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Easy ride is over – now investor choices become harder

3 June 2018

It’s time to decide between the baby and the bathwater, says Anthony Rayner, manager of Miton’s multi-asset fund range.

During the QE dominant years, it didn’t seem to matter if investments fell into the ‘baby’, or the ‘bathwater’ category. More to the point, the process of ‘throwing out’ was pretty infrequent. Monetary policy was so historically loose that very little ‘creative destruction’ actually happened, in contrast to more typical downturns. As a result, capital was misallocated, zombie companies multiplied and, in many ways, investors had a fairly easy ride.

Have we reached a handbrake turn moment? The yield of the US 10-year Treasury, the so called risk-free asset, has pushed through 3% (having started the year at 2.4%) and so increasingly challenges the relative attractiveness of other asset classes, and at the same time is pushing up the cost of debt. In short, it’s a more demanding environment for many corporates but also for their equity and their debt, and this extends to government debt too.

Markets had seemed to be fairly relaxed about this, possibly because the US Federal Reserve has been pretty consistent in communicating higher rates and so it has not been new news for markets. However, the combination of persistently higher US Treasury yields and a recent strong US dollar (whose previous weakness had confounded many, including us), seems to have awakened markets. Not too surprising perhaps, as both contribute to tighter financial market conditions.

Going forward, we are more confident in higher US Treasury yields being part of our base case (as the Fed’s communication and US economic momentum has been pretty consistent) than a strong US dollar, as it’s much less clear what drives currencies. That said, if strong US economic growth relative to other economies is the dominant dynamic here then maybe it’s reasonable to expect the more recent double act to continue.

In that sense, shouldn’t they act as a natural stabiliser of the US economy? In practice, it’s never as easy as that and we expect more causalities than we have been used to in recent years. In fact, we’ve already seen a number of areas flashing red. The chart below shows how the Argentinean peso and the Turkish lira have weakened materially in recent weeks against the US dollar, and it’s no coincidence that they both have high and deteriorating current account and government budget deficits to finance.

Emerging currencies feeling the heat

Source: Bloomberg, 01/01/2018 – 21/05/2018.

In these situations, for the fragile emerging market, the dynamic can work as a natural stabiliser in reverse. Authorities are often forced to raise rates to respond to changing external pressures, which can cause capital flight, which often leads to compounding already deteriorating domestic growth.

We have no exposure to Turkey or Argentina, nor do we to Russia or the Philippines, which have also showed signs of stress recently. We do have a small exposure to Brazil but have been reducing this in light of extra volatility in Brazilian assets.

We retain a small exposure to Mexico, which has so far proved more resilient, as well as equity exposure in areas like India and China, whose more self-sustaining economies are about as far removed from the emerging markets of Turkey and Argentina, as Germany is from Greece in the ‘developed’ market universe.

It’s not just emerging markets though. European political risk is nothing new and recent price action amongst Italian assets is reflective of an extremely unusual coalition, where there seem to be far too many moving parts, even by the standards of Italian politics. However, it also seems to reflect more demanding investors, indeed, and it feels like the bond vigilantes might be back in town. We have no Eurozone government or corporate bonds, and we have three Italian equities which have so far weathered the storm well, as they are dominated by earnings outside Italy.

To say central banks are aware of the risks of raising rates too quickly is to underestimate their concern around this issue. That said, the narrative is definitely evolving, especially for the Fed. Recent hints that the concept of forward guidance will be phased out at some point, plus the absence of any market-calming words during this year’s market rout, feel like further moves away from QE, as is the rise in volatility and, importantly, a more discerning investor.

Are these developments positive or negative? If financial markets are becoming more discerning, it would look to benefit active investors over passive investors, assuming the active investor is any good. More generally, if markets are entering a period where central banks exit QE then that should also be broadly positive, assuming that markets digest rather than dislocate. In this environment we would continue to expect to see cyclical equity perform best, which remains our bias.

To conclude, risk is now being teased out in different ways. The proverbial ‘risk-free asset’ is now offering more in yield and, potentially, more from currency strength for overseas investors, thereby changing investor attitude to risk across asset classes. At the same time, it’s increasing the cost of financing, which is being compounded for those businesses and governments where revenues are in a depreciating currency and debt is denominated in US dollars. Investors will have to work harder than they have done in recent years, as they decide what to throw out.