Quarterly Publication - July 2017
Mere Monetary Mortals - July 2017
The first half of 2017 was largely characterised by momentum investing, especially rallying behind large-cap technology stocks. Passive (index-tracking) investment flows no doubt continued to play a major role in these flows. Although this trend appeared to have peaked in early June, there were impressive gains in top-tier technology stocks as they retained their leadership in the US equity market in the past six months. Stocks such as Tesla, Facebook, Amazon, Apple and Netflix were the clear winners.
By comparison, industrial, materials and energy stocks had a very tough six months. Financial stocks also materially lagged the technology sector. As has become a familiar pattern in recent years, the underperformance of the industrially sensitive stocks was essentially due to fears over the resilience of the US economy. In particular, this was sparked by signs of weakening motor vehicle demand and ongoing gridlock within US government. Additionally, pre-Brexit uncertainty in the UK did not help sentiment.
Despite these concerns, and even with increased tensions between the US and North Korea, equity market volatility remains low. Although this is a potential red flag in terms of investor complacency, it no doubt represents (for now, anyway) a prudent commitment to equity investing. This is supported by continued liquidity injections from central banks, rising earnings and a slow but steady return towards expectations for modest but synchronised global growth for 2017 and into 2018.
When looking at returns beyond US equity markets, it must be borne in mind that the US Dollar Index fell by 6.4% in the first half of 2017. This currency rotation towards the euro and the yen therefore exaggerated the first-half gains in many foreign equity markets when measured in US dollars. European equity markets outperformed the Standard & Poor’s Index by a range of between 12% (Spain) and 6% (Sweden), measured in US dollars.
Additionally, the broad rise in global equity prices over the first half of 2017 fed strong gains in liquidity-sensitive emerging equity markets. Anticipation that Germany (to preserve the EU) will provide further support for peripheral market banks and debt exaggerated the rotation toward Greece, Italy and Spain. Also, the modest pullback in the US dollar, combined with economic resilience in the US and China, enhanced the rotation toward most emerging market equities – with the exception of oil-sensitive Russia, which fell by 12%. The top-performing emerging markets were Greece (39%), Turkey (29%) and Mexico (25%).
As already mentioned, a rotation out of the momentum-driven technology sector and towards value in emerging markets, financials and industrials began in June. By way of example, despite a further 4.7% drop in the price of West Texas Intermediate crude oil in June, the Journal of Commerce Material Price Index and the Integrated Oil & Gas Index fell only 0.7% and 0.9% respectively. Hence, fears that US equities are overpriced may be counterbalanced during the second half as domestic economic resilience attracts some capital back toward US financials, industrials and the energy sector.
Given that the expectation is for the cost of money to continue to rise, it is not surprising to note that bond yields have moved up during June and July. This is a change in trend from earlier in 2017 when bond yields fell due to a waning of the overexuberant expectations of stimulatory policies under US president Donald Trump. Additionally, it should be pointed out that companies with high levels of borrowings have underperformed the broad equity market so far in 2017.
RE-EMERGENCE OF INFLATION
Looking towards the remainder of 2017, the issues currently weighing on investors’ minds relate to the following two questions: Has the US recovery peaked or will it remain resilient through into 2018? And have equity prices peaked or will the rally be supported into next year by strong earnings and a broader rally, possibly lifting financials and energy stocks?
We believe that conditions favour continued resilience in US consumer spending and a modest but synchronised upturn in global growth later this year and into 2018. That said, we believe that the outlook for inflation, and central bank actions, will be vital to understand the direction in the near future.
After a decade of central bank intervention aimed at preventing a deflationary contraction and restoring liquidity and solvency in the banking system, the return to market pricing for money and risk will be slow, halting and unpredictable. That said, the first steps toward normalcy have been taken and despite continued central bank bond buying in Europe and Japan (and the reinvestment of the Federal Reserve’s [Fed] massive bond portfolio), interest rates have begun to rise. Since real rates remain negative in much of the northern hemisphere, the slow withdrawal of intervention over the next 18 to 24 months is not likely to affect consumer spending or private sector investment materially.
The potential re-emergence of inflation is a critical issue investors face today. This is partly because three decades of benign inflation have bred investor complacency – and that complacency has become even more entrenched in the nearly nine years since the financial crisis. As a result, investors are largely underweight assets that stand to do well in an inflationary environment, probably leaving their portfolios insufficiently insured against a significant rise in prices.
Influencing this is the fact that, during the current recovery, traditional measures of inflation have lagged significantly when compared to prior recoveries. Implied inflation measures remained extremely subdued until late 2016. The result is that most equities sell-offs over the past decade were associated with fears of deflation, not inflation. As a result, investors in recent years have gravitated toward assets that tend to do well in low-growth, low-inflation environments, and these assets did indeed provide valuable diversification.
Economists often attribute the benign inflation that prevailed since the 1980s to a number of institutional changes, including monetary policy independence and globalisation, which suppressed the cost of goods and labour. This allowed investors and consumers to anchor their inflation expectations better. The 2008 global financial crisis and its aftermath – particularly a slow recovery in business confidence and corporate spending, and overcapacity in the commodity sector – intensified these trends and increased fears about outright deflation. Historically speaking, this was highly unusual. As a recovery takes hold, inflation normally rises as debt levels and aggregate demand increases. But this recovery was a weak one and, without inflation, companies lacked pricing power. That, combined with low productivity, led to an earnings recession that lasted from 2012 until 2016. This contributed to weakness in confidence, hiring and capital spending.
However, there is reason to believe things will be different in the years ahead. Several disinflationary factors that kept prices in check over the last three decades, such as globalisation, are fading. At the same time, cyclical factors such as earnings growth, rising confidence and capital spending plans, tighter labour markets and capacity rationalisation in commodity markets are setting the stage for rising inflation. Additionally, governments’ willingness to expand fiscal policy despite a low level of slack in their economies is raising inflation expectations in the US, Japan and the UK.
CENTRAL BANKER FALLIBILITY
In our opinion, too many investors like to take their cue from the utterings of central bankers – simply due to the belief that these central bankers have a great deal more insight that most. In our opinion this a dangerous and flawed approach. Central bankers can and do frequently get things wrong. Not because they are being duplicitous, but rather due to the reality that they are seemingly blind to the bubble-creating effect that their policies have had in the last 20 years or so. As we know, bursting bubbles can devastate both investment markets and the real economy.
To illustrate this point, one need look no further than quotes from former Fed chair Ben Bernanke around the time of the housing peak in 2005/2006:
“We’ve never had a decline in house prices on a nationwide basis. So, what I think is more likely is that house prices will slow, maybe stabilise, might slow consumption spending a bit. I don’t think it’s going to drive the economy too far from its full employment path, though.” (Bernanke, July 2005).
“Housing markets are cooling a bit. Our expectation is that the decline in activity or the slowing in activity will be moderate, that house prices will probably continue to rise.” (Bernanke, February 2006).
As it turns out, Bernanke was wrong. House prices did not continue to rise, or even stabilise. Shortly after his comments, house prices started to fall across the US, and would only begin to stabilise after a 25% decline over five years.
Recent weeks have been no different, with central bank comments and statements abound. One of the more recent comments, from Fed vice chair Stanley Fischer, referred to high asset values – specifically that “high asset values may lead to future stability risks”. In essence, he is warning that central bankers are now worried that their extraordinary policies have created significant asset bubbles, and a future bear market would hurt both financial markets and the real economy. Their poor forecasting track records aside, when central bankers tell us that asset values are “somewhat rich” (Fed chair Janet Yellen) and that they are worried about future stability – whilst at the same time raising interest rates and potentially reducing their balance sheet – we as market participants should take note. Our view remains that the Fed will continue to walk a bit of a tight rope, that is, tightening policy until something ‘breaks’, either in the US or globally.
Of course, even if the Fed is worried that they have created a massive bubble, they will be very careful in the way they manage markets. As a result we will continue to get ridiculous comments such as when Yellen recently said she did not believe that there will be another financial crisis in our lifetime. This statement conveniently ignores the fact that, historically, every period when asset markets have become this expensive and debt this high has been followed by a financial crisis. This is of course looking backwards.
The trigger for past crises has always been falling asset values; we now have a Fed that is acknowledging high asset values and yet is still tightening policy. Logic suggests to us that the monetary policymakers are also privately worried about this, and are now trying to dig themselves out of a very deep hole with their policy tightening. What worries us is the implicit reason that many investors are remaining invested in risky assets – despite the increasing warning signs. Many investors simply believe that during the next crisis, the Fed will be very quick to slash interest rates and print money. After all, Fed governors have told us that this is what they expect to do.
CONFIDENCE VERSUS ANGST
Analysing 2017 thus far can be summed up as follows: capital flows, exaggerated by central bankers’ liquidity injections (in Europe and Japan in particular) aimed at suppressing interest rates, flowed towards risk from January into early February. Capital then became overexposed to economic risk and allocations were pulled back, crowding again into the momentum of top-tier large-cap equities in the tech sector. The perceived safety of sovereign debt also attracted money flows. This rotational momentum was exaggerated as a mild northern-hemisphere winter triggered a gathering exodus from the energy sector. Simultaneously, delays in passing meaningful fiscal reforms in the US tempered expectations for the scope and timing of monetary tightening, pulling capital away from interest rate-sensitive financial equities. In our opinion, current investor worries should be balanced by our expectation of renewed confidence in the outlook for global growth as we move into 2018, triggering a rotation back toward economically sensitive stocks and sectors. Capital will again flow from safe havens and bonds toward financials, industrials, commodities and the deeply oversold energy sector.
While any investment forecast is dangerous and flawed, the current dynamics influencing the direction of global equity markets are particularly hard to predict. The primary reason for this is the relentless growth in passive investing. Passive investment products represent a very large part of flows into US equities in particular, thereby changing the demand dynamics. What is very difficult to predict is how passive investors will respond to any material market correction.