Asset Allocation Monthly...2012/09/07 · risky assets should resume their gains, particularly if...

Asset Allocation Monthly SEPTEMBER 2012

GLOBAL EQUITY RESEARCH

This material is provided on a complimentary basis Please see important disclosures and Analyst Certification beginning on page 27

Favour equities as policy hopes rise

After a summer of rhetoric, it seems the long-awaited policy responses from the ECB and perhaps even the Fed are finally materialising. Will this be enough to generate further gains in risk assets?

The insight from our behavioural metrics is that institutions had been positioned very defensively, but we are now starting to see this unwind, with higher-beta assets seeing renewed inflows. Growth concerns meant global stocks underperformed bonds for much of August; Draghi’s “bazooka” reversed that, but our Asset Allocation framework has now shifted back in favour of equities, suggesting risky assets should resume their gains, particularly if policy makers do indeed provide some support. Crowded and overvalued safe havens (Bunds, Pacific equities) would be most at risk in this environment. Overweight European equities rather than the EUR is our favoured risk trade.

Equities. Both emerging markets and European equities still appear underowned and undervalued. Both are seeing inflows, but Europe ex UK is our favoured way of adding beta exposure. Both Pacific ex Japan and the UK look overvalued and overowned, putting them at risk of an unwind.

Fixed Income and FX. Introducing emerging market bonds and currencies to our benchmark (Emerging Asset Allocation Expansion) has allowed us to run risk in our Fixed Income portfolio while avoiding the binary risks of the European periphery. Strong demand for European emerging market bonds prompts us to begin with an overweight in Polish bonds. We also take on PLN currency risk. FX flows are consistent with investors exiting underweights in risky high-yielding currencies like the PLN. We retain the EUR underweight as a modest hedge against the nascent improvement in risk appetite and to reduce the beta of our FX recommendations.

Figure 1: Asset Allocation framework is now pro-equities after being pro-bonds last month

Indicator Favours Change

Inve

stor

be

havi

our

Regime Map Bonds Global Sector Risk Appetite Stocks Emerging Markets Flows Stocks Global Sovereign Bond Flows Neutral Global Dividend Yield Correlation Bonds

Fund

amen

tals

Valuation momentum indicator Stocks Global Earnings Growth Bonds Global Yield Curve Stocks Systemic Risk & Turbulence Stocks Global Breadth Stocks

Model Favours Stocks

Source: State Street Global Markets

Figure 2: Positioning risks are low in key risky assets

0%

25%

50%

75%

100%

Jan-07 Feb-08 Apr-09 May-10 Jul-11 Aug-12

hold

ings

(per

cent

ile)

emerging market FX Europe ex UK equities


Portfolio recommendations

Equities

Overweight: Europe ex UK

Underweight: Pacific ex Japan, UK

Fixed Income

Overweight: JGBs, Poland

Underweight: Bunds

Foreign Exchange

Overweight: PLN

Underweight: EUR Source: State Street Global Markets

SSGM Research teams

Equities (Boston) +1 617 664 8932 [email protected]

Equities (London) +44 (0)20 3395 7340 [email protected]

Macro Strategy (London) +44 (0)20 3395 7309 [email protected]

For additional contact details please see back cover.

https://globalmarkets.statestreet.com/Proxy/PDFRendering?p=VDJM0gEcuLQTFt8HvY7z3jvg_Gal_0Tshe3Wm8k4YEJK-Zklc4fx7p59kJitjsIjFSPTStlLkvwBlqnyrpZlJ3xo6udp56YSRDUnzaKItaTwZuRzPCFD9LkoWgZhNTolQK_eUBz3-b_uAjggJfwTHLS89l1Yng0qZ_ZfcUpJltKpu2J745xpCv9WXrTwj6TiN2xmbqYO9xqr41OZ4JZiAWLiLdBWtskA&e=1347003504223

mailto:[email protected]

ASSET ALLOCATION MONTHLY

2

Key Indicators and Portfolio Recommendations at a Glance

Asset Allocation Model Regime Map Systemic Risk and Turbulence

Improvements in both the behavioural and fundamental side of our Asset Allocation scorecard lead us to upgrade equities this month.

Continued outflows from equities means that our Regime Map stays in Riot Point for a fifteenth month.

Both Systemic Risk and Turbulence have continued to fall and both are now in the bottom third of historical observations.

-6

-4

-2

0

2

4

6

8

10

50

70

90

110

130

150

Aug-05 Jan-07 Jun-08 Nov-09 Apr-11 Sep-12

composite score, rhs global stocks/bonds

published history

Riot Point

Neutral

Safety First

0%

25%

50%

75%

100%

Sep-09 Apr-10 Nov-10 Jun-11 Jan-12 Aug-12

perc

enti

le

SRI TI threshold

Regional Equity recommendations Fixed Income recommendations Foreign Exchange recommendations

We add risk to our portfolio by upgrading Europe ex UK to overweight and downgrading UK equities to underweight. We maintain our Pacific ex Japan underweight.

We replace our OATs underweight with one in Bunds, and we shift overweight positioning from Gilts to Polish government bonds.

We add risk to our FX recommendations with an overweight in the PLN. However, to reduce the beta of our FX portfolio to equities we retain a EUR underweight.

Europe ex UK overweight

US neutral

Japan neutral

Emerging Markets neutral

UK underweight

Pacific ex Japan underweight

Japan overweightPoland overweight Canada neutralSpain neutralUS neutralSouth Africa neutralItaly neutralFrance neutralKorea neutralUK neutralMexico neutralGermany underweight

PLN overweight GBP neutralCHF neutralUSD neutralCAD neutralNOK neutralAUD neutralJPY neutral SEK neutral KRW neutralZAR neutralMXN neutralEUR underweight

Source: State Street Global Markets, Thomson Datastream


3

Overview

POLICY HOPES PROMPT UNWIND OF DEFENSIVE POSITIONS IN FAVOUR OF RISKY ASSETS

A lot has happened over the summer, not only in London’s sporting arenas but also across financial markets. In early summer, risk assets were supported by anticipation of an imminent policy ‘fix’, but with a distinct lack of tangible action by policymakers, which kept investors wary of increasing beta exposure, and the beta trade faltered a little. As we end the summer, there are finally some signs of action; post Jackson Hole the door appears open for further policy stimulus from the Fed and ECB plans for intervening in the bond market have become a reality. These are providing support to institutional risk appetite and, after a relatively weak month for global equities — equities underperformed bonds by 1.4% before the ECB announcements on 6 September that led to a sharp rally — our Asset Allocation framework has shifted from last month’s pro-bonds view to a more positive, pro-stocks stance (Figure 7).

The risks to a more positive view are clear: the European crisis is still far from fully resolved, and global growth is not yet on a clear recovery path. To help navigate these uncertainties, last month we provided a framework for thinking about what factors need to be in place to see a sustainable recovery in risk assets (Figure 3). A month ago, it was already clear that economic sentiment (at least measured by Economic Surprise Indices) was already starting

to bottom out, and both valuations and holdings (Figure 3) were already discounting a lot of bad news. However, the two factors that were conspicuously absent were signs of improvement in investor sentiment or global growth.

The important new development is that we are now seeing an improvement in institutional risk appetite. On one hand, asset allocators are still reluctant to commit new capital to equities, reflected in our Regime Map remaining in Riot Point (Regime Map Update: Bernaghi vs. the Three Bears). But within Equity, FX and Fixed Income portfolios,

institutional flows are starting to find their way back into higher-beta areas of the asset classes. At a regional level in equities, institutions are buying emerging markets and Europe ex UK relative to other regions. At a global sector level, institutions are favouring higher-beta sectors once again (Figure 4) as defensive positions are unwound. Historically, this has been a pre-cursor to equities outperforming bonds significantly. Within FX, institutions are once again favouring carry reflected in the positive correlation between FX flows and yield (Figure 4), and there is appetite for peripheral European sovereign debt as well as emerging market debt in Fixed Income markets.

Figure 3: A number of factors are now in place for a sustained rally in equities, which could prompt a reversal of institutions’ very defensive positioning

Market support

Sustainable market rallies since 2009

Current backdrop

Economic sentiment Improving growth Valuation Investor positioning Investor sentiment

-1.0

-0.5

0.0

0.5

1.0

Jan-00 Feb-03 Apr-06 Jun-09 Aug-12

recessionsbeta correlation with holdings

Source: State Street Global Markets, Thomson Datastream, NBER

Figure 4: Institutions are now buying high-beta sectors and putting on the carry trade within FX

-1.0

-0.5

0.0

0.5

1.0

Jan-09 Sep-09 Jun-10 Mar-11 Dec-11 Aug-12

beta correlation with flows

QE

1

QE

2

LTR

O

EC

B h

ope

-80%

-60%

-40%

-20%

0%

20%

40%

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80%

Jan-12 Feb-12 Apr-12 Jun-12 Aug-12

correlation: FX flows and yield


https://globalmarkets.statestreet.com/Proxy/PDFRendering?p=MWwoJ9Z_CB2ysU7b7qXZOvmmIRwu7-i-UkgwMee_SWWr--_n5Hb7gQTPGXYqWlEQV83Ap3MJOPNYbCtA0q91_lVXfFZnJ_hh-dSmhdN8ndl226CJd7GPlUukvPxhT1c9sz3MzPEnJW6A2v8Du4eSFeYuD6N5-PPuO0Jj8a6ESegwqWHj_zpvsag-yA7yRb9O-z8wS4GlwGM&e=1346763124581



4

NAVIGATING POSITIONING RISKS RATHER THAN SIMPLY ADDING BETA

Despite the hopes on the policy front, as the growth risks remain acute this shift in investor behaviour needs to be kept in context. Investors are by no means running headlong into risky assets. It more likely reflects a repositioning of portfolios, which have clearly become skewed towards high holdings of overvalued defensive assets (Figure 5). These positions are exposed should decisive policy actions mitigate the worst of the growth risks, and investors are therefore responding.

In terms of the economic outlook, although expectations for growth are depressed, there are some signs that we are past the worst in terms of the growth slowdown. There are some tentative signs that August’s PMI readings, at least in Europe, are starting to bottom out (Figure 5), but there is a long way to go before we can safely say that growth is improving, which is why the need for further policy stimulus remains. But if growth can merely stabilise, this could support a continuation of the latest positive trends in investor behaviour. Therefore while our behavioural metrics support taking a higher-beta asset allocation stance, our approach within the underlying asset classes is to do this selectively, and to focus in particular on the positioning risks that have built up.

Equities. We took the first step to getting some exposure to Europe by upgrading the UK to overweight two months ago. However flows have now faded and the relative preference is

now for Europe ex UK, supported further by the low level of holdings of Europe ex UK (Figure 6), whereas the UK looks crowded. Therefore, this month, we upgrade Europe ex UK to overweight and downgrade UK equities to underweight in our regional portfolio. We remain underweight Pacific ex Japan given the region is still crowded and its valuations remain stretched.

Fixed Income. Higher beta within fixed income means European periphery or emerging market debt. We prefer an overweight in the latter. The ECB’s bond buying programme has already prompted a dramatic rally at the front end of the curve. Further gains only seem likely once intervention is enacted, which still requires governments to submit themselves to a bailout programme. Instead we go where the flows are strongest and overweight PLN bonds, where demand is increasing in anticipation of additional rate cuts in Q4.

Foreign Exchange. Emerging markets is the more attractive beta play in FX, too. Developed market risky currencies are typically overvalued and some like the AUD are exposed to the downdraft in Asian growth expectations. Again, the PLN offers the best risk/reward (Figure 6), but we retain our EUR underweight as a way of reducing the equity beta of our FX recommendations.

Figure 5: Holdings of risky assets are low across asset classes and there are some signs that the global slowdown is easing

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US

EQ

s

USD

EU

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s

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EM

FX

hold

ings

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safe havens risky assets

30

35

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Jan-09 Mar-10 May-11 Aug-12

G10 economic surprise indexglobal manufacturing PMI, rhs

QE

I

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II

LTR

O

EC

Bho

pe

Source: State Street Global Markets, Bloomberg

Figure 6: Positioning and valuation risks play a key role in our portfolio selection across asset classes

Emerging Markets

US

Pacific ex Japan

Japan

UK

Europe ex UK

Overvalued Undervalued

Underw

eightO

verweight

MXN

AUD

GBP CAD

EUR

PLN

CHF

ZAR

NOK

USD

JPYKRW SEK0%

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100%

-15% -10% -5% 0% 5% 10% 15%

Hol

ding

s

Valuation



5

ASSET ALLOCATION

Asset Allocation

ASSET ALLOCATION FRAMEWORK MOVES TO FAVOUR STOCKS OVER BONDS

Our Asset Allocation scorecard has moved from a pro-bonds to a pro-stocks stance. This is a result of both an improvement in investor behaviour (albeit only back to a net neutral score) as well as better readings from our risk indicators (Figure 7).

Regime Map. Overall demand for equities among institutional investors remains weak, and this has kept our Regime Map in Riot Point for a fifteenth month (Regime Map Update: Bernaghi vs. the Three Bears).

Global sector flows. But within equities, institutional investors appear to be taking a more optimistic stance. Demand for high-beta sectors has turned positive in the last month (Figure 8). This has been a result of the improvement in flows into Materials and Energy and selling of Utilities and Consumer Staples. Demand for yield remains positive although the strength of the correlation here has faded.

Emerging markets. Echoing this theme, emerging market flows have improved in recent weeks and are now back in positive territory (Figure 9). This factor moves pro-stocks this month.

Sovereign bonds. Institutional investors are still net buyers of sovereign debt but at moderate levels (Figure 10), which keeps this factor neutral. Within the sovereign space, flows into US Treasuries are muted, and the most recent flows show positive demand for Italian and Spanish debt — implicitly a sign of improving sentiment.

Figure 7: Asset Allocation Scorecard

Figure 8: Buying high-yield and high-beta sectors Indicator Favours Change

Inve

stor

be

havi

our

Regime Map Bonds Global Sector Risk Appetite Stocks Emerging Markets Flows Stocks Global Sovereign Bond Flows Neutral Global Dividend Yield Correlation Bonds

Fund

amen

tals

Valuation Momentum Indicator Stocks Global Earnings Growth Bonds Global Yield Curve Stocks Systemic Risk & Turbulence Stocks Global Breadth Stocks

Model Favours Stocks

beta* div. yield*Health Care 0.20 8 8Materials 0.08 1 5Telecoms 0.08 7 1Energy 0.02 2 4Financials 0.00 3 3Industrials -0.05 4 7IT -0.06 6 10Cons. Staples -0.06 10 6Cons. Disc. -0.08 5 9Utilities -0.10 9 2

correlation 39% 13%

relative flows (bp of mkt cap)

-0.2 0.0 0.2

Source: State Street Global Markets Source: State Street Global Markets, Bloomberg *2yr beta using weekly returns;12m trailing dividend yield

Figure 9: Flows have turned positive for emerging market equities

Figure 10: Demand for sovereign debt is positive but

fading

-0.50

-0.25

0.00

0.25

0.50

0.75

Sep-09 Apr-10 Nov-10 Jun-11 Jan-12 Aug-12

flow

s (b

p of

mkt

cap

) favours stocks

favours bonds

0%

25%

50%

75%

100%

Sep-11 Nov-11 Jan-12 Apr-12 Jun-12 Aug-12

mon

thly

flow

s (p

erce

ntile

)

favours stocks

favours bonds

Source: State Street Global Markets Source: State Street Global Markets



6

ASSET ALLOCATION

FUNDAMENTALS SUPPORT EQUITY MARKET OUTPERFORMANCE

The balance of our fundamental indicators firmly supports stocks over bonds with the earnings growth indicator yielding the only pro-bonds signal.

Valuation and momentum favour equities. The relative valuation case for equities over bonds has been strong for some time now, but previously negative momentum in our implied growth measure stopped this factor from turning pro-stocks. In the last three months, however, momentum has turned more favourable as equity markets have re-rated relative to stable real corporate bond yields (Figure 11).

Earnings growth. Our earnings analysis shows that trailing earnings are still declining back to trend and are perilously close to moving to earnings contraction, which has historically been a difficult environment for equities. Moreover global earnings momentum has been weak over the summer months as Q2 earnings season proved disappointing. The most recent observations suggest an easing in the rate of downgrades, but current readings are still consistent with earnings weakness (Figure 12). Nonetheless, these growth risks are offset to some extent by the easy policy settings, evident by the upward sloping yield curve (Figure 14).

Risk backdrop. As we highlight on page 3, our Systemic Risk Index remains at high levels relative to a long history, but it has now fallen to its lowest level in more than 12 months. Couple this with our Turbulence Index moving below the critical 33rd percentile threshold (Figure 13), and this factor moves pro-stocks.

Figure 11: Valuation is supportive, and momentum has turned in favour of stocks

Figure 12: Earnings have moderated and analysts

continue to downgrade their estimates

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85 88 91 94 97 00 03 06 09 12

real corp. bond yieldcyclically adj. earnings yield

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Jan-08 Mar-09 May-10 Jul-11 Sep-12

prop. of upgrades

Earnings deviation from trendglobal earnings momentum (12m lead), rhs

Source: State Street Global Markets, Thomson Datastream Source: State Street Global Markets, Thomson Datastream, I/B/E/S

Figure 13: Risk backdrop has improved

Figure 14: Policy remains accommodative

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Sep-11 Nov-11 Feb-12 Apr-12 Jun-12 Aug-12

perc

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SRI TI threshold

favours bonds

favours stocks

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Apr-06 Aug-07 Nov-08 Feb-10 May-11 Aug-12

global manufacturing PMI Yield curve, rhs

Source: State Street Global Markets Source: State Street Global Markets, Bloomberg, Thomson Datastream

* market cap-weighted average PMI series


7

EQUITIES

Regional Equity strategy

COMBINING FLOWS AND FUNDAMENTALS

Figure 15: Summary of flows and fundamental signals

Active stance (pp) Flows Holdings

Regime Map

Asset Allocation

Stocks/Bonds Behavioural Earnings

momentum Valuation Price

momentum Fundamental Real rates

Economic growth Thematic

Europe ex UK 2 US 0 Japan 0 Emerging Markets 0 UK -1 Pacific ex Japan -1

Source: State Street Global Markets, I/B/E/S, MSCI, Consensus Economics

Flows: relative flows, month average

Holdings: Institutional holdings. Low holdings are positive, high holdings are negative.

Risk Appetite: expected probability of outperformance following current Regime Map reading

Asset Allocation Stocks/Bonds: favour high-beta regions if stock/bond models prefers stocks

Earnings Momentum: relative proportion of earnings upgrades over the past month

Valuation: relative cyclically adjusted P/E relative to its 10-year average

Price momentum: six-month relative price change

Real interest rate: policy rate – GDP deflator

Economic growth: 3m change in Purchasing Managers Index

Figure 16: Active regional stances

-2 0 2

Europe ex UK

US

Japan

Emerging Markets

UK

Pacific ex Japan

active stances (pp)

currentprevious


Navigating the scorecard:

We compare the regions in terms of three broad areas: behavioural factors, fundamental factors and key macro and micro themes. These are summarized in our scorecard.

The cornerstone of any investment process is based on fundamentals, particularly valuations. However it has been well established that prices will deviate from fair value for extended periods and we therefore use our investor behaviour indicators, together with price and earnings changes, to help determine that speed at which assets are likely to revert to fair value. This forms the underlying structure of our regional allocation framework.

The second step of our approach is to think about the pertinent macro and micro themes that are likely to influence relative regional returns. We incorporate our views on these themes directly into our scorecard.


8

EQUITIES

POLICY VERSUS GROWTH REMAINS THE FOCUS

The opposing forces of growth risks and policy stimulus remain critical for regional equity allocation. Mr Draghi’s announcement in July “to do whatever it takes” certainly buoyed European equity markets over the summer (Figure 17). Policy rhetoric and action in emerging markets and Japan have been less aggressive, and these markets have lagged (Figure 17).

Looking for growth momentum and policy support. Global growth is increasingly hard to find (Figure 18); all six regional PMIs are in contractionary territory. Arguably, with expectations already so low, what matters more is where growth momentum turns most positive. There are some signs in Europe and Pacific ex Japan that PMIs may be bottoming out (Figure 19). Growth concerns also have to be set against the prospect that a decisive policy response would mitigate some of the growth risks. The probability of additional easing from the Fed looks to have increased following Jackson Hole, while the ECB looks to be well advanced in planning bond purchases to remove contagion risks even if they are not prepared to undertake full-scale QE.

Upgrade Europe ex UK, downgrade UK. Europe ex UK has exceedingly low valuations and is underowned. Institutions have been buying, and given signs of growth stabilisation and policy support, we move to overweight. Demand for UK equities has fallen sharply in the last month, and our holdings metric points to elevated positions. We therefore downgrade the UK to underweight from overweight. Considering how expensive and crowded the US trade is, we would expect US equities to be only a limited beneficiary of a policy-induced rally and so maintain our neutral recommendation. Although PMIs have climbed in Pacific ex Japan, analysts are less convinced that the growth outlook is positive and are downgrading earnings estimates (Figure 19). Valuation and positioning risks also keep us underweight.

Figure 17: European equities outperformed on the back of policy hopes …

Figure 18: … even as global growth continues to

moderate -8% -6% -4% -2% 0% 2% 4% 6%

Europe ex UK

US

Pacific ex Japan

UK

Emerging Markets

Japan

July - Aug rel rtn

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Apr-06 Aug-07 Nov-08 Feb-10 May-11 Aug-12

prop. Of upgrades

global manufacturing PMI*global earnings momentum (12m lead), rhs

Source: State Street Global Markets, Thomson Datastream Source: State Street Global Markets, Thomson Datastream, I/B/E/S. * market cap-

weighted average

Figure 19: European PMIs have started to stabilise, and analysts are upgrading earnings estimates

Figure 20: Pro-stocks Asset Allocation signal suggests a

preference for higher-beta regions

UK

Pacific ex Japan Europe ex

UK

Emerging Markets

Japan US

-4

-2

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MI (

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relative proportion of upgrades

40% 45% 50% 55% 60% 65%

Japan

Europe ex UK

Emerging markets

Pacific ex Japan

UK

US

prob. of outperformance when AA favours equities

Source: State Street Global Markets, Bloomberg, Thomson Datastream, I/B/E/S Source: State Street Global Markets


9

EQUITIES

INTRODUCING THE EQUITY HOLDINGS INDICATOR (EHI) FOR REGIONAL EQUITIES

We introduced the Equity Holdings Indicator in our H2 Equity Market Outlook in August. In that piece, we identified both crowded and unloved industry groups. We are also able to carry out similar analysis at the country and regional level (Figure 21). Regions in the top-right quadrant of Figure 21 are unloved: they are undervalued, and institutional investors are underweight. In the subsequent three months, these regions have tended to outperform, but performance improves significantly when flows are positive (Figure 22). Similarly, we find that when areas become crowded (bottom-left quadrant of Figure 21), performance tends to be much weaker. Once again, using flows to time the exit from these trades significantly improves the performance of a short strategy (Figure 22).

Including holdings in our approach to regional equity selection. We explicitly include our Equity Holdings Indicator in our Regional Equity scorecard (Figure 15). Regions with holdings above the 50th percentile are deemed to be overweight and score negatively, while those with holdings below the 50th percentile score positively.

European equities are looking attractive. Europe ex UK is a textbook example of an unloved region that is now seeing interest. It sits in the top-right area of our holdings and valuation scatter (Figure 21), and flows are positive. The sovereign debt crisis has clearly taken its toll on European equity markets, but despite recent outperformance, relative multiples are close to their mid-1990s lows (Figure 23). Institutional investors have been underweight European equities for much of the last three years (Figure 24). Flows are positive, and we upgrade Europe ex UK to overweight.

Figure 21: Flows, holdings and valuation for regions

Figure 22: When positioning and valuation become skewed, flows are critical

Emerging Markets

US

Pacific ex Japan

Japan

UK

Europe ex UK

Overvalued Undervalued

Underw

eightO

verweight

40%

45%

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60%

-8%

-4%

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over

wei

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+ ov

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unde

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ght

+ un

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d

+ bu

ying

prop. time outperform

s (3m

)

avg.

3m

rel

. rtn

. ann

3m rel. rtn (ann.) prop. Of time outperforms (3m), rhs

Source: State Street Global Markets + / - denote whether the industry has seen inflows or outflows in the past month.

Source: State Street Global Markets, Thomson Datastream Regional average local currency relative returns using holdings, cyc. adj. P/E rel to mkt rel to 10yr avg and flows from March 1998-July 2010

Figure 23: European equities appear undervalued

Figure 24: Institutional investors are underweight European equities

0.6

0.8

1.0

1.2

1.4

1.6

69 78 86 94 02 10

cycl

ical

ly a

dj. P

E re

l.

cyclically adj. PE rel. 10yr avg.

75

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85

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95

100

105

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115

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100%

Mar-98 Feb-01 Jan-04 Nov-06 Oct-09 Aug-12

index

hold

ings

(per

cent

ile)

holdings price rel (local curr.), rhs

Source: State Street Global Markets, Thomson Datastream Source: State Street Global Markets, Thomson Datastream

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10

EQUITIES

EUROPE EX UK: UPGRADE TO OVERWEIGHT

Low holdings and attractive valuations. The last three months has seen a rally in Europe ex UK equities, with the region outperforming by 7% since the trough. This outperformance has done little to erode the relative valuation case for European equities. Relative multiples are depressed compared to their historical average (Figure 23), indicating that bad news is already well priced in for European equities. Flows are modestly positive (Figure 25), and as we show in Figure 24, institutional investors remain underweight and so have scope to buy.

Improved risk appetite bodes well for European equities. Historically when our Asset Allocation framework has pointed to a pro-stock recommendation, Europe has outperformed (Figure 26), and arguably European equities are now the highest-beta play to a decisive policy action that underpins a recovery in risk appetite.

Signs of growth? As well as recent equity market outperformance, there have also been some early signs that economic growth in Europe may be bottoming out. Over the last three months, some countries within the region have seen PMIs come off their lows (although they remain in contractionary territory (Figure 27). Although the ECB seems to be talking about sterilising its bond buying, real money supply has already expanded over the past year and historically has been a good indicator for future industrial production (Figure 28). This provides some support to the idea that the worst of the slowdown in Europe may be behind us, even if the outlook remains one of depressed activity as the debt overhang is worked off.

Figure 25: Flows have slowed but remain modestly positive into European equities

Figure 26: Pro-stock reading from Asset Allocation

framework has historically favoured Europe

-0.2

-0.1

0.0

0.1

0.2

0.3

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Jan-12 Feb-12 Mar-12 May-12 Jun-12 Jul-12 Sep-12

flow

s (b

p of

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cap

)

Europe ex UK

40%

45%

50%

55%

60%

Stocks Bonds Neutral

prob

abili

ty o

f out

perf

orm

ance

Asset Allocation recommendation

Europe ex UK

Source: State Street Global Markets Source: State Street Global Markets, Thomson Datastream

Figure 27: Early signs that PMIs are bottoming out in Europe

Figure 28: Money supply has begun to increase in

Europe

40

45

50

55

60N

orw

ay

Sw

itzer

land

Fran

ce

Sw

eden

Ger

man

y

Spa

in

Ital

y

Man

ufac

turin

g (P

MI)

May August

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

Oct-96 Dec-99 Mar-03 Apr-06 Jun-09 Aug-12

Real M1 growth (yoy)industrial production (yoy, 9m lag)

Source: Bloomberg Source: State Street Global Markets, Thomson Datastream


11

EQUITIES

UK: DOWNGRADE TO UNDERWEIGHT

Holdings and valuation risk. As we highlight on page 9, holdings and valuations are stretched for UK equities (Figure 21). Indeed holdings of UK equities are close to a five-year high (Figure 29), making them vulnerable to a period of underperformance. However, crowded trades can become more crowded, and it often pays to wait for flows to turn negative, and this has happened in the last month (Figure 30). The move in our Asset Allocation framework also provides a headwind for the lower-beta markets such as the UK (Figure 20). We therefore downgrade to underweight.

Analysts have also changed their tune. From a fundamental perspective, after a brief period rising above trend, earnings have now fallen back below trend again (Figure 31), and earnings momentum is also negative. Given the UK trades on an elevated valuation multiple, this also poses a threat to future performance.

Monetary policy remains supportive. On the policy front, the BOE continues to engage in quantitative easing, and our PriceStats measure of inflation in the UK continues to show disinflation (Figure 32), which suggests little pressure on policy makers to change course. However, this indicator is rapidly reflecting the poor state of the demand side of the UK economy. As inflation fast approaches the 2% target level, there is a distinct possibility of an overshoot on the downside.

Figure 29: Holdings of UK equities are close to five-year highs …

Figure 30: … and flows have turned negative

75

80

85

90

95

100

105

110

115

0%

25%

50%

75%

100%

Mar-98 Feb-01 Jan-04 Nov-06 Oct-09 Aug-12

indexho

ldin

gs (p

erce

ntile

)


-0.2

-0.1

0.0

0.1

0.2

0.3

0.4


flow

s (b

p of

mkt

cap

)

Source: State Street Global Markets, Thomson Datastream Source: State Street Global Markets

Figure 31: UK earnings have fallen back below trend again

Figure 32: Inflation pressures continue to fall

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

Jan-09 Oct-09 Jul-10 Mar-11 Dec-11 Sep-12

UK earnings deviation from trend

0

1

2

3

4

5

6

Oct-08 Jul-09 Apr-10 Feb-11 Nov-11 Aug-12

PriceStats United Kingdom Yoy (%)

Official United Kingdom Yoy (%)

Source: State Street Global Markets, Thomson Datastream, I/B/E/S Source: State Street Global Markets, Bloomberg


12

EQUITIES

PACIFIC EX JAPAN: UNDERWEIGHT

Although flows are positive for Pacific ex Japan, we remain concerned that the region is very crowded and valuation is extremely stretched versus history. Our holdings metric shows that Pacific ex Japan is the second-most-crowded region after the UK (Figure 21) and based on a cyclically adjusted PE, it is the most richly valued of the six regions (Figure 33).

Financials outside of Europe and the US are crowded. The Pacific ex Japan stock market is dominated by Financials, accounting for nearly 50% of market cap. Whilst investors have been trying to avoid some of the European and US Financials, which arguably have been at the centre of the global financial crisis, Financials in Asia have become increasingly crowded, which is a risk for the region (Figure 34).

Lower-beta market. Given our Asset Allocation framework has now moved pro-stocks, the beta of each market is important. Pacific ex Japan typically underperforms when our framework is pro-stocks and is therefore likely to be less geared into a recovery in risk appetite versus other regions (Figure 20).

Growth outlook mixed. Growth in Pacific ex Japan has remained robust throughout much of the recent financial crisis. Although the economy has slowed recently and earnings momentum is negative again, the PMI in Australia did improve over the past month. However, this good news is already well-priced into the equity market, and inflation pressures, as measured by our PriceStats measure for Australia, have started to tick up (Figure 36), which could be an issue for further policy stimulus and overall growth.

We remain underweight Pacific ex Japan in our recommended portfolio.

Figure 33: Pacific ex Japan still trades at a premium to its decade average

Figure 34: Financials outside of Europe and the US are

crowded*

-30% -20% -10% 0% 10% 20%

Pacific ex Japan

US

UK

emerging markets

Europe ex UK

Japan

cyclically adj. PE rel. rel.

ROW Banks

ROW Div. Fin.

ROW InsuranceROW Real

Estate

0%

20%

40%

60%

80%

100%

overweight and selling underweight and selling

underweight and buying overweight and buying

Source: State Street Global Markets, Thomson Datastream Source: State Street Global Markets

* Global Financials ex Europe and the US

Figure 35: Measures of economic growth are holding up in Australia …

Figure 36: … and our PriceStats measure of inflation

has just started to rise again

0

1

2

3

4

5

6

30

35

40

45

50

55

60

Mar-06 Jul-07 Oct-08 Feb-10 May-11 Aug-12

Australia PMI Australia GDP YoY%, rhs

0.00.51.01.52.02.53.03.54.04.55.0

Jan-09 Oct-09 Jun-10 Mar-11 Dec-11 Aug-12

PriceStats Australia Yoy (%)

Official Australia Yoy (%)

Source: State Street Global Markets, Thomson Datastream Source: State Street Global Markets, Bloomberg


13

EQUITIES

US: NEUTRAL

US assets have become crowded safe havens in recent years as foreign investors have built up large positions in US equities (Figure 37), Treasuries and the USD (Figure 73). We downgraded US equities to neutral in early July following the longest overweight recommendation we have ever held. Since July, US equities have outperformed, but at a much slower rate than in the previous three-year period (Figure 37).

Jackson Hole. Bernanke’s apparent endorsement of further QE at Jackson Hole and his comments that he “stands ready to take action” gave hopes to the doves that further easing will arrive in mid-September. However, the prospect of further stimulus in the US may not support the relative call for US equities. Current valuations in the US are looking stretched, and although holdings are lower than at the start of previous QE cycles, institutional investors are still overweight (Figure 38). Fed QE would more likely be a greater stimulant of higher-beta equities with low ownership, such as Europe ex UK, especially as the ECB also taken action.

But inflation is picking up. Our daily PriceStats inflation metrics suggest that some upward price pressure is creeping in (Figure 39). If this persists, it may stay Bernanke’s hand in September in light of their explicit inflation target.

Asset Allocation favours riskier equities. Historically when our Asset Allocation framework has had a pro-bond stance, US equities have performed poorly (Figure 20 and Figure 40). We maintain our neutral recommendation for US equities.

Figure 37: Holdings are high, and US price momentum is slowing

Figure 38: Market backdrop now is different than

during previous QE announcements

90

95

100

105

110

115

0%

25%

50%

75%

100%

Jan-04 Sep-05 Jun-07 Mar-09 Dec-10 Aug-12

indexho

ldin

gs (p

erce

ntile

)


0%

25%

50%

75%

100%

-15%

-10%

-5%

0%

5%

10%

15%

QEI QEII QEIII?

holdings (percentile)

prem

ium

to d

ecad

e av

erag

e

cyclically adj. PE rel rel holdings, rhs

Source: State Street Global Markets, Thomson Datastream Source: State Street Global Markets, Thomson Datastream

Figure 39: Inflation may stay Bernanke’s hand yet

Figure 40: Pro-stocks Asset Allocation framework does not support US equities

-3

-2

-1

0

1

2

3

4

5

6

Jun-09 Jan-10 Sep-10 May-11 Jan-12 Aug-12

PriceStats United States Yoy (%)

Official United States Yoy (%)

40%

45%

50%

55%

60%

Stocks Bonds Neutral

prob

abili

ty o

f out

perf

orm

ance

Asset Allocation recommendation Source: State Street Global Markets, Bloomberg Source: State Street Global Markets


14

EQUITIES

EMERGING MARKETS: NEUTRAL

Holdings supportive and valuation headwinds have faded. Institutional investors are buying emerging markets once again, led by buying of Asia and emerging Europe (Figure 41), and the move to pro-stocks in our Asset Allocation framework would support emerging market outperformance (Figure 20). Our Equity Holdings Indicator shows that institutional investors are underweight emerging markets (Figure 21), and after underperforming by 11% in the last two years, the region trades on a relative cyclically adjusted PE just below its decade average (Figure 42).

But policy is not working yet. Policy makers in emerging markets should be having an easy time of it. Most still have plenty of scope to cut nominal, and therefore real, rates. Unlike the developed economies, there is no need for extraordinary measures just yet. However, it looks as if all the action so far is having little effect. Brazil has cut rates by 5pp since August last year, to 7.5% the lowest-ever rate, and yet posted growth of just 0.4% qoq to the end of June. China has cut reserve requirements and deposit rates, but still economic activity has slowed. Freight volumes are falling almost as quickly as in 2008 (Figure 43), and the official and HSBC PMIs in August were below the critical 50 level. Within the PMI numbers, it was also worrying that while new export orders stabilised, total new orders slowed (Figure 43), indicating that the Chinese domestic slowdown is worsening.

Earnings momentum. Analysts appear to have taken these economic indicators on board and have released a swathe of downgrades over the past month (Figure 44). Positive behavioural support offsets the weak macro backdrop, and we therefore maintain our neutral recommendation.

Figure 41: Asia and emerging Europe lead emerging market flows higher

Figure 42: Relative valuation is just below decade

average

-0.4

-0.3

-0.2

-0.1

0.0

0.1

0.2

0.3

0.4


flow

s (b

p of

mkt

cap

)

EM Asia Latam EMEA

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

Sep-95 Feb-99 Jul-02 Nov-05 Apr-09 Aug-12

cycl

ical

ly a

dj. P

E re

l.

cyclically adj. PE rel. 10yr avg.

Source: State Street Global Markets Source: State Street Global Markets, Thomson Datastream

Figure 43: Chinese economic slowdown continues

Figure 44: Analysts are revising down the earnings forecasts for emerging markets

-30%

-15%

0%

15%

30%

25

35

45

55

65

75

Jan-06 May-07 Sep-08 Jan-10 May-11 Aug-12

PMI - new ordersPMI - new export ordersChinese freight volume (yoy %), rhs

-10%

-5%

0%

5%

10%

15%


rela

tive

pro

port

ion

of u

pgra

des

Source: State Street Global Markets, Bloomberg Source: State Street Global Markets, Thomson Datastream, I/B/E/S


15

EQUITIES

JAPAN: NEUTRAL

Japan is in the most attractive quadrant based upon our holdings and valuation metrics (Figure 21). Holdings are below the 50th percentile, and the market continues to trade on a discount versus its own valuation history. Flows are positive, but they have faded significantly over the past couple of months (Figure 45); therefore we retain our neutral stance.

The growth backdrop has deteriorated for Japan, which may have prompted institutions to reduce their buying of the region. The Japan PMI fell again in August (Figure 46), in contrast to modest improvements in some of the other regions.

The strength of the yen has been an issue … The strength of the yen since its March low may be a contributory factor to this weakening growth backdrop. As Figure 47 shows, the yen has risen by nearly 7% since March, exports are down more than 8% over the past year, and earnings momentum is now negative.

… but JPY strength could start to abate. Institutional buying of the yen has now faded (Figure 48). If this feeds through to some weakness in the JPY, this would clearly be a welcome relief for the export side of the Japanese market.

Given the balance between relatively low holdings of Japanese equities and valuation coupled with on-going growth risks, we retain our neutral stance.

Figure 45: Flows have faded for Japan

Figure 46: The Japanese PMI has continued to deteriorate

-0.2

-0.1

0.0

0.1

0.2

0.3

0.4


flow

s (b

p of

mkt

cap

)

46

47

48

49

50

51

52

Dec-11 Feb-12 Apr-12 May-12 Jul-12 Aug-1

Man

ufac

turin

g P

MI

Japan

Source: State Street Global Markets Source: Bloomberg

Figure 47: JPY strength reflected in weakening exports and earnings expectations …

Figure 48: … but institutional buying of the JPY has

now faded

-10.0-8.0-6.0-4.0-2.00.02.04.06.08.0

JPY appreciationsince March low

YoY change inexports

1m rel. earningsmomentum

0%

25%

50%

75%

100%

Aug-11 Nov-11 Jan-12 Apr-12 Jun-12 Aug-12

20-day JPY percentiles

Source: State Street Global Markets, Bloomberg Source: State Street Global Markets


16

FIXED INCOME

Fixed Income strategy



Flows

Asset Allocation Behavioural

PriceStats Inflation rate and momentum

Yield Growth Relative Fiscal Risks Fundamental Real rates


Japan Poland Canada Spain US South Africa Italy France Korea UK Mexico Germany


Flows: Flows into country sovereign debt markets over the past month scaled relative to history Asset Allocation Stocks/Bonds: Beta of country sovereign returns compared to asset allocation signal Inflation trend: PriceStats YoY inflation level to indicate outright inflationary pressures and change in quarterly rate to indicate inflationary momentum

Yield growth relative: Deviation of 10y yields from level implied by relationship with nominal GDP forecasts Fiscal risks: Combined rank of four variables; change in sovereign CDS, projected deficit and debt levels in coming five years and the projected interest rate on government debt minus growth over the same period Oil trade balance: 2007-2010 average crude oil trade balance (% of GDP) Economic growth: Level of Purchasing Managers Index

Figure 50: Fixed Income Active Stances Japan overweightPoland overweight Canada neutralSpain neutralUS neutralSouth Africa neutralItaly neutralFrance neutralKorea neutralUK neutralMexico neutralGermany underweight



We compare country sovereign debt markets across behavioural factors, fundamental factors and key macro themes and summarize these in our scorecard. In the behavioural section we rank how sovereign bond returns typically respond to our top down asset allocation decision, as well as analysing our duration weighted total sovereign bond flow indicator.

We have a straightforward fundamental approach that measures whether yields are appropriate given changes in growth and inflation expectations. Further, we use our real-time PriceStats Inflation series to gauge whether the likely trend in inflation will be favourable for bonds. Finally we gauge medium-term fiscal risks by ranking the coming year’s gross funding requirement from foreign investors as a percentage of expected government receipts. The final step in our approach is to consider the pertinent macro and micro themes running across asset markets. We incorporate the expected tilt of these factors with reference to what it will mean for fixed income returns.


17

FIXED INCOME

PREPARING FOR POLICY RESPONSE

The pro-stocks shift in our Asset Allocation framework — partly reflecting investor unwind of more defensive positioning — suggests that we scale back last month’s tilt towards safe havens. The shift in behaviour may well reflect anticipation of policy response, perhaps most evident in the eurozone. Together with prospects for more Fed action and recent data gains, we shift our underweight exposure from OATs to Bunds and replace our overweight in Gilts with one in Polish government bonds. The latter move reflects the extension of our Fixed Income portfolio recommendations to select emerging markets (Emerging Asset Allocation Expansion).

Discounting Draghi. As noted last month, the term structure of peripheral spreads has steepened since late July. After reflecting imminent Eurozone blow-up, spreads now reflect heavy ECB intervention on the short end (Figure 51). Investor appetite for peripheral bonds has also turned on a dime, as Draghi’s support tempts yield-hungry investors (Figure 52).

Safety is riskier. Given extended positioning in many safe havens, renewed central bank action may reverse notions of safety and risk in sovereign bond markets. With our Asset Allocation framework now tilting towards stocks (Figure 53), the spring collapse in yields may be set for unwind. Meanwhile, Germany’s contingent liabilities are growing, pointing to a deteriorating credit profile. Incorporating worst-case scenario losses on loans to the periphery via the ESM and Target 2 into its debt profile offers a frightening picture (Figure 54). The ECB’s (and hence Germany’s) forthcoming jump in exposure to Spain points in the same direction; we recommend underweight Bund exposure this month.

Figure 51: Front-end priced for ECB buying

Figure 52: Investors warming to peripheral debt

-150

-100

-50

0

50

100

150

200

250

Jan-10 Jul-10 Jan-11 Aug-11 Feb-12 Aug-12

Spread to German bunds: 10yr minus 2yr

Spain Italy

0%

25%

50%

75%

100%

Jan-10 Jul-10 Jan-11 Aug-11 Feb-12 Aug-12

Peripheral Europe - SBFI 20-day percentiles

Source: State Street Global Markets, Bloomberg Source: State Street Global Markets

Figure 53: Asset Allocation negative for safe havens

Figure 54: Germany’s implied liabilities are growing

-10

-5

0

5

10

0

1

2

3

4

5

6

2003 2006 2009 2012

Composite model score (rhs)German 10-year yield (%)

60%

70%

80%

90%

100%

110%

120%

Debt-to-GDPratio, general

gov't

With Germany'sESM contribution

With ESM andGermany's

Target2 claims

German government debt, including loans to periphery

Source: State Street Global Markets, Bloomberg Source: State Street Global Markets, Bundesbank, German Finance Ministry

https://globalmarkets.statestreet.com/Proxy/PDFRendering?p=VDJM0gEcuLQTFt8HvY7z3jvg_Gal_0Tshe3Wm8k4YEJK-Zklc4fx7p59kJitjsIjFSPTStlLkvwBlqnyrpZlJ3xo6udp56YSRDUnzaKItaTwZuRzPCFD9LkoWgZhNTolQK_eUBz3-b_uAjggJfwTHLS89l1Yng0qZ_ZfcUpJltKpu2J745xpCv9WXrTwj6TiN2xmbqYO9xqr41OZ4JZiAWLiLdBWtskA&e=1347003504223


18

FIXED INCOME

GROWTH FEARS EASING

Worst may be over. Despite Europe’s on-going slump, the global economic slowdown may have passed its most dangerous phase. Economic Surprise Indices are improving, both in developed and emerging markets (Figure 55). While partly reflecting depressed expectations, this also reflects a better tone to economic data, especially in the US.

A similar message recently became evident across our global measures of online consumer prices. While still volatile, our global inflation diffusion index picked up sharply in July and August, reaching its highest point since January (Figure 56). While partly reflecting higher oil prices, this suggests that global consumer demand conditions may be improving, despite the global slowing on the production side. Signs of consumer resilience are perhaps most clearly evident in the US, where the most interest-rate-sensitive sectors (housing and autos) are showing a sustained pick-up in spending (Figure 57).

Credit barometer in neutral zone. While this year’s US economic data have been highly volatile from quarter to quarter, our US Credit Turbulence Index has been relatively stable, hovering within a stone’s throw of its median level throughout 2012 (Figure 58). Given fears over the fiscal cliff and the impact of overseas weakness on US growth, this may represent somewhat of a victory. Credit markets also appear more settled than last year, in the wake of the US debt ceiling drama. While not as benign as some other asset classes, the moderate reading from credit markets helps assuage the worst fears for the US economy.

Figure 55: Economic Surprise Indices improving

Figure 56: Inflation rebound flags bottoming demand

-120

-80

-40

0

40

80

Jan-09 Sep-09 Jun-10 Feb-11 Nov-11 Jul-12

Major economies Emerging markets

-0.2%

0.0%

0.2%

0.4%

0.6%

0

20

40

60

80

100

Sep-09 Sep-10 Sep-11 Sep-12

Inflation Diffusion IndexPriceStats Global Inflation MoM (rhs)

Source: State Street Global Markets, Citigroup Source: State Street Global Markets

Figure 57: US consumers buying durables again

Figure 58: Credit markets back from the brink

0

20

40

60

80

7

14

21

Jan-05 Jul-06 Jan-08 Jul-09 Jan-11 Jul-12

US vehicle sales (annual rate, mn)US homebuilders index (rhs)

0%

20%

40%

60%

80%

100%

Aug-00 Aug-03 Aug-06 Aug-09 Aug-12

US recessionsUS Credit Turbulence 30d percentiles

Source: State Street Global Markets, Bloomberg Source: State Street Global Markets, NBER


19

FIXED INCOME

EM EUROPE IN FOCUS

Investors still like EM bonds. While falling short of the surging inflows seen from 2009-2011, longer-term investors have continued to raise their exposures to EM sovereign bonds in recent months. Over the past 20 days, our global EM bond flow aggregate rests in the 70th percentile of its five-year history, despite the broader nervousness infecting global markets (Figure 59). At the same time, that aggregate preference to EM bonds masks some differentiation among regions, with flows into Eastern Europe in the top decile and those to Latin America — where inflation has been more of a concern — in the 44th percentile. Europe’s broader weakness in activity and price pressures — as evident in the slowing in our Eurozone PriceStats online inflation aggregate (Figure 60) — only reinforces prospects for lower rates and yields across the continent.

Polish slowdown to drag yields lower. The eurozone’s economic slump has been tough on its eastern neighbours, as their export growth slows to its weakest since 2009 (Figure 61). As the Polish economy decelerates, scope for monetary policy easing will grow, as suggested by the NBP earlier this week. Polish real interest rates are still relatively high given the economy’s softening, pointing to the potential for policy rates to move lower (Figure 62). Given persistent investor appetite for the region’s debt, we recommend overweight exposure to Polish government bonds this month, implying net long exposure to EM bonds in aggregate.

Figure 59: Investors buying east European bonds

Figure 60: Weakness in Eurozone set to persist

0%

25%

50%

75%

100% SBFI 20-day percentiles

EM Asia EM EuropeEM Latin America EM Aggregate

0%

1%

2%

3%

4%

5%

40

45

50

55

60

Mar-10 Sep-10 Mar-11 Sep-11 Feb-12 Aug-12

Eurozone services PMIEurozone agg. PriceStats inflation, 3M ann rate (rhs)

Source: State Street Global Markets Source: State Street Global Markets, Bloomberg

Figure 61: Exports fading (3m year-on-year %)

Figure 62: Polish rates set to fall

-30

-20

-10

0

10

20

30

40

Mar-03 Jan-05 Dec-06 Oct-08 Sep-10 Jul-12

Hungary Czech Poland

-15

0

15

30

-1.0

0.0

1.0

2.0

Mar-08 Jan-09 Nov-09 Oct-10 Aug-11 Jun-12

Poland real interest rates %Industrial output yoy % 3mma (rhs)

Source: Bloomberg Source: State Street Global Markets, Bloomberg


20

FOREIGN EXCHANGE

Developed Foreign Exchange strategy



Flows Holdings

Asset Allocation Behavioural Yield

Value (REER Deviation)

Price Momentum Fundamental Real rates


PLN GBP CHF USD CAD NOK AUD JPY SEK KRW ZAR MXN EUR


F Flows: FX flows, month average percentile versus past five years Holdings: FX holdings percentile versus past five years Asset Allocation Stocks/Bonds: Favour high beta/ carry currencies if stock/bond models prefers stocks Carry/Current account: Relative 3-month interest rates/Relative 4q average c/a balance as % of nominal GDP. Determined by Asset Allocation regime: carry (when favours stocks), current account (when favours bonds) or discretionary (when neutral)

Value: Rank of current REER versus long-run average adjusted for movements in terms-of-trade Price momentum: Ratio between the (dollar-based) 10-day and 20-day moving averages. US dollar momentum is calculated based on the DXY index. Oil trade balance: 2007-2010 average crude oil trade balance (% of GDP) Economic growth: Level of Purchasing Managers Index

Figure 64: Foreign Exchange Active Stances PLN overweight GBP neutralCHF neutralUSD neutralCAD neutralNOK neutralAUD neutralJPY neutral SEK neutral KRW neutralZAR neutralMXN neutralEUR underweight



We compare the regions in terms of three broad areas: behavioural factors, fundamental/price factors that are specific to each asset class and then key macro themes that permeate across asset classes. These are summarized in our scorecard. Over the long-run FX is dominated by switching between four principle styles: carry or current account, valuation and trend. These return streams typically work independently of one and another. The stage in the economic cycle and in particular investor appetite for risk will help gauge which style is likely to be effective in the short-run. To this end we use our gauges of investor flows and holdings in FX and broader risk metrics to make a judgment on which factor is likely to be most influential on FX markets at any given time. When our overall Asset Allocation Model is pro-equities, for instance, we focus on the rank of carry; when it is pro-bond, we focus on current account positions. The second step of our approach is to consider overarching macro themes across asset markets.


21

FOREIGN EXCHANGE

CARRY FX

Our timing to add emerging market currencies to the FX overlay this month has proved prescient. A pro-stocks reading from our Asset Allocation framework is just one of four factors that have created a favourable environment for EM currencies — the combination of FX flows and holdings, valuation and volatility are all favourable, too. The main difficultly this month is the decision on which currency to fund in.

Risk appetite. The shift in our asset allocation framework toward stocks is typically associated with superior hit rates for emerging market or high-yielding currencies (Figure 65). If the next moves from developed market policy makers is aggressive quantitative easing, possibly as early as September, we can only assume that EM currencies will benefit in a similar way to past policy easing. Both QE1 and QE2 produced significant appreciation of EM currencies (Figure 66).

Going with the FX flow. FX flows in particular are increasingly consistent with this interpretation. The correlation rank of FX flows with yield is currently in excess of 50%. In stark contrast, FX flows are negatively correlated with current account positions (Figure 67). The implications are that FX investors are chasing yield and shunning “safe currencies” with current account surpluses. This is a surprisingly strong signal, which may in part reflect the unwind of sizeable underweight positions in EM currencies (Figure 68).

Figure 65: Asset allocation tilt and EM FX hit rates

Figure 66: EM FX returns and US QE

25% 50% 75%

KRW

MXN

PLN

ZAR

USD

Pro-stock

Pro-Bond

95

100

105

110

115

-60 -50 -40 -30 -20 -10 0 10 20 30 40 50 60

QE1Jackson Hole 2010Jackson Hole 2012

Source: State Street Global Markets, Bloomberg Source: State Street Global Markets, Bloomberg

Figure 67: FX flow correlation with yield and current account positions

Figure 68: EM FX position unwind under way

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

Aug-11 Oct-11 Jan-12 Mar-12 Jun-12 Aug-12

Yield Current AC

0%

25%

50%

75%

100%

Jan-10 Aug-10 Feb-11 Aug-11 Feb-12 Aug-12

EM FX holdings indicator (BIS weights)

EM FX flows percentile

Source: State Street Global Markets Source: State Street Global Markets


22

FOREIGN EXCHANGE

Value. The favourable turn in risk appetite is only one of the catalysts for the return of carry. EM currencies in particular fall into the category of being undervalued (relative to terms of trade) as well as underowned (Figure 69). The same cannot be said of risky currencies in developed markets such as the AUD or the CAD. The valuation of the Australian dollar in particular looks vulnerable for two reasons. First, the sharp reduction in iron ore prices will continue the recent reversal in terms of trade. Second, Asian growth forecasts continue to revise downwards as Chinese growth stutters (Figure 70). This trend of weaker growth in Asia also means we shy away from a long in the KRW even though it is the most undervalued and underowned of our EM FX currencies (Figure 69).

Volatility. Even though event risk remains elevated, August 2012 could not have been more different from the point of view of volatility. While last August saw extremes, this summer has seen a collapse in delivered volatility. While unusual correlations have boosted our FX Turbulence Index somewhat it is still only in the second quartile which is favourable to carry. Specifically in emerging markets EURPLN has the most favourable carry-to-volatility ratio (Figure 72). Given it also looks to be one of the most underowned and undervalued EM currencies, this prompts us to pick the PLN as our overweight to express stronger risk appetite.

Figure 69: FX holdings and valuation

Figure 70: Change in growth expectations year to date

MXN

AUD

GBP CAD

EUR

PLN

CHF

ZAR

NOK

USD

JPYKRW SEK0%

25%

50%

75%

100%

-15% -10% -5% 0% 5% 10% 15%

Hol

ding

s

Valuation

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

INR

AU

D

JPY

CN

Y

KR

W

USD

BR

L

CAD

GB

P

PLN

EU

R

MXN

NO

K

Cha

nge

in y

ear a

head

gro

wth

pr

ojec

tion

s


Figure 71: Terms-of-trade changes (YTD) for beta currencies

Figure 72: Carry-to-volatility ratios of selected

currencies

-6.0%

-5.0%

-4.0%

-3.0%

-2.0%

-1.0%

0.0%

1.0%

2.0%

AUD ZAR MXN PLN CAD KRW

Cha

nge

in T

oT (%

ytd

)

0.2

0.4

0.6

0.8

1.0


BRL MXN EURPLN ZAR



23

FOREIGN EXCHANGE

FUNDING CONUNDRUM

Picking a funding currency for our risk-on trade is harder. It is complicated by positioning, risk sensitivity, and forthcoming central bank action.

Holding on. The reduction in European tail risk implied by the potential for further ECB action has encouraged long-term investors to reduce their underweight in the Euro. This is now complete. USD holdings are being reduced rapidly but still show an overweight. Investors already hold a modest JPY underweight (Figure 73).

Policy response. Policy is the second complication. Another round of QE is an obvious risk to the US dollar. But our analysis shows the EUR’s response to ECB easing has been equally negative for the euro (Figure 74).

Beta bets. Our three potential funding currencies also have a very different relationship with equities. EUR has a positive beta. Over the past year, a 1% rise in the S&P has been associated with a 0.4% appreciation in the euro, a similar depreciation in the US dollar and no change in the JPY (Figure 75).

Euro hedge. Taking these three factors into account, we lean toward retaining our underweight in the EUR. While we have seen a significant turn in our asset allocation framework, some uncertainties remain, in particular the aggregate level of cross-border flows. To that end, we chose to balance our risky PLN overweight with a more defensive EUR underweight. This is the lowest-beta way to overweight the PLN (Figure 76).

Figure 73: FX holdings, EUR, USD and JPY

Figure 74: FX response to policy easing

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

Aug-04 Aug-06 Aug-08 Aug-10 Aug-12

EUR USD JPY

98

100

102

-60 0 60

FX p

erfo

rman

ce

(day

of p

olci

y ea

se =

10

0

Days before and after policy announcement

EUR USD


Figure 75: FX beta to S&P

Figure 76: PLN betas with different funding currencies

-50%

-25%

0%

25%

50%

Jun-01 Sep-03 Dec-05 Mar-08 May-10 Aug-12

52

-wee

k ro

lling

bet

a

USD EUR JPY

-50%

-25%

0%

25%

50%

75%

100%

Jun-01 Sep-03 Dec-05 Mar-08 May-10 Aug-12

52

-wee

k ro

lling

bet

a

PLNUSD PLNEUR PLNJPY



24

Flows at a glance

Figure 77: Equity Flows at-a-glance Figure 78: Fixed Income and Foreign Exchange Flows at a glance

MSCI AC World

United StatesEurope ex UK

United KingdomJapan

Emerging MarketsPacific ex Japan

Latin AmericaEmerging Asia

Emerging Europe

GermanyFrance

ItalySwitzerland

AustraliaChinaBrazilIndiaKorea

TaiwanNegative Neutral Positive

United StatesUnited Kingdom

GermanyJapan*CanadaFranceSpainItaly

USDEURJPYCHFGBPSEKNOKAUDCAD

Negative Neutral Positive

Soveriegn bond flows (duration weighted)

Foreign Exchange flows

Figure 79: Regional Equity Flows Figure 80: Fixed Income Flows Figure 81: FX Flows

-0.3 -0.2 -0.1 0.0 0.1 0.2 0.3

Pacific ex Japan

Emerging Markets

Japan

Europe ex UK

United States

United Kingdom

AC World (abs)

flows (bp of mkt cap)

1 month1 week6 months

0% 25% 50% 75% 100%

Germany

Spain

Canada

France

Japan*

US

UK

Italy

SBFI (percentile)

1 month1 week6 months

0% 25% 50% 75% 100%

GBPEURCADAUDCHFNOKJPY

USDSEK

FXFI & FXHI (percentile)

1 month1 weekholdings

Source: State Street Global Markets *Japan applied cross-border SBFI


25

HOW WE ARRIVE AT OUR VIEWS

Asset Allocation framework

Our Asset Allocation framework was initially launched in August 2008. We analyse trends in investor behaviour alongside a set of fundamental factors to determine the outlook for global equities relative to bonds.

We assess trends in investor behaviour based on country flows, industry flows, sovereign bond flows and our Regime Map. The full list is shown in Figure 82.

In addition to these investor behaviour factors we also consider five fundamental factors that are likely to influence the relative returns of stocks and bonds. These cover valuation, macro and price-based factors.

Figure 82: Asset Allocation factors (sample) Indicator Favours

Inve

stor

be

havi

our

Regime Map Bonds

Global Sector Risk Appetite Bonds

Emerging Markets Flows Stocks

Global Sovereign Bond Flows Neutral

Global Dividend Yield Correlation Bonds

Fund

amen

tals

Valuation momentum indicator Bonds

Global Earnings Growth Stocks

Global Yield Curve Stocks

Systemic Risk & Turbulence Indices Stocks

Global Breadth Bonds

Model Favours Neutral


Each one of these factors has predictive qualities about the decision to allocate between bonds and equities. We combine them based on equal weights to produce a simple composite indicator (Figure 83). Positive readings have tended to be associated with the outperformance of stocks relative to bonds. Furthermore, the signal tends to be persistent with an average duration of three months.

For complete details on the Asset Allocation framework and its applications please see Asset Allocation Framework from

8 September 2011.

Figure 83: Composite Asset Allocation indicator

-6

-4

-2

0

2

4

6

8

10

50

70

90

110

130

150

Aug-05 Dec-06 Apr-08 Aug-09 Dec-10 Mar-12

composite score, rhs global stocks/bonds


Regional equity, fixed income and FX allocation

The approach we take to portfolio construction within the three broad asset classes (equities, fixed income and foreign exchange) consists of constructing a scorecard in which we combine behavioural indicators, fundamentals metrics and a thematic score.

Our behavioural factor combines short-term flow measures and longer-term positioning metrics as well as the score from the signal from the Asset Allocation framework to dial up or down the risk exposure of the recommended portfolio.

Next, we calculate a composite score for fundamentals based on relative measures that are relevant to each asset class.

Finally we incorporate a thematic score which takes account of the current dominant global themes such as economic momentum, policy or inflation risks. These are summarized in our scorecard (Figure 84).

Our view is that fundamentals, particularly valuations, are the cornerstone of our investment process. However we acknowledge that prices will deviate from fair value for extended periods. We use our investor behaviour indicators, together with other macro and micro indicators, to help determine the speed at which assets are likely to revert to fair value.

Figure 84: Regional Equity scorecard (sample) Active

weight bp Combined

signal Behavioural Fundamental Thematic

US 5 +

UK 2 +

Europe ex UK

0 =

Emerging Markets

-2 -

Pacific ex Japan -2 -

Japan -3 - Source: State Street Global Markets


26

FLOWS ADD TO FUNDAMENTAL ANALYSIS

State Street: Leaders in flow analysis

State Street serves as an administrator of around $22tr of assets globally, which represent 15% of the world’s tradable securities including a 20% market share in global stock lending.

We process this information to generate aggregated indicators of what investors are buying and selling – the Equity Flow Indicator (EFI).

The EFI and the relationship between flows and returns

Flows are persistent. Flow persistence is the key feature in establishing a relationship between flows and returns. If institutional investors are buying this month then there is a greater than even chance they will be buying next month. One illustration of this is that the correlation between this month’s and next month’s flows is as high as 63% (Figure 85).

Large institutional investors have market impact. Another feature of flows is that there is a positive contemporaneous correlation between flows and returns (Figure 85). We would expect this if investors have market impact, if they tend to push prices higher when they buy.

Flows and returns. These two features of flows, persistence and market impact, provide an explanation of why there might be a positive relationship between flows and future returns. If institutional investors buy this month there is a good chance they will buy next month, and if they buy next month there is a good chance that prices will rise. The correlation between current flows and future returns is generally positive (Figure 85).

What is a flow?

Flows indicate the value of net buying by large institutional investors (the value of buys minus the value of sells), expressed in terms of basis points of market capitalization. We use the term “flows” in this document to refer to relative flows; that is, flows relative to the market average.

But surely for every buyer there is a seller?

We have a perspective on the behaviour of institutional investors and how they act as a homogenous group. Other investors (Hedge Funds, Retail Investors, Corporates, Brokers) are the counterparties to their actions.

Are flows backward looking?

We find that there is persistence to institutional behaviour. Therefore their recent actions are likely to continue and we capture this on a timely basis.

But institutions do not always drive price?

True. Corporate actions, hedge fund and retail activity as well as institutions can have price impact on any given day. However our measures of institutional behaviour tend to capture the longer term strategic trends in price.

With the growth in hedge funds, are your indicators less relevant?

We use both fundamental data and information on hedge fund activity to provide context to and conviction about the trends we are seeing in institutional behaviour.

Figure 85: The interaction between flows and returns

0.490.60

0.77 0.77 0.71

0.47

0.63

0.0

0.2

0.4

0.6

0.8

1.0

UK US Japan Europeex UK

EM Pacificex Ja

Average

Correlation between this month's and next month’s relative Flows

0.220.15

0.29

0.13

0.40

0.150.22

0.0

0.2

0.4

0.6

0.8

1.0


EM Pacificex Ja

Average

Correlation between this month's relative Flows and returns

0.080.20

0.300.16

0.08 0.12-0.07

-0.2

0.0

0.2

0.4

0.6

0.8

1.0


EM Pacificex

Japan

Avg

Correlation between this month's relative Flows and next month’s relative

returns

Source: State Street Global Markets NB: Sample monthly data from 1995-2007


27

Legal disclaimer

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Each of the research analysts primarily responsible for the content of this Report, in whole or in part, certifies that (1) all the views expressed accurately reflect his or her personal views about the industry sectors that are covered in this Report and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by that research analyst in this Report.

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© State Street Corporation, 2012

Publication date: 7 September 2012

Research: Equities Macro Strategy Saul Henry, CFA +1 617 664 8932 [email protected]

Christopher Mellor, CFA +44 (0)20 3395 7610 [email protected]

Georgina Taylor +44 (0)20 3395 7340 [email protected]

Marija Veitmane, CFA +44 (0)20 3395 7366 [email protected]

Michael Metcalfe +44 (0)20 3395 7309 [email protected]

Robert Blake +1 617 664 6683 [email protected]

Benjamin Jones, CFA +44 (0)20 3395 7630 [email protected]

Jonathan Morton +1 617 664 8843 [email protected]

Simon P Whitten +1 617 664 7789 [email protected]

Ryan Marks +1 617-664-3101 [email protected]

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