When we look at the financial markets, the mixed messages are concerning. By extrapolating today’s low interest rate environment almost indefinitely into the future, quality government bond markets are looking expensive.
But central banks are indicating that the overall direction of travel is towards higher interest rates. At the same time, equity markets agree with central banks and are moving higher, on the back of positive economic and earnings data and a growing global economy. At some point, the difference between these two views will be reconciled.
If the bond market is correct, then the world is still very much in a critical condition, requiring that emergency monetary policy be maintained. This is unlikely to be good for the equity market (imagine the surprise if Janet Yellen cut rates at the next Federal Reserve meeting). If equity markets are sending the correct message – that the global economy is resilient – the resulting rate rises could cause distress in bond markets.
Another alternative is that we see an equity market sell-off that is not related to interest rate policy but down to something else. While these kind of risks are difficult to call ahead of time, there are times when positioning for them feels more comfortable:
- A long period of low volatility can cause complacency, and then spark an overreaction as market participants remember that asset prices can go down as well as up. The VIX Volatility Index has been bumping along its all-time lows for the past nine months. Investors should have learned in 2007 that stockmarkets are most risky when they are least volatile.
- Narrow market leadership from too few large stocks can reduce resilience to a pull back. There wouldn’t have to be too many sellers of Amazon, Apple and Google to drag the whole S&P 500 lower, for example.
- High valuations that can’t be sustained. We are also seeing valuations that need record earnings growth in order to be justified. We’ve had two quarters in a row where earnings have delivered above expectations, but now forecasts will have been ratcheted up for next quarter, making it tougher to outperform them.
- A rise in geopolitical events with the potential to spill into markets: North Korea; US-China trade relations; US internal social unrest; problems in the Middle East with Qatar; and trouble at the eastern edge of the EU, as Polish politics becomes divided. Some of these are more troubling than others, but the point is that the overall number has increased. If there are enough different events with a 1/100 probability of occurring, one will eventually happen.
If there are enough different events with a 1/100 probability of occurring, one will eventually happen.
With the above in mind, we remain cautiously positioned – both with respect to duration and to equity markets. We are prepared to forgo gains in fixed income assets that are predicated on low rates, just as we are prepared to lag a further step up in equity markets that increasingly seem to be ignoring downside risks at a moment in time when they appear to be increasing.
Having discussed our outlook for Brexit at length last month, we don’t want to repeat ourselves. It is just worth noting that each passing month sees new and different practical issues raised with the idea of a quick, clean and effective exit from the EU. The arguments in favour of a hard Brexit are becoming more and more based on hope rather than reality. We continue to feel that fear of economic pain is as big a motivator for Theresa May’s government as it is for individuals, and that the direction of travel is towards a soft Brexit. There are likely to be setbacks on the path to this outcome, but in general this should be positive for Sterling – and is the rationale behind our own high Sterling exposure.
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