Change of direction or gradual normalisation?

23 February 2018

The end of the low volatility goldilocks stock market environment has been unnerving for investors, but it has also triggered a fascinating debate amongst economists and market strategist about where we may be heading from here. As a result I have had the dubious pleasure of having to analyse and read even more than usual, although at least it has been more stimulating than the previous endless musings whether markets had once again fallen into a state irrational exuberance – or not.

I can report that there is a fairly broad consensus supporting our view that the economy is in a more stable position of synchronised global growth than it has been for a very long time and that this is most likely going to continue, although most expect (or perhaps hope?) at a slightly slower rate than of late.

There is also a growing consensus that the prolonged era of stall speed growth and ever further falling inflation, yields and interest rates is ending. I thought our colleagues at MRB Partners – one of our independent investment research providers – put it rather succinctly in their latest article: The world is not on the verge of returning to the inflationary 1970s, but the mediocre and choppy economic landscape, combined with no inflation and hyper-accommodative monetary conditions, is gone. The same is true of the heady days of ever-falling interest rates and yields, and ever-rising asset prices.

The last bit is where the discourse between the different sides starts.

The bears argue that higher volumes of debt make the global economy so vulnerable to rising yields and interest rates that the return of even mild inflation of around 2% marks the end of this economic cycle.

The bulls on the other hand argue that this cycle is only just getting started as we finally return to the old ‘normal’, where companies are at long last deploying their plentiful capital to expand their productive capacity through higher productivity rather than relying on short term ‘hire and fire’ staffing strategies. This should keep persistent inflationary pressures arising from staff shortages at bay as CapEx investment driven productivity gains are finally returning to facilitate falling unit labour costs even as wages rise. As long as this doesn’t lead to an overheating of economic conditions, we could indeed hope for the goldilocks era of cheap capital transitioning neatly to the next goldilocks era of productivity gain driven growth.

Unfortunately, such transitions do not tend to occur in straight lines, especially when capital markets have never before experienced such transition from extreme monetary ease back to more normal factor costs of funding, labour and capital investment. The most relevant concern is that either the central banks or the bond markets overshoot from the one extreme to the other, which could cause a credit squeeze that triggers a renewed economic slowdown. Another valid concern is that the recently weak US$ rebounds so strongly on the back of rising US interest rates that this turns into a once again formidable economic headwind for emerging markets and global trade in general.

The more benign transition scenario is that the above described forces become counterbalancing and thereby prevent the deterioration of necessary changes from overshooting into the opposite extremes. As I have argued here before, we are still living in an environment where we tend to overestimate the severity of cause and effect. The shocks of the 2008/2009 global financial crisis (GFC) are to blame that we have a far higher propensity to assume that we are heading for disaster rather than resolution.

This is what makes the current market environment very difficult to assess and manoeuvre. From our perspective, there is a higher probability that the end of this economic cycle is still a considerable time away than to be lurking around the corner. Yet as we transition from the post GFC slow growth era gradually back to what we knew before the GFC as ‘normal’, there are plenty of opportunities for market forces to lose orientation and temporarily lose faith in the longer term growth path perspective.

During such a period of reorientation we have to therefore expect more bouts of unnerving market volatility as the one we have just witnessed. We may have been a little early, when we expected this to start back in the summer of 2017, but now that it appears to have finally been recognised by the wider markets we will stick to our prudently cautious stance of slightly reduced risk asset allocations compared to our long term allocation benchmarks and industry peers. At the same time, we will continue to position portfolios in terms of regional and investment style allocations for the opportunities that also arise in such an environment of paradigm change.

Should the speed of change in inflation expectations and bond yield levels recede (as we expect) or another market correction occur without there being a notable deterioration in economic outlook, then we are likely to close our cautious position and move portfolios back to a neutral or even risk asset overweight stance.