Mag 7 becomes Bag 7 - Changing market conditions

In recent weeks, markets have been very changeable and volatile as investors struggle to adapt to the changing regime. One aspect of this is the new era of economic nationalism. Another is the US’s efforts to simultaneously rebalance the global trading system and its own fiscal deficit, while maintaining the US dollar’s reserve status. At the same time investors are facing the potential of the unravelling of the indexation (AI) bubble.

History has seen many such huge regime shifts, during which massive repricing of asset classes can occur.

We have discussed these themes in prior notes over past weeks, but in summary the US must attempt to impose its new tariff and trade regime whilst preventing its trading partners from weakening their currencies in response. Thus far this appears to be successful.

The demands on Europe and Japan to cover a much greater proportion of the defence costs have led to a material and ongoing increase in their bond yields. This is leading capital to flow out of the US and into Europe and Japan, attracted by the higher yields available. In particular, greater fiscal stimulus is making European equities, in certain sectors, relatively more attractive compared to the US.

At the same time China is injecting material liquidity into its capital markets and is keen to stimulate domestic stock market investment. This is also leading investors in that region to switch out of large cap US stocks into the Chinese and Hong Kong stock markets.

The overall result of this may be that the long-standing bubble in large cap US equities may well have come to a shuddering halt as the marginal investor seeks more attractive options elsewhere. While not an intended consequence of policy this is arguably an inevitable outcome. Investors are already asking at what level is the ‘Trump put’, despite the fact we are barely 10% below the all-time high.

Amusingly, the term BAG7 has already been coined, referring to ongoing holders of MAG7 positions as bag holders, the guys who the smart investors sell to after a bubble.

The change in the overall regime, while challenging, greatly favours our process and in particular income management. As we are highly disciplined in position scaling we have been consistently selling large cap US stocks as they have risen. These gains have been reinvested into international markets particularly Europe and Asia. In addition, our momentum approach has naturally drawn us out of US positions as they have deteriorated and to make a considerable switch into areas of improving momentum. This includes a sizable switch into defensive sectors over the past months, such as healthcare and consumer staples.

On the income side the benefits are considerable. In recent years we have relied on reinvesting gains in the US and growth shares into higher yielding positions. Now many higher yielding areas of the market are also leading markets higher, which greatly favours income strategies.

Overall, this is a market which favours experienced pragmatic truly active managers who are comfortable with making considerable adjustments when necessary. Inflexible managers and those that hug a benchmark will struggle with such a generational regime shift.