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Preamble:
The first and almost final draft of this paper was written in late January, but a few days in markets can make a world of difference. While I’ve incorporated the early February acceleration in volatility into the text, the essential conclusions are unchanged and the focus of the paper remains on the medium-term outlook, as who knows where we’ll end up in the short term. We outline in this short note what we see as the key issues for 2018, how this could play out in financial markets, where the risks lie, and how we are approaching these challenges from a portfolio construction perspective.
Overview:
Investors with a cautious view of the world ended 2017 with egg on their faces. Equity markets reached new highs, credit spreads narrowed significantly and investors generally were rewarded for taking risk. The more risk taken, the better the returns. Geopolitical risk did not derail asset markets, nor did increasingly demanding valuations. Instead, relatively synchronised global growth, rising profits and low inflation have allowed central banks to continue to tread gently. The party rolled on.
We did not expect 2017 to go as well as it did. We were among the nay-sayers arguing that relatively full valuations made markets vulnerable, and while we did not expect that this alone would topple markets, it did mean future returns would be modest, at best. While we may ultimately be right, 2017 was clearly not the year.
Inflation and valuation
In essence, and notwithstanding early February falls in risk assets, there are two critical differences between today and 12 months ago. The first is that valuations in risk assets are materially more demanding, particularly at the end of January. Equity multiples are higher and credit spreads narrower. The second is that the preconditions for rising core inflation have continued to build and, as our base case[1], is more likely.
Medium-to long-run valuation metrics summarise the valuation challenge. While the Shiller PE framework has its critics (and criticisms[2]), it does provide a relatively independent and agnostic starting point. The end January Shiller PE of 34 x is at its highest level since later phases of the late 1990’s tech bubble and implies returns of around 0% pa in real terms over the next decade.
Outside the US, the extent to which structural valuations are stretched is less evident but nonetheless has similar - although less extreme - implications for returns.
We believe there is mounting evidence of building pressure on core inflation, especially in the key US market, and this will start to exert itself in coming months. Our arguments rest on the idea supported by the Federal Reserve and other academic research suggesting that the Phillips curve is non-linear and that we are approaching the levels of unemployment in the US where wage growth will assert itself - it may be mild by past standards, but nonetheless still evident. Anecdotal and hard data support this premise and we expect to see evidence continue to mount as 2018 unfolds. Walmart, known for being a tough employer, has recently agreed to raise its starting wage and expand benefits to employees.
The critical questions will be: how do policymakers respond? Are central banks behind the curve? Or perhaps more importantly, how significant this shift in inflation is to investor perceptions about the prices they have increasingly been prepared to pay for assets.
Blow-out, or blow-up?
Sovereign bond markets have had a shaky start to 2018 after trading in a pretty narrow range in 2017. We have argued for some time without much reward that there is a mismatch between the level of yields prevailing in key sovereign markets - especially the US - and economic conditions, and yields were unsustainable in the medium term and that remains our base case. While we are encouraged in this view by the recent rise in yields, in the absence of hard evidence of rising core inflation, we will curb our enthusiasm in calling a start to a “bear” market in bonds, as it overstates the impact on overall bond returns, albeit we do expect sovereign yields to continue to rise from here. The bigger risk from rising yields is on financially leveraged assets (like A-Reit’s and infrastructure) that have, at least until recently, seen significant price appreciation directly related to lower yields.
The difficulty though is timing, mainly because the macro-economic and policy environment is still broadly favourable. As recent volatility demonstrates, markets are vulnerable; but, as history tells us, that alone is not sufficient. Equities were expensive in 1998 and 1999 and didn’t fall sharply until 2000. Likewise, credit spent three years in the mid 2000s at lower spreads than they are at today, before unravelling through the GFC. For equities in particular, it is entirely possible that in the near term further gains accrue as markets ‘blow-out’ in the absence of an economic or policy shock. What could this shock be? As noted above, rising inflation will be the most probable culprit, and the risks here are building. The more material challenge for markets would be recession, and we do not think this is likely on a 12-month view.
There is a fine line between a blow-out and a blow-up. Notwithstanding the arguments made above, and the early February correction, market valuations aren’t cheap and are supported by relatively utopian assumptions about ongoing growth, low inflation and policy accommodation. In a logical world therefore, the catalyst for a blow-up lies with anything that challenges the fundamental macro and policy support for the market. A growth shock (potentially China); a surprising pick-up in wages/core inflation (especially in the US or Europe); a policy shock (such as trade war); or central banks either failing to respond adequately to rising inflation, or indicating a more aggressive path to normalisation, would all have the potential to derail investor comfort.
The near euphoric sentiment evident in January was a good precursor to February’s repricing. The bigger risks though are fundamental, and rising inflation is a legitimate cause for caution.
How are we dealing with this in portfolios?
Fortunately, our job is not to accurately forecast market returns over the next 12 months, but to invest client money to achieve agreed performance objectives amid inherent uncertainty. Forecasting is a means to an end, but not the end itself — investment and portfolio construction implications are more important. In this context, we believe the implications of the current environment are as follows:
- The valuations embedded in most assets make low nominal and real returns at an asset class level over the medium term a near certainty.
- As we’ve recently been reminded, the path to lower returns won’t be smooth. Low volatility is not the norm. While 2018 might again defy gravity, this will simply make the outlook beyond that more challenging.
More specifically:
- Our well documented concerns about the mismatch between volatility and risk in asset markets has been validated in early February with sharp falls in risk assets and rising market volatility.
- We don’t expect a major bear market in risk assets to start just yet, but current valuations and the asymmetric risk in bonds and credit suggests heightened vulnerability;
- Returns from risk assets — equities and credit— will moderate as valuation constraints exert themselves;
- We are seeing a spike in volatility and expect heightened volatility to remain, largely on the back of rising inflation and growing uncertainty about how central banks will respond;
- We are relatively “cashed-up” and focused on high-quality assets with reasonable liquidity. All else being equal, we expect to be tactical buyers of risk assets on weakness;
- Investments and strategies that perform well in moderately rising inflation environments are favoured, and we continue to incorporate these into our portfolios. These include cash, inflation-linked bonds, break-even inflation positions, and the avoidance of bond sensitive sectors (like A-REIT’s);
- With broad markets likely to deliver moderate returns at best, we believe cross market strategies will be important sources of return. In this we include currencies where volatility is more “normal” and both strategic and tactical mispricing evident (e.g. GBP and USD v AUD);
- The risks around this outlook we’d simplistically describe as either “blow-out” or “blow-up”. The critical question is which is the most important? For us, a “blow-up” takes precedence as the minimisation of drawdown risk is crucial to the achievement of our objectives across most of our client portfolios.
- While we may again leave some return on the table by not adopting a more aggressive near term stance, we are not uncomfortable with taking our chance here given that the medium-term risks favour the “blow-up” scenario.
For those interested in more depth, we have a more comprehensive outline of our analysis available here.
[1] "Inflation and markets - where to from here?" White paper by Simon Stevenson - Head of Strategy, October 2017
[2] The main criticism at present is that as it uses 10 year trailing earnings, and we haven’t had a recession in that time (trough to peak earnings) that it overstates the valuation multiple of the market calculated in this way.
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