Vista: The Outlook

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06/11/2018
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A few months on from our last edition and, although the weather is notably different, as far as the financial markets are concerned, it’s very much same old. Some key geopolitical issues continue to fascinate market participants (albeit bore the rest of us) – the progress, or otherwise, of Brexit for the domestically minded and Donald Trump’s continuing trade assault upon China, although the wider ramifications of these issues continue to befuddle most commentators. From an economics perspective, most parts of the world continue to roll happily along, although there has been some slowing down of late, particularly in Europe. As for the financial markets, global bond yields continue to rise, while equities have sold off, in some cases quite aggressively. Indeed, the recent highs on Wall Street were obscuring the fact that most financial markets (with the notable exception of UK commercial property) were flat to slightly down over the year to date.

Investment managers are not usually the most humble of people. The answer to the question 
“what’s the least likely phrase to come out of an investment manager’s mouth?” is – “I don’t know”. We’re paid and required to have opinions and views about what might happen and to implement our asset market views in portfolios. Likewise, people expect us to be very well informed. Each individual manager will implicitly or explicitly have a model of the world which they use to inform those portfolio views. That model will have been formed over time by the manager’s experience of how markets behave. Contrary to popular opinion, we are no better than anyone else at predicting the future. But the typical manager will compare the current set of circumstances to those which prevailed in the past and use that comparison and his model to draw asset class conclusions.

The point of that little digression is this. Particularly in the UK, but frankly almost everywhere else as well, we are now (and have been for a while) in an economic environment which is without precedent and therefore our capacity to predict asset market movements is extremely limited. We are about as near to a “don’t know” moment as I can remember in my professional career. What is the basis for that assertion? Well, the Global Financial Crisis (GFC) of 2008/9 and the tenth anniversary of the inception of which we have just “celebrated”, was in itself a global economic event of unparalleled severity. Not even the Great Depression could have rivaled its extent. Moreover, the policy reaction to the GFC, the Quantitative Easing (QE) undertaken by the world’s major Central Banks, was equally portentous. That it was necessary at the time there should be no doubt – the recession of 2009/10 was pretty severe, but the consequences of doing nothing were just too awful to contemplate. To remind ourselves, starting almost at once, the 4 major Central Banks not only reduced interest rates to virtually zero, but also began to use newly-created funds to purchase high-quality, fixed income securities in the open market – the aim being to provide liquidity to the markets and put downward pressure on bond yields.

That policy is only just being reversed. The US Federal Reserve began increasing interest rates late in 2015 and started to reverse QE a little later. But not before it had amassed a staggering amount of assets – assets on its balance sheet rose from around $1trillion in 2008 to around $4.3 trillion at its peak. The combined balance sheets of the 4 Central Banks amounted to around $16 trillion at the start of the year. The Bank of Japan owns a staggering 48% of its government bond market.

This policy has indeed been successful in driving down bond yields – but to an unprecedented extent. Indeed, at one stage at the end of last year, it was calculated that $10 trillion of sovereign bonds were actually trading at negative yields – that is, their purchase would guarantee a loss if held to maturity (1). It also had the effect of driving down the prevailing yields on all competing asset classes as well – as investors chased yield as they exited cash and bond markets which exhibited none whatsoever, they turned to other, more risky assets and increasingly to illiquid vehicles to satisfy that thirst. As a consequence, the valuations exhibited by many public and private securities markets now look elevated. The other consequence is that most asset classes have done well in the last five years but have also exhibited an unusual degree of correlation – never has the phrase “a rising tide lifts all boats” been more apposite.

This, the first major consequence of the GFC, I have written about before. Just how can we expect global assets to behave when this unprecedented degree of economic and monetary stimulus is reversed? And, as the actions of the US Federal Reserve have recently indicated, it will be reversed. While the omens for sovereign bond markets, from such low yields, look very uninspiring, analysts have pinned their hopes on the reaction from other assets being more orderly. But, to return to my earlier theme, since there are no precedents for this kind of policy reversal in history, we are very much in the dark.

We might hope for more orderly behaviour from other asset markets in a relatively stable economic and political environment, but 2018 seems to have brought about heightened uncertainty on both counts, exacerbated by our collective loss of confidence in our political leaders. It is not healthy when members of such an august body as the United Nations are reduced to disbelieving tittering in the face of Trump’s claim to have achieved more in the first two years of his presidency than any other US administration. But, more seriously, the attack upon China’s trade surplus, in the form of punitive tariffs, chips away at one of the pillars of the post-war economic architecture – the opening up of global trade which had been led ironically by the US. We may hope that the practice of free trade has made such enormous progress over recent decades that the Trumpian initiative creates only a temporary interruption to real economic activity. It also has an impact upon sentiment - witness the poor relative performance of emerging equity markets so far this year. Asian markets too have performed poorly as contagion from China has spread, in spite of their more favourable fundamentals this time around.

Finally, what are we to make of Brexit? Theoretically, by the time of the next edition, things should be much clearer (!). But the inability of the leaderships of both political parties to reconcile the competing ideologies of the respective wings of their parties (and the inability of the political system to reorient along Brexit lines) has meant that we have made no progress towards an orderly exit solution in 2 years. It is increasingly likely that because Parliament is at an impasse, we crash out of the EU with no deal at all. That may not be good for the EU but it may be far worse for us. Business is right to complain about the uncertainty.

All this, as you may imagine, makes us suitably very cautious about the road ahead. In more “normal” times, we would be advocating a move to less risky, monetary assets but the returns and volatility of bond assets have almost kept pace with equities over the past few years. This means there are no obvious safe havens to retreat to. Investors should expect a period of lowish returns and enhanced volatility.

 

Source: Fitch Ratings 2018 (1)