Time to take some profits

2 March 2018

February brought a sudden, even if long expected end to the calm and steady rising equity market conditions. We wrote at length during the month what triggered the correction and what it is likely to mean going forward. In a nutshell, we agree with the view of many respected investment research institutions, that the return of more resilient global economic growth means that the end of the deflationary era has finally arrived. This will lead to a gradual normalisation of interest rates and bond yields away from the ‘lower zero bound’, but probably not higher than 3.5 – 4.5% over the remainder of this rate cycle. This reduces the relative attractiveness of equities and makes extended equity valuations less easily justified.

But exactly because this shift in relative valuation dynamics is occurring as a consequence of economic growth and not fear of decline, it is unlikely that February’s correction heralds a medium-term equity bear market. However, it does mean that the relative attractiveness of different parts of the stock markets will be shifting. Those who particularly benefited from low cost of debt capital and investors’ relentless hunger for growth prospects might suffer, while vice-versa those who can sustain or improve their margins when input costs rise should now become more attractive. Over the shorter term this reorientation is likely to result in more market volatility, while over the medium-term risk asset markets retain upside potential in sync with further economic expansion.

During this period those parts of the market that have done best in the run-up to the correction are likely to come under the most scrutiny. Emerging market equities as well as US tech stocks are such areas. We already took some profits in the tech stock area at the end of last year and we have now decided to reduce our allocations to emerging market stocks. As an asset class they have gained around 80% since the start of the rally in February 2016 and we judge them as vulnerable in the upcoming market environment.

In other news, the first public appearance of the new US central bank chair Jay Powell, who came across as more assertive than previous chief central bankers, appeared to confirm market concerns that they will no longer be able to rely on monetary support should stock markets wobble. They duly sold off again, not helped by president Trump’s announcement that he is prepared to slap tariffs on steel and aluminium imports.

I am not sure I agree with the notion that he has declared ‘trade war’ with the rest of the world, but rather that he means business with his intention to secure better trading terms for the US. However, as his sudden softening on the firearms issue in light of the swelling public support for the ‘#NeverAgain’ high school movement has shown, he is swayed more by popular opinion than feeling tied by previous statements of principle. Expect a deal to be done, rather than a painful trade war to be fought.

Similar bargaining tactics could be observed between the EU Commission and the UK government in the Brexit negotiations. The provocative language on both sides tells us that we may soon see more specific positions being teased out, which would be about time, given the beginning of the first potential transition period is only a little over a year away. Capital markets continue to indicate that they expect a ‘muddle through Brexit’ rather than a Hard Brexit or Remain.

Behind the political noise, economic data flow around the world told a story of continued strong and synchronised economic expansion, even if the rate of the expansion no longer seems to be accelerating further. The UK remains a special case due to Brexit, but even here construction and manufacturing business sentiment were reported at healthy expansion levels, although still considerably behind the Eurozone economies.