where to hide during the market rout

If you've owned (almost) anything other US equities this year, you've lost money. Whether it's Canada, Europe, emerging markets or any kind of bonds, it's now all in the red, and some deeply in it. So if the US economy and its equity market is only bastion left standing, what will happen when it falls?

Higher interest rates and tighter liquidity are starting to bite. So cyclical sectors of the US economy, like automotive, real estate and industrials, are starting to feel the pain. And higher oil prices and trade tariffs are not helping. Thus we could be seeing the first early indicators of an economic turnaround towards recession. But in any case, the laws of gravity have to prevail. This economic recovery is aging. The Trump tax cuts have extended a lifeline to it, but all good things come to an end, including the US economic and equity market boom.

Perhaps what's keeping US equities standing is that things around the world are not encouraging. China is slowing down and and dragging down other emerging markets, while Europe is confronting its eternal existential threats, currently in the form of Brexit, Italy's deficits and rising populism around the continent. So in the absence of attractive alternatives, US investors are happy to pay 150 times earnings for Amazon, or 50 times earnings for the likes of Google or Microsoft. But we all know this is not sustainable: if the US market is grossly over-valued versus anything else in the world, something has to give: will the US drop down to earth? Or will Europe and emerging markets recover to narrow the valuation gap? or will it be a combination of both as it often happens?

It could also be something similar to what's happening this week: US equities drop big, while remaining global markets drop less. The gap can be adjusted like that as well. And while everybody loses under this scenario, US equity investors lose more.

Regardless of which one of the above four scenarios will prevail, one can draw an obvious conclusion, namely that under-weighting US equities and over-weighting other countries is the way to go. If Europe is bocoming attractively valued, and you like the higher dividend rates and believe that the Union will eventually survive, then European equities might be a better place than the US for the time being. Alternatively, if you believe that emerging markets will recover, which obviously depends in large measure on what will China do to counter the slump, then you can start building or adding to your emerging markets allocation. But no matter what you do, do not forget Canada. Now that a USMCA deal has been tentatively agreed, much of the uncertainty has been removed and Canadian equities present a couple of advantages. First, Canadian banks are reasonably valued and are well positioned to benefit from higher interest rates by boosting their net interest income. Second, energy stocks, another major pillar of the S&P/TSX, are also reasonably valued and will obvioulsy benefit from higher oil prices. In summary, there are reasons to believe that Canadian equities have some wind in their tails and should out-perform the US in the short term.

Against all this background, one major question remains unanswered. If US equities take a big hit, what will happen to US bonds? Isn't that the safe haven that everybody goes to in difficult time? Over the past week or so, we've seen a temporary break down of the inverse relationship between stocks and bonds, as both have gone down. But we stress on the word temporary. Typically, when investors, partticularly institutional investors, dump equities, they have to invest somewhere and they have to maintain some portfolio allocation rules. So some of the money will go to bonds. Having said that, the prospects for bonds look, at least in the short-term, pretty grim. There are more interest rate raises coming our way znd therefore investors are in a bond-dumping mood on both sides of the North American border.

What has happened in the past, during similar stages of the cycle (and there is no guarantee that history will repeat itself, but still), is that investors sell bonds on fears of higher rates and buy stocks instead. This could explain, or justify, one final round of equity appreciation. Then, when the market is ready to start buying bonds, equity prices will start falling beyond a 5% or 10% correction, and bonds will start appreciating. So, despite temporary periods of simultaneous depreciation in both asset classes, the inverse relationship, in our opinion, should prevail.

Having said that, some money managers have serious fears that, this time around, US Treasury bonds may not be a safe haven, and could instead prove to be a dangerous asset class. This is a topic that we will take up in detail in next week's update. Stay tuned.

October 10, 2018

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