The writing has been on the wall for a while.
First, in March Ray Dalio [14]who heads the world's biggest hedge fund, said that "though prices of risky assets are high... these things are not in relation to existing levels of interest rates and liquidity. However, should interest rates rise and liquidity levels decline materially, that picture will change. Further, though cash returns are terrible, few investors in risky assets have given much attention to how quickly losses of capital can be worse. For the reasons explained, we do not want to have any concentrated bets especially at this time."
Then, just last week [15], Goldman which has repeatedly refused to boost its S&P year end target from 2100, also warned that if indeed the Fed is hiking, that the party is coming to an end:
"by almost any measure, US equity valuations look expensive. The typical stock in the S&P 500 trades at 18.1x forward earnings, ranking at the 98th percentile of historical valuation since 1976. For the overall index, the aggregate forward P/E multiple equals 17.2x, a rise of 63% since September 2011, compared with the median expansion of 48% during 9 previous P/E expansion cycles. Financial metrics such as EV/EBITDA, EV/Sales, and P/B also suggest that US stocks have stretched valuations. With tightening on the horizon, the P/E expansion phase of the current bull market is behind us."
Today it is SocGen's turn, which overnight advised clients that with "US set to unwind QE", now is the time to "increase cash" and "reduce risk." This is how SocGen advises its clients to be positioned ahead of the end of QE:
Correlations have significantly increased between asset classes and it therefore becomes difficult to naturally protect portfolios through asset class diversification: for the first time in a long time we recommend raising the cash allocation (+4 point to 11%) to better manage portfolio risk. We add a position in cash sterling (+4) on top of the existing US dollar one (7%). In parallel, we reduce our equity and bond allocation by 2 points (to respectively 45% and 36%). To enhance risk diversification, we upgrade our weightings in alternative investments (now 8%), including commodities (up 3 points).
Note that despite Socgen recommending a 45% allocation to equities it is now underweight the asset class.
As to what SocGen believes is the catalyst for the upcoming risk retrenchment, the answer: the new normal "fundamental" of less liquidity.
Market liquidity is expected to fall due to much tighter regulation and the US central bank policy tightening, announced for the second half of the year, which also creates the risk of policy errors as QE unwinding has never been implemented before. Illiquid assets like small cap equities and corporate bonds may suffer more than average in a de-rating process: in the MAP we recommend reducing weightings in both assets.
US Treasuries are facing conflicting forces. If they appear attractive compared with the average bond market valuation (yield spread) of the G9 countries, they will be confronted with monetary policy tightening by 2016. However, given the increased correlation between regional bond markets, diversification benefits have diminished. Overall, we reduce US Treasuries (-2 points to 10%) but, in a context of expected market turbulence, we nevertheless believe they remain one of the few safe havens around, especially when looking at total return in US dollars.
The bolded sentence is key: remember what happens every time QE ends (or S&P downgrades the US)? Equities plunge while Treasurys surge (and yields collapse). Which is why if the selling in the early selling trickle in the S&P seen in the past two weeks accelerates and becomes and all out avalanche, it will mean that the 10Y, currently approaching 2.50% may soon be yet another "generational" bargain.
An infographic summary of SocGen's latest positioning:
And, tying it all together, is SocGen's belief that inflation is finally starting to warm up... Again.
Prepare portfolios for inflation to warm up
Both our US chief economist and our inflation strategist agree that fears of deflation have receded. In the context where oil prices have risen since their trough in January, this leaves room for the return of inflation fears. Accordingly,
1 – We prefer variable rate bonds (like inflation–linked) to traditional fixed rate bonds.
2 - For the first time in many years, we start to re-weight the commodity complex (from 2% to 5%), with a strong preference for base over precious metals.
3 - Inflation triggers valuation compression of financial assets, so we recommend a stronger focus on asset valuation: super expensive US equities should continue to be reallocated into cheaper Chinese equity markets that are opening up to global investors, and into euro area equities to benefit from the cyclical upswing.
Yet what SocGen and others appear to have forgotten is that inflation "warmed up" before. So much so that in the summer of 2011 the ECB hiked rates by the smallest possible amount. The result was yet another near collapse of the Eurozone, and only the Fed's intervention in November 2011 with global liquidity swap lines prevented Europe from disintegrating.
Which is why we firmly believe that the only reason the Fed is engaging in a "rate hike" exercise is to lead to precisely the kind of Risk Off event that SocGen is warnings against, which will cripple the US economy even further (whose Q1 GDP is negative contrary to what Wall Street's weathermen will tell you), and serve as the alibi to engage in QE4.
Because for all the posturing, and all the debate among serious people, the Fed has no way out absent one of two things: paradropping money which launches hyperinflation, or wholesale defaults on global debt, which at last check (by McKinsey) was $200 trillion between government, household and corporate.


