Weekly Digest

Time for Clear Heads

James Klempster, CFA

16 September 2019

It all seems a bit breathless at the moment, doesn’t it?  Long gone are the reassuringly (if artificially) benign times of 2017 where markets were bid up seemingly without any heed being paid to what was going on in the real world.  Today, hunkered down in the City’s metaphorical ivory towers, there can be no doubt there’s plenty going on out there.

Quite a lot of the noise is unhelpful.  Barely a day goes by without a Presidential tweet, a Brexit deadline, an inverted yield curve or data surprise to knock the market off its stride. Is it right, however or are the fears overdone presently?

It is easy enough to paint a negative picture at the moment.  We are now over a decade past the financial crisis and we are in the longest (and one of the most tepid) economic expansion in history.  Simply by sheer dint of time passed it is tempting to think growth can’t possibly go on for much longer.  But this expansion was pretty long in the tooth a couple of years ago and even then there were plenty of commentators seeing the cracks in growth starting to appear.  They were illusory, however.  Equity and bond markets have risen sharply this year, driven by the prospect of easier financial conditions, and valuations have become stretched in some areas, notably in fixed income.  The economic backdrop has deteriorated, corporate earnings are under pressure especially in sectors most exposed to manufacturing, and markets are largely discounting sizeable policy easing by central banks in coming months.

The extent of the global slowdown needs to be kept in perspective; trade and manufacturing are contracting but the service sector continues to grow, employment remains strong and the consumer is generally in good shape. There are no signs of systemic financial problems and an ensuing liquidity crunch nor of capacity shortages, inflation and a sudden tightening of policy. With inflation subdued central banks have considerable flexibility in keeping policy ultra-loose for much longer, thereby extending this extraordinary cycle.

Furthermore, the corporate sector is in a solid position financially and while it is true to asset that levels of corporate debt have increased it is also a pretty rational response in response to all time low levels of interest rates.  Clearly we live in unusual times.   There is about USD15 trillion of government bond issuance in negative territory including the entire German and Swiss yield curves and even the Spanish and Portuguese curves are negative in the short end.  It goes without saying that these levels are without precedent.  Fundamentally they are only a good deal if one believes protracted recessionary or deflationary periods lie ahead.  Global growth is paltry but positive and so the prices of a large proportion of government debt worldwide does not seem to reflect the macro backdrop as it stands today.

The apparent antipathy on the part of market participants may yet prove to be correct.  The past year neatly demonstrates the unpredictability of politics and its ability to provide either a positive or a negative impetus to markets.  Good fundamental analysis should be rewarded in the long run.  Periods of market uncertainty and volatility such as these present a good opportunity to find undervalued assets that can be invested in for the long term.  As a result, while it is near impossible to predict political outcomes as a source of investment theses, it is imperative to remain alive to identifying where the markets have mispriced the odds of an outcome compared to other available data.

The falls in interest rates this year, both at the short end and throughout the yield curve, across all government bond markets, provides a strong underpinning to equities and other risk assets, offsetting the more challenging conditions faced by the corporate sector. Against a backdrop of heightened uncertainty some consolidation is overdue, but we believe that the cycle has further to run and any falls in markets will give rise to opportunities to add to risk assets, while at all times maintaining careful diversification in portfolios to provide protection during inevitable shorter term setbacks.  Ultimately most equity markets remain reasonably priced and the overarching cautious mood does not suggest the collective exuberance or mania that could so easily tip into a recession.  Nevertheless care is warranted from investors today and our central bankers and politicians must demonstrate a similar level of prudence.

Download the above article >