If the economic and geopolitical backdrop is so fragile that the US Federal Reserve (Fed) needs to change course, we believe it ought to be reflected in stock and credit markets. However, we would argue that it isn’t, given that the US stock market is at an all-time high and credit markets are offering some of the lowest yields ever on low-quality debt.

The jury is out on whether a further easing cycle is bullish – as was the case in 1995 – or a bearish indication of impending recession, as it was in 2000 and 2007. One thing looks certain to us: in recent history, once the Fed signals the economy needs more support, the prices of risk assets move sharply higher. Given policymakers’ recent pivot, it is reasonable to ask if the authorities are set to trigger another leg of the bull market. The history of stock-market bubbles suggests to us that anything is possible.

Growth Disconnects

Throughout this bull phase, financial markets have arguably not been rerated because the world offers an enticing growth opportunity. In truth, we believe they have performed despite the economy, as sluggish growth has been repeatedly shrugged off.

The reality is that economic growth is structurally low, and its trajectory dominated by demography which is largely beyond policymakers’ control. To us, disinflation appears structural. What we call ‘the four Ds’ – demography, debt, disruption from new technologies, and distortions wrought by ultra-loose monetary policy – combine to keep a lid on demand and corporate pricing power.

The global economy is highly indebted, and the productivity of new debt (measured by the amount of GDP growth generated by each incremental increase in debt) is falling as capital is increasingly misallocated. Economies are also cyclically challenged, particularly with regard to global trade, in relation to which frictions, and pressure on supply chains, are intensifying. The auto and smartphone cycles are turning down and tariffs are rising. Meanwhile, the benefit of cyclical improvement in employment has already occurred.

The current disagreements between the US and China, ostensibly over bilateral trade, run much deeper. There is a bipartisan view in the US that integration with China is a security issue, and that China is a competitive threat. To our minds, this will not prove easy to resolve.

The corporate sector has benefited enormously from globalization, automation and the weak pricing power of labor. Political and geopolitical tensions suggest that these trends may be changing. Although the US economy is relatively closed (with trade representing less than 20%), the profits of America’s largest corporations are highly correlated with global trade.

Animal Spirits

We believe that speculative excess is visible in many markets. The current crop of US IPOs (initial public offerings) are largely unprofitable, and we would contend that valuations are stratospheric. Investment firm PIMCO recently described credit markets as “probably the riskiest ever”,[1] and we concur. UBS recently warned that the US sub investment-grade market (junk bonds and leveraged loans) could lose as much as US$480bn in a downturn, or some 2.2% of GDP.[2] That compares with 1.9% at the worst point in 2009.

The excesses seen in US markets are mirrored elsewhere, with by far the biggest growth in credit having taken place in China. The recent nationalization of Baoshang Bank suggests cracks are forming in the world’s largest and most opaque banking system.

Market structure has also changed radically as ‘price-insensitive’ buyers (passive investors, central banks, and companies buying back their own shares), and black boxes such as algorithmic traders, dominate activity. These trends can give a misleading picture of market liquidity, while underlying liquidity has fallen as banks have withdrawn from market-making.

Over the last decade, US equities, as represented by the S&P 500 index, have posted annualized returns of around +15%.[3] For the period ahead, the picture appears very different: at current valuations and yields, and levels of nominal growth, we see prospective returns as extremely low across financial assets.

A New World Order?

Globalization appears to have peaked for now, and the international organizations, alliances and agreements that characterized the post-World War II liberal order are losing their status in an era of ‘America First’ and parallel nationalist/populist movements across the West. Monetary policymakers at the Fed now turn on a dime, not least because financial markets now dwarf the real economy. Politics appears to be in a state of flux almost everywhere, and the markets hang on President Trump’s every tweet.

We think that the odds that markets can move higher on the back of fresh central-bank easing, or retreat from recent highs, are reasonably balanced. To us, risk and reward are not. At current yields and valuations, we do not think that investors are being compensated for the risks that the benign trends that have supported risk assets for so long may be in the process of changing. As absolute-return investors focused on seeking to preserve client capital as well as growing it, this is crucial to us.

We believe caution and a defensive posture continue to be warranted, but with both investor and policymaker sentiment capable of rapid 180-degree shifts, an ability to be flexible and opportunistic is, in our view, an increasingly valuable asset.

[1] https://www.bloomberg.com/news/articles/2019-05-29/credit-market-probably-the-riskiest-ever-pimco-s-mather-says

[2] https://www.bloomberg.com/news/articles/2019-06-05/credit-losses-could-reach-2-2-of-gdp-when-cycle-turns-ubs-says

Any reference to a specific security, country or sector should not be construed as a recommendation to buy or sell this security, country or sector. Please note that strategy holdings and positioning are subject to change without notice.

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