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Batten-down-the-hatches?

11 May 2018

We recently received a number of questions from investors on whether we thought the economic and capital market cycle is coming to an end. Basically, is it time to ‘batten down the hatches’? The UK’s uncertain post Brexit trading position was another source of concern, with some fears going as far as anticipating the reappearance of 1970’s style capital controls. After years of quite pleasing investment returns, there is clearly a growing private investor sentiment of ‘should I take what I have and run before the pain begins in capital markets?’

We discussed in last week’s lead article how the slowing of global economic growth, together with a return of some inflation, is currently having a sobering effect on stock markets world-wide, following their short but concerning fling with ‘irrational exuberance’ in January. This week’s postponement of a second rate rise by the UK’s central bank (Bank of England / BoE) on grounds of diminishing economic growth and inflationary pressure has added to the sense that all is no longer well in the global economy.

Donald Trump’s renewed assault on global diplomatic consensus by withdrawing the US from the Iran nuclear deal, which took 10 hard years of negotiations, adds to the fear of potential unwelcome external shocks. After opening the prospect of a trade war with China in April, his pouring of oil onto the lingering flames of the tensions in the Middle East now increases the possibility of military conflict between the various regional hotheads. Predictably, the price of oil hit a new high for the year – its highest in 3 ½ years.

What was our answer then to the queries, in light of all this disconcerting news-flow? Well, as always, it was to take a step back and point investors to the bigger picture. We see that picture by asking how likely it is that the current economic cycle will come to a sudden end, which would lead to falling corporate profits or losses. While activity levels are undoubtedly slowing, and this cycle is now the second longest of the last 100 years, it is worth remembering that cycles do not ‘die of old age’. They come to an end either because of (1) economic overheating, (2) central bank policy errors or (3) external shocks. The 2008 Global Financial Crisis (GFC) and the 1970 oil price shock are prime examples for the external shock scenario (3). The premature hiking of US interest rates in 1994 are the most cited example of a recent central bank error (2) causing recession (although we would argue that central bank’s complacency during the pre—GFC structured debt bubble could also be seen as a policy error). All remaining cycle ends go back to the well understood boom to bust overheating scenario (1).

What’s the likelihood of any these three causes happening soon? In our view, overheating is not a big risk, given the recent return to very pedestrian rate of economic growth. Nevertheless, the tightness of labour markets that leads to cycle-ending levels of runaway inflation can be observed in some western economies, particularly in the US. However, it is not (yet) leading to particular inflation pressures – possibly because businesses can so far maintain their profit margins without pushing up prices through productivity enhancing capital goods investments and employees’ reluctance to change jobs in search of better pay. Wage developments need to be watched because they can often cause inflation, but the latest uptick in inflation to the 2% (in the US) was caused by oil price increases, not wages.

On the second cause, the risk of central bank error, we just learned from the BoE that central bankers remain willing and able to go back on their previous so-called ‘forward guidance’ and adapt their policy to changing data flow. As a result, monetary policy around the world remains more accommodative relative to prevailing economic activity levels than it has historically ever been. So, it is hard to argue that they are committing a policy error by overtightening monetary policy. To be sure, monetary conditions have tightened recently, as economic growth no longer outpaced central bank’s gradual tightening, as was the case in 2017.

However, with central bankers continuing to prefer to err on the side of caution and with stable longer-term debt yields, conditions remain accommodative and therefore unlikely to cause recession.

This leaves the vulnerability, and perhaps probability, of external shocks. Here, the US president’s highly disruptive ‘Trumplomacy’ foreign policy style can be perceived as the proverbial ‘Bull in the China shop’ in terms of shock risk. We recently discussed on these pages how his bullying negotiation style is becoming increasingly predictable and thus potentially less disruptive than it may seem. Iran’s increasing hegemonic behaviour since the lifting of the sanctions has been highly disappointing and arguably requires push back. Whether Trump’s ‘carpet bombing’ style sanctions approach – through which the entire Iranian population will suffer more economic hardship – is the best way to achieving this is highly questionable.

We observe that Trump’s ‘bark’ continues to be much more disconcerting than his actual ‘bite’. We would therefore agree with the muted market reaction which implies that, for the time being, not much immediate economic harm is expected from his unorthodox foreign policy actions.
The UK’s very own external shock scenario is the Brexit dilemma and the fear of crashing out of the world’s single largest economic free trade zone. Shockingly little progress has been made on either side, which is finally resulting in businesses across the whole of Europe raising their game and leaving the cosy cover of not wanting to upset either side of the highly polarised public. This, together with the already-reached agreement for a 2 year ‘standstill’ transition period, makes a shock scenario highly unlikely in the medium term.

There are some who believe that, if the value of £-Sterling was to collapse (through Brexit or a Labour government), the UK’s position could deteriorate back to 1970s-style capital controls. But this is a fundamental misconception of the UK’s 21stcentury position in the world – the same misconception shared by those Uber-Brexiteers who believe that the UK can succeed in today’s world fending entirely on its own.
Neither the dire conditions of the 1970s, nor the 19th century global superpower position, are at all realistic prospects for the UK’s medium-term future in today’s interdependent global economy, of which the UK now makes up just over 3%. We would, however, agree with the BoE’s view that economic growth is most likely to lag behind the Global pace as a result of the lingering uncertainty over Brexit detail and/or further political polarisation between the UK’s metropolitan and rural parts of society.

This reflection on the medium-to-longer-term drivers of the current economic cycle leads us to answer the questions at the top with: ‘not very likely’. Thus, a withdrawal from capital markets would likely result in similar opportunity costs as in the pre and post Brexit referendum period of 2016.

This does not mean that the remainder of 2018 and (in particular) the coming months will be plain sailing for investors. Capital markets have over the short-term the unfortunate habit of not following long term economic fundamentals, but sentiment swings around how the long term may or may not change relative to previous predictions.

Slowing economic growth, gradually returning (yet still benign) price inflation and the concern that Trump’s high-risk policy approach may eventually cause collateral damage will at times sour market sentiment. And on the other side, (bullying) policy successes, continued economic growth, corporate earnings growth and measured but supportive central bank action will attract ‘fast money’ back into the market.

In conclusion, we expect that, following the extended 2016/2017 period of sustained capital market growth, sentiment will swing much more widely, with slightly more down- than upside risk in the coming months. By the autumn, we would expect it to have become clearer that the global economic expansion is continuing and the recent slowdown has been nothing more than yet another one of the numerous mini-cycles we have experienced since the end of the 2008/2009 GFC.

In such an environment, we believe the best way of adding value to the investment portfolios of our long-term investors is through the tactical asset allocation and fund selection positions as they are at work at the moment. We are therefore maintaining our emerging markets underweight in anticipation of the continued adverse effect of the rebounding US$ on these regions, as well as the overall equity underweight and cash overweight. The latter will provide us with the ability to buy into downside overreactions of the markets, while currently reducing the capital volatility experienced.