Investment View October/November 2014
The autumn calm has been broken by a period of sharp volatility across world markets. Recent volatility has been driven by fears that central banks will step away from providing support just as the global economy begins to slow: fears that many, including us, believe are misplaced.
In Europe, inflationary risks are receding and the probability of outright quantitative easing is growing. Since 2009 developed market central bankers have shown themselves to be exceptionally dovish. Certainly in recent months some have expressed more hawkish sentiments but have retreated. But this does not change the core realities of their positions.
At the European Central Bank Mario Draghi is currently releasing a cocktail of stimuli set to inject €1 trillion of credit as directly as possible into the Eurozone economy. The Bank of Japan remains committed to quantitative easing (QE) and the chief economist of the Bank of England Andrew Haldane has indicated UK rates will stay lower for longer if the economic soft-patch persists.
Most importantly though, within days of this volatility appearing, Federal Reserve central bankers were quick to raise the prospect of slowing the tapering programme if events required it. We believe this generation of central bankers is determined not to be held responsible for a market capitulation.
The focus of economic fear has of course been Europe. In part this can be attributed to renewed fears that the sovereign crisis will re-emerge in Greece if the current government fails to maintain a majority. However, it is also linked to more serious fears over whether political opposition from Germany will prevent the European Central Bank (ECB) acting to tackle Eurozone deflation. Recent tough talk from German politicians reflects a conviction that action should not be taken simply in response to a soft patch in economic data. This may be so but it is likely that over the medium to long-term the more profound economic fear of deflation will drive policy decisions.
Added to this is the fall in the oil price in recent weeks towards $85 a barrel for Brent Crude. Whilst other central bankers may seek to strip out the impact of the oil price from their calculations, it is thought that the ECB, with its unrepentant focus on ‘core’ inflation, will include it and conclude inflationary risks are receding.
Taken together these factors lead many to believe that the probability of outright QE from the ECB, in addition to its already announced stimuli, is growing. However, the existing policy mix is highly supportive in its own right.
None of this takes away from the fact that economic momentum is slowing. This backs up a wave of economic data in recent weeks which shows that whilst US consumer confidence and employment remain relatively buoyant, industrial activity is slowing.
However, historically equity investors have achieved modest positive returns in the slowdown period and indeed history suggests that the economy will often swing back from slowdown to recovery. The use of central bank forward guidance has created a perception that central banks are underwriting equities, known in the markets as the “Draghi put”, for example. When accompanied by massive liquidity provision, the effect has been to suppress volatility, creating an environment where investors are willing to accept lower returns whilst taking greater risks.
This is a dangerous process as it can, and has, led to the creation of bubbles in asset prices. The concern is that current central bank policy will lead to a massive misallocation of capital and the same problems which led to the Global Financial Crisis. The bubble would be in a different market but may prove as damaging. However, such concerns have been downplayed by Federal Reserve Chair Janet Yellen. In recent comments to Congress she indicated that she would only be worried if financial market bubbles threatened a systemic crisis and, as the banks are now better capitalised, that risk is low.
The question for investors is whether this environment has made equities too expensive. There are certainly pockets of the market which seem frothy, but in aggregate we do not see significant overvaluation. For example, price-to-earnings ratios have risen over the past year and are generally above average but are not extended, with most markets trading well within their historical range. The exception would perhaps be the European markets of Spain, Italy and France which seem to be discounting a significant recovery in earnings. At the other end of the spectrum, Japan and the emerging markets look attractive on this metric. The recent period of volatility has seen a change in the relationship between the global equity index and sovereign bond yields, from one where both moved in the same direction to one where the two have parted company. Some see this as setting up a battle between bond and equity markets: falling bond yields are often associated with expectations of weaker growth, which is a bad outcome for corporate earnings and thus equity prices. Since global growth expectations have been falling this year, the argument goes that equities will soon start to track bond yields lower, and the correlation between the two will become positive again.
Another important factor supporting equity exposure is that policymakers are committed to economic recovery. Reviving and sustaining economic growth, as well as reducing unemployment, are the priorities. Consequently, in the debate about sustainable growth and corporate earnings, there is a sense that central banks will respond to economic weakness, just as the European Central Bank has recently done.
.Amidst concerns about an end to the equity bull market and the seemingly conflicting behaviour of bonds we remain positive on equities. We still believe that equities can generate a premium for investors. Moreover, policymakers continue to target growth and in doing so offer support to equities.
I had intended to look at property in this edition of Investment View but the volatility of the last two or three weeks moved that topic off the agenda. Suffice to say that during this period of turbulence property has performed as it should: robust and steady. Those that continue to be somewhat sanguine about the sector should consider taking another look. Yields are attractive and overall returns are appealing. Property let everyone down in the financial crisis but it is proving its worth to have in a portfolio once again.