Developed Countries

No significant change was made except that the weight of France was increased to 7% from 1.7%, largely driven by improvement in relative liquidity conditions. It's mainly financed by a reduction in the U.S. weight which remains the largest overweight in the model.

Are the arguments for overweighting European equities still valid? If so, overweighting relative to what?

Industrials stocks have been coming out of their funk lately, on the back of a selloff in the U.S. dollar, easing in financials stress, a tentative trough in the commodity hemorrhaging, and a relative calm in China and the emerging markets. We upgraded industrials to a benchmark allocation in mid-February as the brutal sell off in deep cyclicals was due for a breather courtesy of continued U.S. dollar weakness. We expect the relative share price ratio to be range bound in the coming months. The latest ISM manufacturing survey showed some glimmers of hope, but it remains below the 50 boom/bust line. The new orders survey sub-component ticked higher, however the mean reversion in industrials profit margins is well underway, and the path of least resistance remains lower (third panel). Bottom Line: While we are not calling for an imminent resurgence in global manufacturing or business investment, an easing in the U.S. dollar has the potential to cause a meaningful re-rating in overly depressed industrials profit expectations and relative valuations (not shown). We reiterate our recent upgrade to neutral.

The recent rebound is not a harbinger of a prolonged recovery in risk assets. The many potential negatives will keep volatility high and trigger further occasional selloffs.

Return on equity (ROE) has clearly peaked for the cycle (top panel). In fact, S&P 500 ROE topped out in 1999 and has shown a pattern of descending cyclical tops since then. Employing the DuPont framework, ROE is declining because of falling asset turnover and decreasing margins, despite rising leverage. In more detail, the structural decline in asset turnover (second panel) reflects deteriorating corporate efficiency - owing to weak productivity growth - since asset turnover measures the amount of revenue generated per dollar of assets. Profit margins have clearly peaked for the cycle (third panel), and downward pressures are intensifying. In a deflationary world rife with excess capacity, pricing power is deteriorating for the majority of U.S. companies, at a time when wages continue to rise, albeit slowly. Importantly, ROE is declining despite rising financial leverage. It made sense for companies to leverage up over the past few years given the low after-tax, real cost of debt. Unfortunately, most of this debt was used for short-term purposes such as stock buybacks and M&A, rather than long-term investment to improve productivity and ROE. Moreover, the capacity of rising debt levels to increase ROE has reached its limit. Bottom Line: All three trends raise the risk profile of U.S. equities. Please see yesterday's Special Report for additional details.

The Treasury market is now discounting too slow a pace of Fed tightening, while junk spreads are discounting too rapid an increase in the default rate. This week we examine the risk/reward proposition of temporarily leaning against some prevailing long-run macro trends.

Inflation expectations in the Developed Markets have been adjusting down to the lower trend of actual inflation, although the bulk of this adjustment now appears complete.

Special Report

In this Special Report for the U.S. "Super Tuesday" primary elections, we offer a short primer on what you really need to know about the nomination process. We explain why Clinton's nearly inevitable victory will still take time, and why a "brokered" Republican convention in July is not enough to stop the Trump juggernaut. This sets the stage for our coverage of what promises to be a wild election with important consequences for American productivity, economic growth, and political risk.

For the month of February, the model underperformed both global and U.S. equities. For March, the model has modestly pared back its equity risk exposure, shifting the allocation into bonds. While Europe remains the largest equity overweight, EM and Canada also received some allocation. The U.S. and New Zealand were slightly downgraded. In the fixed-income space, the model is sticking with Italy and Spain.

Special Report

The risk to ROE remains to the downside, which suggests that valuation multiples have peaked for the cycle. Beyond a potentially violent near-term counter-trend bounce, valuation multiples will remain under pressure.