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Liquidity drives stock markets to new highs – for how long?

5 July 2019

The highly anticipated meeting between US President Trump and China’s President Xi Jinping at the G20 summit in Osaka came and went – with somewhat of a damp squib outcome compared to some sky-high expectations of an end to the ongoing trade war. Yet the mere intention to re-engage in trade negotiations and not engage in further proliferation of trade hostilities appeared enough to push many equity markets around the world to new historical highs.

We would however caution against such rash conclusions. We deem it highly probable that stock markets had already priced in a resolution of the trade conflict before the autumn and simply saw this view confirmed. On the other hand, what is and has been driving risk asset valuations higher since the beginning of the year is the prospect of central banks restarting monetary easing through rate cuts and further QE (quantitative easing) as global economic activity levels have slowed markedly and companies have struggled to deliver any substantial profit growth.

This stands in stark contrast to 2018 which was characterised by double digit profit growth, but also central banks’ steady rate rises and QT (quantitative tightening) which in the end resulted in the Q4/2018 market correction. It seems that despite their very best efforts, even 10 years after the Global Financial Crisis forced central banks to engage extraordinary monetary support measures, capital markets remain more driven by a change of direction in monetary policy than corporate fortunes. It is therefore far more likely that the positive start to July, that followed a very strong June, was much more driven by the news of Mario Draghi’s successor in the post of president of the European Central Bank (ECB).

It had been feared that the German monetary easing opponent and head of the Germany’s central bank (Deutsche Bundesbank), Jens Weidmann, would win the race for the nomination. The news that Christine Lagarde, the IMF’s head and staunch supporter of Draghi’s monetary support policies would be appointed instead, therefore brought relief and surprise to capital markets. Lagarde’s appointment seemed to ensure that the ECB’s hinted restart of quantitative easing would indeed outlive Draghi’s presidency and could once again provide the seemingly so vital flow of additional monetary global liquidity that had accompanied the 2016/2017 stock market rally.

All who now expect the equity market ‘melt-up’ to continue on the back of the anticipated monetary ‘fuel’ injection, need to take a step back and ask for how long investors will be willing to ignore deteriorating economic fundamentals and rely on the monetary soothing.

During previous periods of monetary policy success (in this, now the longest global economic cycle) corporate earnings had previously fallen steeply and had therefore much headroom to recover. Or credit availability had tightened so much that the central bank reprieve made a considerable difference for businesses. This time around, neither is the case and it is not obvious who, apart from capital markets, will benefit from a return of ultra-low cost of finance – while the negative side effects are most likely to return.

We have therefore entered an uncomfortable period during which market valuations have every (monetary) reason to grind higher, while there will eventually come a point when investors will be disappointed by the lack of corporate profit growth to underpin their higher valuation levels with proportionate dividends or at least cash flow. Unfortunately there is no good indicator for the length of such a period, but central banks are now on notice by capital markets to follow through on their hints, or risk an almighty disappointment which would in itself worsen the economic environment towards recession, from what currently still only amounts to (the third) mid-cycle slowdown.

In such an environment of fragile balance between hope and fear, we are satisfied to have pursued our investment positioning that has neither banked on a continuation of the ongoing rally, nor cut investment exposure in anticipation that markets may eventually face a rude awakening. Our neutral asset allocation in alignment with portfolio investors’ chosen risk profiles has generated very decent returns during 2019, which means that all portfolio types have now recovered beyond their previous high points of late August 2018.

We are cautiously optimistic that the global economy will, just as before, return from near stagnation back to steady yet slow growth. This should prevent the rude market awakening referred to above, even if this might mean that there is not much further upside to equity market returns on top of the double-digit levels that have been achieved thus far (see returns table below). At the same time, in such an environment it is not possible to argue convincingly for risk exposure overweight, without risking long-term investor performance in return for short-term outperformance kudos for the investment team.