Return of the '˜old normal' or calm before the storm?

17 March 2017

Scanning the events that made the financial news of the past week it would appear difficult to choose what to comment on.    US employment highest in 2 decades?   Pan-European stock markets hitting new all-time highs?   2nd rate rise in the US in 3 months, but with very dovish accompanying commentary?   No rise in sight for the UK?    European populism on the retreat?   Chancellor Hammond forced into humiliating U-turn over NIC increase?   Chinese authorities increasing their efforts to counteract credit excesses?   US President Trump presenting his budget proposal and getting nowhere with his policy initiatives?  India's president Modi winning landslide regional elections despite/because of his audacious but poorly executed monetary reform?  Or the oil price falling 10%, back to the $50/bbl level?

From an investor's perspective, the stock market highs are perhaps the most pleasing, while the sudden oil price decline is perhaps the most relevant concern for the near term.

The oil price fall was caused by doubts over OPEC's ability to stick to its price stabilising production cuts and led to investor concerns that the reflation theme of the past 2 quarters, that arguably drove up stock markets, may not be as sustainable as thought (falling energy prices could see a return of deflationary pressures). The muted market reaction tells us that there is widespread belief that Saudi's threat to crank up production volumes will be sufficient to '˜encourage' the rest of OPEC (and Russia) to stop playing games.

How about the rest of the news? Well, it shows in my opinion that economic and capital market circumstances are much calmer than one would think or would have expected at the end of last year and that there is indeed a possibility that we are more likely to witness a gradual return to what we would call the '˜old normal' rather than having to accept a continuation of the growth ice age as seen during most of the post Financial Crisis decade.

That is perhaps with the exception of the UK, where the humiliating U-turn of the chancellor's attempt to raise additional revenue tells the story of a government that appears utterly challenged by '˜the hand of cards it has been served to play'. Compared to everywhere else, UK consumer and business confidence is beginning to wane and only the prospect of strong global economic growth momentum and a weak UK currency offer a positive tilt to the near-term UK outlook.

Such global momentum is increasingly apparent and Trump's Twitter storms appear to have lost their scare potential. They seem to be increasingly interpreted as what they have been so far - reassuring sound bites to those amongst his electorate who he would expect to struggle to assess the viability of his initiatives(?).

The first quarter of 2017 therefore feels like another one of those rare '˜Goldilocks' periods, when the stock market climate is neither too warm nor too cold. Compared to last summer, however, returns for bond investors have not been equally pleasing. And how could they, after last year's bond rally drove interest income potential for the coming 10 years very close to 0%. For the moment, we are happy that, much as we expected, the feared bond sell-off has not materialised, allowing bond allocations in portfolios to continue to play their role as volatility '˜shock-absorbers', while equity allocations are contributing positive returns.

As ever there are also clouds on the investment horizon. Trump is, perhaps surprisingly, the lesser concern for the coming months as his plans and policies will be substantially slowed and neutered by Washington's political apparatus. Of larger concern is the sustainability of Chinese growth, now that the government has turned its attention from economic stimulus to containing excesses. So far this has not led to a marked slowdown, but considering how crucially dependent last year's growth was on the thrust from China, this is one to be watched very closely.

Once the China concern has passed - and we anticipate chances are higher than evens that it will for coming 6-12 months - now that broader global growth has returned - then the inevitable monetary tightening cycle through rising rates will constitute the next challenge. The US central bank has already embarked on a gradual tightening course, but so far this has not had a significant impact, as all other western central banks have continued to keep their rates extremely lose and below the rate of inflation or even still pursue QE bond purchase programmes.

When inflationary pressures from the strengthening economy force central banks into a policy reversal we could experience another '˜market tantrum'. Should markets and businesses feel that confidence levels are still too low or uncertainty too high, then overreaction by the economic subjects has the potential to lead to a premature end of the cycle.

Such concerns are probably 12-18 months down the line and while we monitor developments closely they are not of immediate concern. For the near term, we are more concerned that stock markets get ahead of themselves and thus become vulnerable to short, sharp corrections. This is the reason why we are content to continue to hold government bond allocations at risk profile target levels in our portfolios. Even though their long-term return potential may at best be at current cash return levels, they tend to be the only asset class that offers a true value counterbalance when equities suffer a correction.

That is except for the case of '˜market tantrums' but as I said above that is more of a concern for 2018.

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