Markets are maintaining the state of dead calm that we wrote about last month. The clock ticks on, with little sign of equity volatility.
The tally of days since the last meaningful market correction is marching on towards record territory. In the short term, there’s no reason why this can’t continue – the UK faces its own peculiar challenges, but across most major economies, economic conditions are good and corporate profits look pretty well supported. Equities look quite expensive in some regions, as do many sectors of global bond markets, but there are enough pockets of value for investors to find ideas where they can put money to work. In any case, valuation is not a good short term timing signal – on the contrary, momentum (i.e. what goes up, keeps going up) can often overcome expensive valuations, as we have been seeing.Markets are navigating the shifts in central bank policy well for now.
Markets are navigating the shifts in central bank policy well for now. The ECB, as expected, announced a reduction of its asset purchases to €30bn a month in late October, and (at the very start of November) the Bank of England increased interest rates for the first time in a decade. Both central banks have been at pains to stress their gradual approach to tighter policy. In the US, markets digested the announcement of a new Federal Reserve (Fed) Chair as Trump appointee Jerome Powell – broadly seen as offering continuity. The Fed will likely increase interest rates once more before the end of 2017. Perhaps markets are right to take these shifts in their stride. After all, central banks’ asset purchase policies (quantitative easing or QE) remain pretty potent, and look set to see the total sum of assets held by central banks still rising well into 2018 and so still pumping liquidity into the system – even if the pace of asset purchases is tailing off. Despite the interest rate and QE moves so far, the broad impression remains of global central banks emphasising gradual steps, more prepared to take the risk of an overheating economy than of tightening policy too fast and snuffing out growth.
Of course, there are risks to the picture: market threats have been suppressed (rather than have disappeared completely).
So the growth outlook remains pretty healthy for the time being. Of course, there are risks to the picture: market threats have been suppressed (rather than have disappeared completely). Financial markets seem relaxed about geopolitical tensions for now – again, perhaps reasonably enough given a series of European elections where mainstream politicians beat off extreme populist challengers and where President Trump is finding that institutional checks and balances make it harder to exercise power than he’d imagined. But we are left with an impression of risk suppressed rather than passed, and that is still figuring in the background of investors’ decision-making, although not at the forefront. Perhaps – for now – the views are secondary to the fear of missing out on strong market momentum.While the shift in liquidity provision by the global central banks is not yet biting, the direction is clear.
So what risks should we be wary of? We won’t dwell today on the well-known political risks, but we certainly maintain a focus on the change in central bank behaviour. While the shift in liquidity provision by the global central banks is not yet biting, the direction is clear and it is hard to imagine that the inexorable steps towards a more normal monetary policy will not have an impact somewhere at some point. For now, inflation has been quite subdued outside of the UK. Here, 2016’s Brexit-related fall in the value of Sterling led to a rise in import prices, but these will fall out of the year-on-year calculations in due course. In other countries, meanwhile, we should see central banks taking a more aggressive stance if inflation pressures intensify. Wage inflation has been surprisingly low, given the falls in unemployment in the US, Germany and elsewhere – if we see employers bidding up for labour as employment conditions tighten further, we may expect central banks to step harder on the brakes.
Elsewhere, oil prices have recently reached their highest levels in over two years. They are now more than double their levels at the start of 2016 and up 25% since the summer. While low oil prices in early 2016 likely provided a subsequent boost to the global economy given firms and households experienced lower input costs across a swathe of goods and services, higher oil prices – if sustained – could unwind that boost and become a more serious headwind.
It’s also far from clear whether major markets could easily process a blip in growth data or corporate profits. Many observers already see this growth cycle as long in the tooth. However, we suspect it can continue for a while yet, and at least until central banks squeeze harder. And any signs of softness in growth when the cycle is well-advanced are at least open to the interpretation that they are the beginning of recession.
Many observers already see this growth cycle as long in the tooth.
Let’s be clear: recession is not our forecast, but it’s easy to see how markets could extrapolate from a perfectly normal period of more subdued growth to reach an overly negative conclusion – it would not be the first time. Markets certainly don’t appear priced for such a risk, and could be unusually vulnerable to a run of bad data.
Portfolio positioning currently is a matter of carefully calibrating between supportive economic conditions on the one hand, and on the other demanding asset valuations, strong market momentum and extraordinarily low equity volatility. We don’t yet see widespread characteristics that might be consistent with a major market top. This suggests it’s too early to retreat to safe havens alone. Instead, we aim to strike a slightly cautious stance, preparing for some volatility by holding somewhat lower than usual exposure to risky assets, but respecting the market’s strong current momentum.
Deputy Chief Investment Officer
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