Multi-Asset Investments Views: From extreme caution to upside chasing

On 17 April, with the Iranian regime having confirmed US President Donald Trump’s claim that negotiations were indeed ongoing in a bid to put an end to the Middle East conflict, we increased our equity exposure to its maximum overweight. 

Relatively cautious investor positioning and depressed market sentiment indicated that, even without any real improvement on the ground, the mere absence of further geopolitical deterioration would potentially help risk assets to rise. 

The gap between weak positioning and strong fundamentals was best found between emerging market and US equities; the latter bolstered by persistent positive macroeconomic surprises and corporate profit growth. 

Surfing the artificial intelligence wave, companies linked to semiconductors and technology performed remarkably over the past couple of months, both in absolute and relative terms, and worldwide - from the US to Asia and also in Europe-based parts of the value chain.

Considering its sectoral composition, this phase of the bull market has not just been down to hopes of a resolution to the Iran War or to a valuation re-rating. Instead, it has been fuelled by fundamentals, and particularly by the best US earnings season in five years: reported sales increased by 11% over a year and earnings by 26% on average, with both metrics surprising to the upside of a decidedly upbeat analyst consensus.¹ 

These positive surprises went beyond the so-called ‘Magnificent Seven’ large technology stocks: 87% of reporting companies in the S&P 500 index, representing nearly all sectors in the US economy, managed to beat expectations of their respective earnings growth.² Logically, this has been leading to the strongest upside revisions to earnings forecasts in five years. It hardly gets better than that on the micro-fundamental front.

Shifting investor sentiment

Still, we are mindful of the weak positioning and sentiment mentioned above - evident two months ago – that have now been replaced by overwhelmingly consensual bullishness and a race chasing the upside. This is reflected in several ways. 

First, with implied and realised volatility collapsing, systematic strategies have quickly ramped up their equity exposure. Second, retail investors (especially in the US) have also added to their equity holdings, and we have just witnessed one of the strongest monthly inflows ever into equity funds.

Third, discretionary investors have also moved away from their March cautiousness, mainly adding exposure to large-cap tech firms. Finally, and as illustrated in the chart below, overall optional exposure on the US tech-heavy Nasdaq index has moved from extreme downside hedging (with investors buying protection as they mainly worried about downside risks) to aggressively chasing the potential upside in equity prices. 

However, positioning is not yet extreme or even stretched. While past performance does not indicate future returns, historical precedents have shown that such an equity exposure could rise further, especially for some of these heterogenous investors. In our view from here, the absence of bad news, or of a positive shock, is no longer sufficient to see incremental purchases; we now need incremental good news.

‘Greedy’ signals

Similarly, market sentiment indicators have moved from oversold or extremely depressed levels at the end of March, to overbought conditions – a scenario often characterised as ‘greed’. These indicators are often based, at least in part, on the distance between the current level of a given equity index and its medium-term average (e.g. its moving average over 50 working days). 

Basically, they quantitatively illustrate the speed and magnitude of the recent rally. Our back-tests confirm the empirical intuition that, at least as investors, we live in a sometimes greedy world. While extreme fear is a good-enough sign of capitulation and therefore a valuable contrarian buy signal, so-called greed can last for far longer. And again, most sentiment indicators are still only flashing greed warnings, but not extreme ones.

Taken altogether and guided by our quantitative investment signals moving from bullish to neutral, we chose to progressively reduce our equity overweight and are now down to roughly a third of our maximum risk exposure. 

Our fundamental conviction remains positive, and, within equities, we still see the outperforming trend of semiconductors and memory chips remaining firmly in place. The technical setup, however, does not look so favourable just now and some consolidation is credible in the next few months.

Bond moves

Our increased caution also stems from the significant moves in the fixed income space. Shocked by the significant oil price surge, inflation expectations and interest rates have been moving sharply higher resulting in multi-decade record-high yields in Japan and the UK. 

There are worries the potential exacerbation of the cost-of-living crisis could be met with renewed fiscal support, which in turn would require higher borrowing and likely higher government bond yields. 

Adding to this, positive economic surprises which have lifted US interest rates into a danger zone whereby any further interest rate rises, normally associated with stronger nominal growth, would instead weigh on risk assets and particularly on equities. In short, we have therefore moved back into the zone where good news for the US economy is potentially bad news for the stock market. 

In energy-importing Europe, signs of demand destruction and of economic weakness should however keep a cap on interest rates. As market pricing is already incorporating a significant monetary tightening by the European Central Bank, which we doubt will be required, we added to our five-year German government bonds position as our favoured expression of our near-term interest rate view.

Finally, we found an investment opportunity in the (limited) US-China alignment. Indeed, the structural rebalancing of the Chinese economy is consistent with the desire from the current US administration to see the US dollar depreciate and the US current account deficit shrink. 

We therefore expect the Chinese currency to appreciate over the medium term. This appreciation should be reinforced against the dollar if oil prices normalise further and if the current risk-on episode extends (as the dollar is back to exhibiting its historical behaviour of risk-off, safe-haven currency). 

China’s currency appreciation should later also manifest against the euro, and although the latter should at least equally benefit from oil prices normalising, it should also eventually lag on negative economic surprises and on some de-pricing of the ECB’s potential monetary tightening.