Positioning for the unstable Fed equilibrium

We still favour overweighting equities while being neutral to mildly underweight fixed income into tapering. We implement the equity leg by being long non-US developed markets, eg, via a basket of long DAX, NKY and FTSE.

Manage fixed income exposure more actively in early 2014. We express our bearish bias in fixed income options, as front end anchoring and little pressure from growth and inflation make risk-reward of directional positions less attractive.

Remain cautious on US equities as they are vulnerable to positive growth and inflation surprises. We express this view via by being long a basket of DAX, NKY and FTSE versus the S&P 500.

Bullish on broader risky assets. We still favour EM equities linked to the manufacturing cycle (we are long Taiwan, Hong Kong and Korean equities) and some high-yielding EM currencies such as the INR. Volatility is historically low and will likely rise as Fed policy normalizes. We are long USD/JPY vol. Rates vol is also low, especially at the front end of the curve, so our 5y6m vs. 15y6m payer position should benefit from higher vol.

Go long euro area energy stocks via options. Implied volatility is historically very low, valuations appear cheap, the prospects for the energy sector look bright and we expect Brent prices to be resilient in 2014 as geopolitics offset ample supply.

There are opportunities within the EM ‘current account five’ (India, Brazil, Turkey, Indonesia and South Africa). High carry and strong policy initiatives make INR longs attractive, in our view.