Seven Investment Themes
The return of volatility to global financial markets in recent months reflects a key inflection point. The long journey towards a zero-interest-rate world provided a significant tailwind for all financial assets, making it relatively easy to secure healthy returns. I believe that period is coming to an end and investors now face the challenge of generating reliable capital growth or income in an environment of very low yields. Living in a zero-interest-rate world is going to be fundamentally different from travelling towards one.
Since the financial crisis, central banks have helped cushion investors from extreme bouts of turbulence by cutting interest rates and injecting huge amounts of liquidity into the system. This fed through into asset prices as the market hung on central banks’ seemingly limitless power to ‘kick the can down the road’. Judging by events in the first quarter, it now appears to be questioning whether they are running out of road.
If we are entering a period where the causes of volatility are changing, investors will need to look beyond the inevitable bursts of turbulence and identify the key drivers of long-term investment returns:
With the global economic outlook still relatively fragile, it appears monetary policy around the world will remain extremely loose for a good while yet. Indeed, even in the United States where the labour market has continued to tighten, expectations of stronger inflation remain low. The Federal Reserve surprised investors when it seemed to express more concern about the external economic environment than the domestic one and began talking about slowing the pace at which monetary policy is likely to be tightened. As a result, real US monetary policy (allowing for inflation) will effectively remain unchanged this year in my opinion. The Fed’s comparatively accommodative stance should relieve some of the pressure on central banks in emerging nations, many of which have had to hike rates to defend their currencies and quell inflation. Meanwhile, I anticipate that the European Central Bank will keep policy accommodative but not loosen it further while the Bank of Japan will continue easing. All told, I expect monetary policy around the world to be looser than previously envisaged. That should underpin global economic output, at least in the short term. But there are now question marks as to how effective this policy action will be in the long run. It seems likely there will be a tug of war developing in financial markets, with periods of relative calm when markets have confidence central banks remain in control, interspersed with highly volatile periods when fears that policy is becoming ineffective dominate. A key risk for markets is stronger-than-expected US inflation. That might put pressure on the Fed and result in markets pricing in a more aggressive path for rate hikes a�� with significant consequences for the US dollar and all asset classes.
With China’s economy having expanded last year at its slowest pace in a quarter of a century, stabilising growth appears to have replaced economic and structural reform as policymakers’ key objective in the near term. With the government acutely aware that a protracted slowdown could be destabilising, the authorities’ task of shoring up activity has assumed a new urgency. And so the National People’s Congress recently set a target to stabilise growth this year at between 6.5% and 7%. I think Beijing will ultimately succeed in this goal. Credit expansion and increased fiscal spending are the key policy tools being used to boost growth. While the stimulus measures are expected to deliver the required rate of growth this year, there is concern that the approach adds more to the already large debt overhang that has resulted from past credit accumulation. The problem is that China’s total debt to GDP ratio already stands at around 230%. Corporate debt alone represents around 160% of GDP. This is worrying, particularly given overcapacity in sectors such as steel, coal and cement. The government’s renewed focus on growth via investment means the overcapacity issues facing these industries will be postponed. By putting off the reforms that are crucial to its long term health the danger is that the authorities are storing up an even bigger problem for the future. One consequence of this is that I think the Chinese yuan will be allowed to gradually depreciate, which will have an adverse impact on the country’s Asian trading partners.
Reflation over Deflation
With headline inflation rates currently negative in the euro zone and Japan, and less than 1% in the UK and US, there has understandably been much talk in recent months about whether central banks will be able to ward off deflation. However, one of the consequences of the first two themes is that this can lead to inflation gradually returning and fears of deflation will eventually be laid to rest. For a start, much of the fall in inflation over the past year can be explained by the protracted plunge in oil prices. Unless oil prices slump anew, that effect will inevitably begin to diminish. For the time being, oil prices have begun to stabilise, partly because more and more US shale producers have been forced out of business. Furthermore, the underlying inflation picture has also started to improve. Core inflation in Europe and Japan is around 1% and US core inflation around 2%. Because of this, I expect an extended period of loose monetary policy (alongside a stabilisation in commodity prices) that will support steady reflation.
The sharp fall in oil prices in 2014 and 2015 prompted concern about the global economic outlook. That in turn affected equities and other asset classes as investors worried about the earnings of energy companies and miners, as well as banks exposed to the commodity sectora��s debts. However, falling oil prices were not a harbinger of global economic weakness. An increase in the supply of oil rather than a lack of global demand a�� which was actually stronger in 2015 than the previous year a�� explained the fall. While it is true that the break-even price of oil has fallen in recent years due to technological advances, prices are now close to the marginal cost of production. That suggests prices should start to stabilise back to sustainable levels of between $60-70 per barrel by the end of 2016, although a further significant recovery is not expected. As for other commodities, I think that there will be a dispersion of performance. The recent reversal in course taken by China has lifted the price of various industrial metals such as iron ore and copper. This revival, however, is not expected to be sustainable in the longer term. As for other commodities, in instances where Chinaa��s share of global demand is smaller, I am less bearish.
Although I think economic growth will pick up for the reasons already outlined, I remain concerned about the amount of debt that has built up around the world, which in some cases is arguably unsustainably high given the low current rates of inflation and economic growth. However, differentiation needs to be made. While private sector balance sheets are much improved in developed countries, such as the US and to some extent the UK, public sector debt has ballooned. But given that central banks own much of that debt and little expectation that government bonds will be sold back onto the market, the debt burden in these economies is not as much of a problem as the headline levels imply. The picture in emerging countries is of greater concern. While debt ratios may be lower, interest rates are much higher and more volatile than in the developed world. As a result, these countries cannot necessarily maintain the same level of debt as advanced nations. Increasingly, investors will have to focus again on the economic fundamentals of each issuer rather than apparently attractive yields.
From Collective to National Risks
The global financial crisis dislocated existing political orders as well as economies. Rising unemployment, falling living standards and widening inequalities between rich and poor have resulted in greater geopolitical instability and a rising tide of nationalism. Consequently, the world seems to be tempted to move away from trying to tackle problems a�� such as the Syrian civil war or the European migrant crisis a�� and appears to want to collectively move towards taking a more nationalistic approach. That development has been reflected in the US presidential campaign, the rising popularity of nationalist parties in Greece, Spain and Portugal, and in the UKa��s referendum campaign on EU membership. At the same time, the rise of China and an increasingly assertive Russia are leading to a multi-polar world, which is exacerbating geopolitical tensions and creating potential flashpoints in many regions. Political and geopolitical uncertainty results in market volatility, as seen with sterling in the past few months.
Changing Market Structures
Calamities, such as the global financial crisis, have periodically struck financial markets throughout history; the tulip mania of the 1630s providing an early example. Inevitably, these events precipitate a wave of new regulation that also often produces unintended and unwelcome consequences. The concern has always been that new rules are designed to address the excesses that caused a past crisis, rather than anticipate the next one. The authorities have introduced a raft of new regulatory requirements since the global financial crisis. The indirect impact of some of these measures is becoming apparent. For instance, new capital rules have seen banks retreat from certain risk-taking activities. That has resulted in sharply reduced levels of liquidity in some markets, particularly in certain areas of fixed income, such as high-yield debt. This, potentially, makes it appreciably riskier to invest in these asset classes than was previously the case.
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