As outlined in our April letter, our rationale for over-weighting equities in early April was based on the size of the market drop and the reason for the drop. Historical analysis showed that twelve month returns after declines of 15% or more are generally much stronger than average twelve month returns. This held true even during recessions, unless they were particularly severe, and as we’ve had to remind ourselves several times this year, the economy has been doing fine. The market volatility has been entirely man-made. Although we had doubted that President Trump’s announced tariffs would all stick, we were surprised by how quickly the bond market forced him to relent, and by how quickly the stock market recovered. Within a month the US and global indices were back to their pre-Liberation Day levels (measured in USD). As our clients know, we strive to be long term investors, not active traders, and we are mindful of frictional costs and taxes. So, our time horizon for tactical portfolio shifts is generally around twelve months. However, some changes work out faster than expected, and in this case, much faster. Given that equity valuations are back to expensive levels, earnings expectations are still elevated and policy risk to the economy is still high, we could no longer justify being above our normal equity weights, and so we decided to reduce the allocation back to neutral.

Figure 3: Equity valuations before and after the tariff crash

Source: MSCI, Bloomberg. Showing price to 12-month forward earnings.

When we went over-weight equities in early April, we were concerned that the words and actions of the US government were weighing heavily on the dollar. So, when we bought the global equity index, which contains roughly 70% US stocks, we wanted to use a version that was currency-hedged. But when the rapid market recovery led us to return to a neutral equity stance in May, our currency concerns had not abated. Although the exchange rate depreciation had slowed, the negative noise had increased, and currency forecasts had swung more negative. While we don’t buy into the more extreme predictions of dollar demise, we recognise that further depreciation may be the path of least resistance (up to a point). So, when we reduced our equity allocation back to neutral by selling global equities and buying back bonds, we sold the unhedged equity index, with ~70% in dollars, rather than the hedged index. In this way, we reduced our dollar exposure further. See the next section for details.

Figure 4: LatAm equity vs US equities since mid-2024

Source: MSCI, Bloomberg. Returns are price returns in USD.

While we have been encouraged by the performance of alternatives during the February-April sell-off, we have also noted how traditional assets have struggled to provide diversification from events in the US. Our strategy team has been scouring world markets for areas that are less exposed to tariffs, less driven by US growth, and less expensive than the broad global index. The Latin American index, which consists of ~60% Brazilian and ~28% Mexican stocks, stood out as being cheap, after years of under-performance, and less affected by the trade war, as Brazil has a trade deficit with the US. Weakness in the Brazilian real led to higher rates last year, but the currency has turned around this year and rates are now expected to fall, spurring a recovery in the local stock market. A weaker dollar and lower energy prices are generally positive for the “LatAm” market.

Figure 5: Change in relationship between US bond yields and the dollar