Earlier this week we witnessed markets behaving in a manner that we have been expecting and waiting for. It’s comforting to see the extreme heat come out of asset markets – but we’re not suggesting a couple hundred points off the FTSE 100 suddenly represents great value. Valuations are still pushing levels that we deem to be expensive and unsustainable, whilst bonds, despite coming back somewhat (The German 10yr Bund one month low was 0.48, today it stands at 0.88) are still incredibly subdued.
So is this an inflection point, where we’re proved right? Maybe, and I really do hope so.
Central banks will not be able to control the market behaviour forever, that I’m pretty sure of, and in the absence of earnings growth and significant pick up in the health of the consumer, the chances of a mismatch are greatly increased. Worryingly so.
Mario Draghi spoke this week and warned market participants that volatility is here to stay – which is perhaps an indication that the authorities recognise it may get rather messy and the recent years of market manipulation has created something of a unstable monster. The speech was felt throughout bond markets, with the German Bund experiencing the worst 48 hour period since the inception of the Euro. To me, it sounded very much like acknowledgement that the ECB will no longer be responsible for safeguarding bond participants (and as a by-product, equity participants). I wrote recently about the lack of liquidity in bond markets, which will only magnify such issues. With the risk free rate moving higher – a phase with bonds at sub 1% is perhaps something of a juxtaposition – it has left parts of the risk universe horribly exposed to weakness – and we’re witnessing that being put right. Bond yields had been manipulated too low, and the equity markets are recognising that without other markets being ridiculously expensive, they’re in danger of no longer being the ‘least worst asset class’ whilst also acknowledging that central bank policy has not generated economic growth in line with forecasts and valuations.
We also suspect the US Dollar carry trade is unwinding – a typical consequence during a period of ‘risk off’ as investors look to neutralise assets and liabilities – the significance of this is that quality collateral (Bunds, Treasuries) is also sold off against this unwind, again, amplifying the weakness. The shift in bond yields may prove to be deflationary forces also, which throws more fuel on the disinflationary fire that’s already cursed many markets for some time now. Longer term, deflation is of course good for Bonds (bad for equities?), but at current levels, it’s questionable as to what is really being priced in and the short term direction is very uncertain. If we are the beginning of a bond sell off, then EM economies may suffer greatly. Courtesy of Andrew Hunt Economics, (Fig 1) shows the flow into such markets since 2005. If this is repatriated, it could get rather bloody, and we remain guarded.
In August 2012 I wrote on record that “rates are likely to remain low for a considerable amount of time – perhaps even into the next decade” – it was bit of a punch-line to get attention, but I think it remains valid. Ok, we may witness a tweak or two between now and 2020 – but no more, and based on little more than lethargy perhaps.
The financial sector is positioned far more robustly than it has been for some time, so we applaud the authorities for righting that dynamic (putting aside the rather precarious situation surrounding some fringe European entities), yet economic data remains fragile and we’re getting to a point where the government and central bank tool kit is empty. So we move now perhaps from relying on the authorities to support the markets, to asking the banks to take on the baton and support the consumer. Fig 2 is perhaps a crude indicator of just how little supply and demand there has been for credit in the UK. M4 is a broad measure of notes and coins in circulation, including bank accounts. For inflation and credit growth to reappear, we do really need the banks to increase supply at a rate low enough to entice individuals and SMEs to borrow (the lifeblood of many economies) – at present there is a huge gulf between supply price and demand affordability. However, loose lending practices are not something we wish to revisit anytime soon, so what is the right balance?
Our approach to investing has gently evolved over recent years but we haven’t lost sight of the end game and what is expected of us. There is seldom a bad time to take profits, which is something we have done modestly over the past week. Now it’s our duty to ensure we rotate the proceeds wisely and at an opportune time. Cash is as good an investment at present than it’s been for quite some time (noting the low / negative levels of inflation) – but we hope it remains an interim measure.
Weekly Comment - Week 25, 2015