Staying investment cautious
18 December 2018
Steve Bates, chief investment officer, GuardCap Asset Management, says a degree of caution is warranted in investment markets at the moment.
It is over eleven years since the start of the Great Financial Crisis (GFC) and during this time the use of quantitative easing has smoothed out many of the fluctuations that investors would normally see. Investors have become inured to the new normal of interest rates being lower than justified by cyclical or fiscal considerations, debt being desirable (because it’s cheap) and growth and inflation being a bit subdued. It’s been going on for so long that investors accept a historically unprecedented set of circumstances as quite usual.
Excessive liquidity can have two effects: the first is that asset prices become inflated; the second that economic activity picks up and inflation rises.
Despite recent falls, we can all agree that the first has happened – bond markets, equity markets and yield spreads all contain a valuation premium which suggests tolerance for risk. It would be hard to argue that if short term rates were 5% that all asset prices would be at today’s levels.
Of course, you might well be regarded as a madman for suggesting that rates could be 5%, but in the eleventh year of a past recovery that would have been anything but unusual.
Economic activity has picked up as well, albeit in a rather anaemic fashion, except in the US where it has been subject to a large fiscal stimulus at a point in the cycle where that is probably unwise and in any event creates a large increase in the government debt burden in the medium term.
The fiscal stimulus has primarily been of benefit to asset owners and corporations rather than to the base which elected the current administration.
Empirically, therefore, it looks as if the monetary experiment has benefited assets and not done much for the real economy. This combination has fertilised the soil in which populism has germinated.
There are a series of risky games of chicken being played in the geopolitical sphere.
From developments in Saudi Arabia, Iran and Venezuela, which are affecting the oil market, via Brexit to North Korea and then to trade tensions, the world feels like a riskier place than it did a couple of years back.
When markets sniff trouble, as they are at the moment, the smell is usually carried off quickly on the wind. Economists, who never agree on anything, do agree (with the exception of the hawks in the Trump team) that a trade war is bad for everybody. The US president seems to believe that trade is a zero sum game and that the US trade deficit is inherently bad and in need of fixing.
The reality is that the trade deficit is a mathematical identity which reflects the fact that the US consumes more than it produces. There are two ways to fix that – consume less or produce more – neither economically possible over anything other than the cosmically long term, and neither in the current policy mix.
Picking a fight with allies and economic rivals alike may play well with the Trumpian base, but it takes little account of the fact that political considerations in China, for example, mean that a public climbdown is impossible. That is why we have seen concerted efforts to weaken the Chinese currency and to stimulate the domestic and services sectors. The authorities there are buying time and ‘wiggle’ room, should events get more heated.
The likelihood is that the initial impact of a trade war hits China hard, but then spills over to US companies operating in that country and eventually to US consumers through higher prices, which are already visible in certain products.
Elsewhere in the world
An unusual divergence in performance has opened up between the US, which has done very well, and other developed markets, which have been less impressive.
In the UK, the market may be cheap, but Brexit remains a nightmare, with no clear outcome yet in view. Although Italy is in the emergency ward, other European economies are rumbling along adequately and the ECB will be scaling back QE at the end of the year.
Japan remains sluggish, but the stock market is quite cheaply valued. Technology continues to disrupt incumbents across many industries and calls for greater regulation are gaining strength in many jurisdictions. These trends will take years to play out.
In developed world stock markets, there are two distinct narratives. The first runs like this: interest rates are lower than they should be, so there is plenty of cash around; because the recovery has been sub-par, there is little sign of inflation in wages, and recent declines in the oil price are a boon to consumers; tax reform in the US has given earnings a real boost; and higher earnings are leading to more capital investment which will in turn lead to improving productivity.
Those investors who were active in the 1990’s will remember the ‘Goldilocks’ economy, which was not too hot, not too cold, in fact just about right. A generation on, and here we are again. It is true that these conditions support equity prices, a contention reinforced by the pitiful returns on offer from other asset classes. Even high yield debt is trading at record low spreads to more respectable bonds.
The other story out there
There is a different story out there as well. This one starts with the length of the cycle – it is close to an all time record in duration – and wends its way through high valuations and extended profit margins to the shifting sands of geopolitics.
It bemoans the abandonment of fiscal targets and associated austerity and tops the cake with a debt flavoured cherry – debt is now higher than it was before the GFC (albeit not in mortgage markets) and by many measures we are back to lax lending standards again.
Recent market declines reflect this version of the future and are based around the worry that the global economy is slowing down. This is the second episode of jitters in a year, and it feels more potent than its ancestor in February.
We do acknowledge that risks have been growing. The underlying dynamics of asset prices depend on a complex interaction of the relative value of one asset class against another, tempered by sentiment and investor timescale. Individual investors do not have to please an investment committee and nor do they have to stay with the herd.
At times like this, when the sun is still shining but dusk is approaching, a degree of caution is warranted.
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