/2007 To 14/03/2008 To 13/06/2008 To 12/09/2008 To 12/12/2008 To 13/03/2009 To 12/06/2009 To 11/09/2009 To 11/12/2009 To 12/03/2010 To 11/06/2010 To 10/9/2010 To 10/12/2010 To 11/3/2011 To 10/06/2011 To 9/09/2011 To 9/12/2011 To 9/03/2012 To 8/06/2012 To 7/09/2012 To 7/12/2012 To 8/3/2013 To 07/6/2013 To 6/9/2013 To 6/12/2013 To 14/2/2014 To 16/5/2014
-1
-2
-3
IR (52W)
IR (36W) projected
All of this will be music to the ears for all gold bugs, since once the current pro-risk rally fades, Gold could be the key play of H1 2014. Our take is a little more nuanced. A great many of these calls are difficult to square with consensus expectations. As a devoted analyst, one could spend a great deal of time trying to resolve these relationships, but surely the correct takeaway is that the Models sign that H1 2014 will usher in a period of heightened and substantial surprise. In this regard, we see current consensus as too complacent (just as it was too pessimistic this time last year), and one further crucial example of this is the message from our Japan equity model.
19
% standard deviation
0 To 20/12/2002 To 21/03/2003 To 20/06/2003 To 19/09/2003 To 19/12/2003 To 19/03/2004 To 18/06/2004 To 17/09/2004 To 17/12/2004 To 18/03/2005 To 17/06/2005 To 16/09/2005 To 16/12/2005 To 17/03/2006 To 16/06/2006 To 15/09/2006 To 15/12/2006 To 16/03/2007 To 15/06/2007 To 14/09/2007 To 14/12/2007 To 14/03/2008 To 13/06/2008 To 12/09/2008 To 12/12/2008 To 13/03/2009 To 12/06/2009 To 11/09/2009 To 11/12/2009 To 12/03/2010 To 11/06/2010 To 10/9/2010 To 10/12/2010 To 11/3/2011 To 10/06/2011 To 9/09/2011 To 9/12/2011 To 9/03/2012 To 8/06/2012 To 7/09/2012 To 7/12/2012 To 8/3/2013 To 07/6/2013 To 30/8/2013 To 6/12/2013 To 14/2/2014 To 16/5/2014
-1
-2
-3
IR (52W)
IR (36W) projected
IN CONCLUSION
Tactical Overview: Equities and risk assets have been drifting in mean-reversion terms since May. This indicates that markets have been in search of reassurance on Fed Policy. The Feds recent Taper move allows for a sharp Global Equity bounce of 4.5% in GBP terms (5.5% in USD). Tactically: There looks to be less mean-reversion scope (a typical mean-reversion bounce from these levels would imply 10% upside), and we think this is consistent with our longer run models that point to further drift through H1 2014... Strategic Overview: Risk reduction is now fully priced, and Global Equities are trying to transition to a new asset pricing environment where equity duration is priced. But, whereas 2013 began with too much pessimism, 2014 will begin with too much Optimism. The balance of risk/reward does not favour reward. Our main forecast is for a period of equity correction. Something much sharper than seen in 2013 (c. 5-8% for US equities in USD terms, -15% for Japanese equities), although this should occur in several phases with the lows occurring in May 2014. This will set equities up for a sharp rally. Strategically: The consensus sees 2014 as an inflection point for US monetary policy and for strengthening growth, at least in the DMs. We see the outlook as much more complicated than this, fraught with substantial scope for policy error (we believe that the Fed has already got it wrong), and our forecast models bear this prospect out. Principally we see Tapering as Tightening which means tapering naturally slows growth. Additionally, we think the US economy is about to head into another 2-quarter mini-cycle period of weakness driven by substantially lower inventories and capex. In other words not only will the economy slow rather than accelerate as the Fed expects (they see 2.8-3.4% growth on the latest fan forecast), the Fed will also find itself tightening into slowing growth. That will drive them to suspend Tapering. Strategic Positioning This is likely to surprise The Consensus and lead to substantial reversals in the most crowded trades (long USD, short Gold, short EMs, short duration). For H1 as a whole we foresee zero TR for Global equities (in USD), ditto High Yield, modest upside for US T10s, and 10-15% upside for Gold (in USD). In H1 we do however see two further important asset pricing effects. First, continued outperformance of duration equities (Industrials, Tech); and, second, increasing differentiation in EM returns. Contact us for more details. John P. Cuthbert BA, MA, MSc, JP Cuthbert Consulting Ltd Independent Financial Economist & Consultant December 19, 2013
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