“Prediction is very difficult, especially if it’s about the future”.
Risk assets maintained the momentum they had shown in the second half of 2016, enjoying yet another bumper quarter in the opening months of 2017. The enthusiasm was global and spanned all risky assets. Strong markets also allowed debt issuance and merger and acquisition activity to boom.1
In contrast, fear was in short supply; as the U.S. indices made subsequent new record highs, the VIX volatility index (broadly the cost of hedging equity risk) consistently languished at low levels.2
Although most commentators seem to agree that we live in acutely uncertain times, financial markets appear to be strongly indicating the opposite. From a sentiment and valuation perspective, the inference is that things have almost never been so good, and many observers seem to expect them to get better.
What is driving the markets?
The dominant narrative appears to suggest that the answer to that question is further acceleration in global growth. In practice though, we think this is not entirely clear.
Is global growth really accelerating? Although the soft data (sentiment surveys and purchasing manager indices) have been very strong, the hard data from real economies remains rather mixed.3
Moreover, the surprise to us in the quarter was that neither the signature ‘global reflation’ trades nor many of the areas associated with ‘Trump reflation’ moved with expectations; U.S. Treasury yields did not rise any further, while the U.S. dollar and the oil price both fell. We see the latter as important as recent energy-price inflation has been seen as the indicator of both cyclical demand and the return of pricing power (despite the fact that the sharp upward move in the autumn of 2016 was triggered by OPEC’s promised supply constraint).
In the U.S. equity markets, the top performers during the quarter were not the apparent beneficiaries of the new administration’s stated policy stance, such as financials, but instead were the multinationals and giant technology stocks which represent large index weights in the exchange-traded funds beloved of retail investors.4
Much of the consensus thinking around rising U.S. activity appears to reflect the renewed conviction of the U.S. Federal Reserve (Fed), which is finally deemed by some to be on a rate-normalization path. We believe the forecasting ability of the U.S. central bank is however legendarily poor, such that even a Fed governor, Neel Kashkari, admitted in a recent blog post that the central bank’s forecasts had been “wrong a lot over the past few years”.5
It is not only forecasting of economic activity that is fraught. In the U.S., official gauges of current economic activity do not even seem to us to agree. The Atlanta Fed’s ‘GDPNow’ is indicating annualized growth in the U.S. running at an underwhelming 0.9%,6 whereas the New York Fed’s model predicts a more robust 2.9%.7 We observe that Wall Street’s investment banks are hovering somewhere in the middle, at around 2%, which, like most forecasts, appears to be largely an extrapolation of the level around which U.S. GDP has been oscillating for years.
In keeping with the consensus view about the likelihood of stronger economic activity seems to be the conviction that a better demand environment will translate into higher consumer-price inflation and higher interest rates. Like many features in economics, we view ‘inflation’ as a slippery concept and, somewhat remarkably, while policymakers seem confident in their ability to ‘target’ an inflation rate, the traditional theories describing what drives general price inflation do not seem to be behaving.
In recent years, neither low, nor indeed no, interest rates nor money printing nor relatively full employment appear to have generated the ‘inflation’ in general prices that the authorities want (in order to inflate away debts and create the level of nominal growth to pay our bills).
To cut a long story short, our view is that the theories that imply causal relationships between economic variables (e.g. between interest rates and goods prices, or between wage inflation and general inflation) vastly oversimplify what really happens in a highly complex and adaptive system. At the current time, we would emphasize, for example, that profound changes in technology have combined with demographic change and generationally cheap money to produce radically different marketplaces for labor, goods and services. Much of the labor market and many sectors of the economy now appear to lack any form of pricing power. We believe that this abundance of competitive pressures clearly challenges the transmission of any underlying inflationary impulse.
In practice, of course, there has been lots of inflation; it has simply been of the asset-price variety. Many asset valuations are at levels we regard as eye-watering versus history. If this ‘inflation’ and its attendant wealth effects cannot be sustained, we believe the outlook will once again revert to being distinctly deflationary.
When it comes to consumer-price inflation, much of the impetus in recent months seems to have stemmed from energy and commodity prices. This effect is now fading, as the year-on-year change in oil prices drops from the more-than-100% increase in mid-February to 30% at the end of March.8 Furthermore, should the West Texas Intermediate oil price remain unchanged (at the end Q1 price of $51 per barrel), we calculate that this annual increase would drop to near zero by the end of Q2.
In some economies, such as the U.S., the headline rate of inflation is boosted by housing costs (broadly asset-price inflation) and health care. In others, such as the UK, the energy-price squeeze is exacerbated by the fact that purchasing power has fallen in line with currency depreciation. The point is that, other than in China, where infrastructure investment has once again been ramped up, it is not clear to us that the rising levels of consumer-price inflation that are visible reflect stronger underlying demand. Indeed, we think it is more likely that much of the inflation we are seeing constitutes a ‘tax’ on economic activity, and thus that it may represent a late-cycle indicator of impending economic weakness.
Follow the money
As we discussed last quarter, our feeling is that the relentless financial-asset inflation that we have seen in recent years (despite rolling crises and a challenging growth and profit backdrop) is a function of markets that have adapted to the idea that money will remain cheap and the central banks will always be there to provide a ‘put’. We think it should be remembered that quantitative-easing-style asset purchases were always supposed to be temporary but, because they are hard to reverse, they have somehow morphed into a permanent level of support.
Under these laboratory conditions, we note that the financialization of our economies has thrived, swelling the community of traders and algorithms utilizing ever-higher levels of leverage. Indeed, given that the bull market is now eight years old, many working in the markets today have never operated in anything other than conditions we would describe as state-inspired asset inflation. As the Bank for International Settlements has noted often, this support has mostly been asymmetric – reinforcing the markets’ Pavlovian tendencies (i.e. central banks move to support markets when they fall, but do not fully withdraw the stimulus when they recover).9
That said, commitment to unconventional monetary policy, and the actors involved, have changed over time. In the last few years, the U.S. Fed has wound down its official asset purchases, while the European Central Bank (ECB) and the Bank of Japan (BoJ) have ramped up theirs. What is most interesting to us is that the most dynamic player in the mix has been the People’s Bank of China (PBoC). In the more recent past, we observe that the ebb and flow of PBoC stimulus has been the main driver in the overall size of central-bank balance sheets globally.
Indeed, when it comes to both state intervention in the financial markets and credit expansion, we would suggest that China leads the world. The Chinese authorities were particularly shaken in the wake of the global financial crisis and escalated their efforts to sustain the growth rate they deem it necessary to achieve. The side effects of excess domestic liquidity sloshing around in China might be likened to the children’s game ‘whack-a-mole’, in the sense that authorities periodically seek to depress speculative bubbles, only to have others pop up in different parts of the economy (in real estate, equities, credit and commodities for example).
By the summer of 2015, global central-bank purchases of financial assets were averaging around $5 trillion per annum (helped by new BoJ and ECB programs), and a ‘mole’ had well and truly popped up in China’s equity markets, with the A-share index rocketing by about 150% in a year.10 The PBoC reacted by draining liquidity in a couple of phases, which saw the world’s aggregate asset purchases fall to virtually zero by February 2016 – around the time at which the world equity index was plumbing its 2016 trough.11
Did global financial stability concerns then cause the PBoC to reverse course once again? Who knows, but that is what happened, and again, with the help of the ECB/BoJ, the headline level of asset purchases rose, this time to an annualized $6 trillion by July 2016, matching the highest level of support for financial assets seen since the start of the crisis.12 In this context, it is perhaps not surprising that risk assets rebounded sharply from last year’s swoon and not only shrugged off, but reveled in, the referendum results in the UK and Italy, OPEC’s plan to boost the cost of energy, and the election of Mr. Trump.
Clearly one needs to be careful not to confuse correlation and causation, but in our view the story of the markets remains one of state-inspired interventions, allied with consistent encouragement of private-sector credit growth to maintain and sustain current levels of GDP in the real economy (by continually bringing tomorrow’s demand into the present). This seems to us to be as convincing a narrative as the official one which states that what has ailed economies has finally been ‘fixed’ and that normal service (i.e. post-war levels of growth and inflation) will resume imminently.
Despite the obvious and growing influence of China, which is where the real action is, we see financial markets as remaining highly U.S.-centric – focused on forensic analysis of all utterances and actions of the U.S. Fed, which has actually only raised rates by 0.25% three times in 10 years. Aside from its influence in terms of official asset purchases, the world’s second-largest economy, China, is, we calculate, also home to almost half of the world’s growth in credit and has a banking system that is now twice the size of that in the U.S., despite it being 40% smaller.
At the time of writing, China appears once again to be attempting to remove stimulus and rein in excesses in its credit markets, shadow banking system, and real-estate sector. We cannot be sure whether China’s influence will extend into global markets in 2017, but we think it remains the major elephant in the room.
The Trump effect
An integral feature of the ‘global reflation’ narrative is that the new U.S. administration will ignite ‘animal spirits’ in the economy, and thereby transform its outlook. Expectations of a stronger U.S. economy appear to have coincided with a similar turn in the rest of the world, offering the tantalizing prospect of a synchronized global upswing.
We think this is odd, given that much of the ‘America first’ agenda would be likely to be contractionary for the world in aggregate. To us, the uncomfortable truth is that globalization has probably been a net positive for the U.S. – and particularly for the U.S. corporate sector – but it has certainly not benefited particular constituencies. The problem is that these are difficult constituencies to satisfy, and to our mind their employment and status have been affected as much by new technologies such as automation and monetary policy (asset inflation) as by the liberal economics of globalization.
The key fact is that the counterpoint to a loss of pricing power by labor has meant greater returns to capital and the corporate sector. U.S. domestic companies have much higher than average margins, partly as a result of having squeezed wages.13
To us, this is at the heart of the inconsistency of ‘Trumphoria’ in the equity market. If Trump is indeed going to up-end these trends, in order to keep his promises to the wage earners, we find it hard to see how this will be hugely positive for the corporate sector, or particularly for Wall Street (which has been the beneficiary of more than three decades of asset inflation). If Trump really does have the ‘little guy’ at heart, then watch out Wall Street!
As the first months of the Trump administration have unfolded, our initial thoughts about the likely scale of the legislative challenges have not changed. A business-friendly, smaller-government U.S. administration is potentially great news, but the expectation that it can reform taxation, deregulate the financial system, and embark on widespread infrastructure spending in its first year or two is wildly optimistic in our opinion.
We think the failure of the administration’s ‘first priority’, to repeal and replace the Affordable Care Act (‘Obamacare’), is indicative of the tangled web of vested interests in the U.S. legislature. The new administration’s other priorities, particularly tax reform, appear no less complex. We think expectations of easy policy success remain too high.
Lots of anomalies…
The many gaps between expectation and reality (or what seems realistic), to us, seem to sum up the current backdrop.
Given the sticky structural backdrop of intense disruption by new technologies, overcapacity, adverse demography and enormous debt levels, we do not see why mature economies are going to revert suddenly to the higher levels of nominal growth seen historically. Nor do we see strong demand-driven inflation on the horizon, and, given that inflation is generally a lagging indicator, the uptick we are seeing may signal that we are late in the cycle. It is worth remembering that this cycle is now eight years old, and that the current U.S. equity bull market is the second longest on record.14
The famous investor John Templeton suggested that “bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria”. We cannot be sure where we are right now of course, but momentum and sentiment towards risk assets looks highly optimistic to us, bordering on the euphoric (Trumphoric even), in the U.S.
What we do believe we can be sure of is that, as this bull market continues, and valuations ratchet ever upward, the risk/reward becomes more skewed to the downside. We believe the longer-term returns investors should expect at current valuations are now very low indeed, and reversion to a more ‘normal’ earnings multiple would be likely to herald a significant drawdown.
This combination of what we see as higher risks and lower expected returns is particularly pertinent to an absolute return strategy, and underlies our continued caution.
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1 Source: Bloomberg data, 04.01.17
3 Source: Thomson Reuters Datastream, 04.01.17
4 Source: Bloomberg data, 04.01.17
6 Federal Reserve Bank of Atlanta, April 2017.
7 Federal Reserve Bank of New York.
8 Source: Bloomberg data, 04.01.17
10 Source: Bloomberg data, 04.01.17
13 Source: Bloomberg data, 04.01.17
14 Source: Bloomberg data, 04.01.17