3 critical issues for investors today
Markets are enjoying a cocktail of somewhat synchronised global economic growth, positive but low inflation and central banks with their feet still on the accelerator. This is a potent mix that will require investors to focus on some important but interconnected areas.
So far this year fortune has favoured the bold. Investors prepared to buy and hold risk assets have, by and large, done well. Emerging markets and tech stocks have headed the list but broader global equity market indices have also done well. Gains have also extended to credit markets with both high yield and investment grade benefitting from further spread compression. Volatility has been virtually non-existent – the ride has been smooth.
I think I’m one of the only Australians who has never been to Bali. There’s no particular reason for this but it’s just never been on my holiday list. Bali’s hit the headlines due to the potential eruption of the Mount Agung Volcano and the evacuation of more than 130,000 people living around the volcano’s crater. Increased seismic activity over recent weeks has been a handy precursor to a possible eruption and while no doubt inconvenient, it has allowed residents to get out of danger. At the time of writing though, no eruption had occurred and the focus of media attention had shifted to the negative impact of the volcano warnings on tourism. Damned if you do, damned if you don’t.
This increase in seismic activity is in stark contrast to the lack of volatility in financial markets. Unfortunately financial markets rarely provide the same warning signs as active volcanos. That said, the fact that market volatility is low does not mean we can stay relaxed and comfortable, but nor does it necessarily presage calamity. Markets are enjoying a cocktail of somewhat synchronised global economic growth, positive but low inflation and central banks with their feet still well and truly on the accelerator – even if some have eased off just a notch. This is a potent mix and one that typically correlates with strong markets and low volatility.
In the absence of an equivalent increase in “seismic activity”, the critical issue for investors today is what breaks this cycle.
In my view there are 3 critical and interconnected things to look at:
The first is valuations. We know that valuations are crude tools in the short run but as our time horizon extends so too does their worth. Valuations tell us that markets are extended having in many cases discounted future returns into current prices – not that unusual to be sure, but clearly helped along by policy makers’ intent on distorting the pricing and allocation of risk in the economy. This is true for both bond and credit markets where risk premium continue to narrow. What this tells us is the base is shaky. To extend the volcano analogy – pressure below the surface is building.
The second issue is inflation. Despite flirtations with deflation and reflation, inflation globally has remained benign due largely to the overhang of capacity in both labour and product markets. However this excess capacity is disappearing. At the pointy end is the US labour market which has gradually tightened. The relationship between inflation / wages and the unemployment rate is non- linear which means that inflation responds more substantially when the unemployment rate falls significantly below the NAIRU. Current estimates have the NAIRU at 4.7% (albeit there is a range of estimates) compared to a current unemployment rate of 4.3%. If this trend continues we would expect inflation to respond.
The third is central banks. The response of central banks to rising inflation, starting with the Fed, is what I think will ultimately lead to a repricing of risk in markets. The mismatch between rates and nominal growth in the economy is still significant meaning there is plenty of scope for rates to rise. Importantly, this would matter less if valuations were more supportive, but arguably extended valuations heighten the risk that even smaller changes in policy can have a disproportionate impact on asset risk premium.
Clearly, the Real Return strategy would have delivered higher absolute returns if we’d backed the risk trade. Ironically though, it’s the markets that have performed the strongest this year that offer amongst the worst returns on a prospective basis, especially once adjusted for risk …. and have done for some time.
Our strategy remains to straddle the gulf between an environment of extended valuations and heightened capital risk with the more constructive cyclical backdrop of reasonable growth, low inflation and supportive policy. The likely pick-up in inflation will cause volatility to rise and some rebuild of asset risk premium. In the absence of a recession we expect (at this point anyway) to be a buyer on weakness but are not willing to risk investor capital on buying overextended and high risk markets at this point in the cycle.
While headline asset volatility (bonds and equities) has been low, sub-asset class volatility has seen more action. Currency markets have created opportunities. US dollar and GBP weakness (for different reasons) have created opportunities which we are taking in the portfolio. Likewise we are looking to position for a change in the volatility environment through a series of positions that will perform well should the current malaise be shaken off. These include a long US utilities v tech position, a long USD v AUD position, S&P put options and of course exposure to safe and liquid short dated securities and cash.
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