Invincible markets?

24 November 2017

Global equity markets hit new all-time highs over the past week, now standing at a gain of roughly 18% for 2017. This took place while politics performed fairly shambolically wherever one looked and (western) society was shaken up by the threat of terrorism and widespread revelations about high profile harassment cases. If capital markets had fallen instead, all this would be used to explain the falls. But, given the gains, one must ask – do politics really no longer matter?

We observe a strong turn in the sentiment of leading economic institutions around the world, who see a further improving picture of growth ahead – sadly with the notable exception of the UK. Such an environment of reviving business investment (Capital expenditure - Capex), lowest unemployment in decades and strong consumer sentiment and spending is potent fuel for corporate earnings growth expectations. The overwhelmingly positive outlook statements of the just finished quarterly corporate earnings announcements only provided further pain to all those hapless investors of old, who had thus far observed the meteoric rise of the stock market in disbelief, given the economic development had been so pedestrian – and had refrained from investing.

This would go some way to explain why last week’s slight market wobble never amounted to any more than a temporary 2% blip, which quickly recovered, as once again, reluctant investors jumped onto the market bandwagon and used their idle cash to ‘buy the dip’.

At Tatton, we held one of our extensive bi-monthly investment committee meetings where we debate at length whether markets are right or wrong, and whether they are irrationally exuberant in their interpretation of the outlook or rationally pricing in likely future developments. At the end of it, we came to the conclusion that, based on all available information, the global economic outlook is indeed positive. But, whether it is quite as bright as current market dynamics imply is, at least for some markets, questionable. It is the extended valuations of US equities which are of particular concern, while Europe, Asia and much of the developing world still trade with further upside potential.

Unfortunately, the high valuation levels in the US make that particular market very vulnerable to even a modest headwind. This has potential consequence for other markets, as sell-off dynamics have a habit of spreading around the world regardless of valuation differences. At the moment, there are no particular threats to the prevailing economic environment on the horizon, but there are plenty who could come and bite over the medium to longer term. Over the coming 3-6 months, it is quite possible that slowing US economic and credit growth could dampen further upside fantasy of US investors and lead to a market correction. Likewise, the notable slowing in China’s activity growth could impact emerging and commodity markets, as well as reduce China’s contribution to Global demand growth.

In the longer term of the next 2-3 years, the vast expansion in the volume of global credit finance, which was made possible by the low interest rates over the past decade, could become a millstone of financing costs, should central banks be forced to raise rates faster than currently expected. Even if this does not happen, at the very least we cannot expect credit expansion to continue to boost economic growth, when rates start to rise and end 3 ½ decades of falling cost of debt.

These concerns do not make us outright bearish in the current environment, but cautious and alert to any changes in outlook and general sentiment. For the time being, we are relieved that positivity is returning to businesses across Europe, the US and Asia. This should prevent any sizeable economic downturn in the near future and thus continue to provide a supportive environment for investment returns. Since we are – as discussed above – wary of the sudden bouts of volatility due to the extended market valuations, we believe our portfolio investors are best served with a continuation of our 2017 investment strategy so far. That is, keeping the equity-bond balance roughly in line with the risk profiles’ asset allocation guidelines, combined with an active regional and currency position that takes account of a world economy that is regionally at different stages of progression through the cycle.

As far as our UK home base is concerned, the chancellor provided sobering news this week with his budget. We think he did a decent job by sticking with leaving austerity behind and directing his spending towards those areas that will strengthen the longer term economic prospects of the country. Sadly, it was also more than apparent that there is not much headroom for fiscal stimulus after the economists of the Office for Budget Responsibility (OBR) finally conceded that the UK was likely to be stuck in the rut of sub 2% productivity growth for much longer than previously anticipated.

Japanese outlook conditions for the UK then? Well, if the Brexit negotiations leave the UK cut-off from its main trading partners, perhaps. However, we would point out that there are encouraging rumours coming across the Channel of EU intentions to make their comprehensive free trade agreement with Canada the blueprint for the post Brexit relationship. This would be a great step forward, even if it would still leave the UK less well positioned that pre-Brexit. Until then, however, the OBR may have become a little too pessimistic in its assumptions. We, at least, observe a stronger second half of the year for the UK, with all those sectors engaged in cross border trade and service relationships reporting much more upbeat than one would expect, against the dire business sentiment the media is painting. It would seem that, despite the sometimes paralyzing Brexit uncertainty, the UK remains a trading nation and will not be left behind when the rest of the world begins to accelerate in earnest. Let’s hope that we are indeed simply witnessing that very darkest point that comes before the dawn.

For the full weekly, please click here.