New article from Tatton Investment Management: Parallels and differences to January 2018

20 January 2020

All central bank liquidity or improved outlook too?

Following the brief wobble after the escalation in tensions between the US and Iran, the risk appetite that drove the substantial stock market rally towards the end of last year has returned. With yet another good week in stock markets, full year return projections of a number of 2020 outlook reports by well-regarded investment research institutions will looked stretched even before we reach the end of the first month.

Unsurprisingly, parallels are being drawn with January 2018, when stock markets were storming ahead with similar levels of upward momentum, touching very similar relative valuation levels, and looked just as over-extended in the US. That particular upward surge ended very quickly, as stock markets took fright from rising bond yields, leading to an overall disappointing year for investors – with the exception of the US.

For now, the strong market performance and extended valuation levels (in certain regions and sectors) is as far as the parallels with 2018 go, while the wider backdrop is substantially different. At the moment, capital markets are under the spell of a very substantial expansion of monetary liquidity, as the US central bank is in the process of easing a global shortage of US$ through the recent injection of $400bn of additional cash liquidity. The cash shortage appears to have been the consequence of post-Financial Crisis bank regulation tightening, which has led to banks hoarding rather than circulating cash. Back in 2017/2018, the opposite was true: in light of strong and synchronised economic growth around the world, central banks were in the process of tightening liquidity conditions.

This leads to the other remarkable difference: back then, the economy had expanded so strongly on the back of one-off stimulus measures in the US and China that a slowdown was a reasonable expectation. This time around, a considerable slump in economic activity lies behind us, but in the absence of recessionary signals we can reasonably expect an improvement in economic growth ahead.

The more disconcerting difference is that last year’s market rally was entirely based on rising valuation multiples and not on rising corporate earnings, as had been the case in 2017/2018. More optimistic market analysts put this down to stock markets having overcorrected in 2018, because they were wrongly anticipating the end of the already prolonged cycle – and an ensuing global recession. Therefore, all that happened in 2019 was a countermove back to the previous valuation levels, when the slowdown did not turn into recession and the outlook improved in the expectation of another prolongation of the cycle.

The pessimists dismiss this argument by pointing out that markets’ ups and downs have become determined by central banks’ monetary stance. When the banks ease (i.e. expand the globally available monetary liquidity) markets go up, and when they tighten they come back down again. All central bank liquidity or improved outlook too?

Both arguments have merit, yet miss the finer points. The aftermath of the Financial Crisis has necessitated a prolonged period of extraordinary monetary ease which has changed the reaction function of capital markets to changes in interest rate levels. Simply put, when yields hover around 1.5%, then a 1% increase to 2.5% (=+66%) constitutes a far more material change in financing conditions than when yields move from 4.5% to 5.5% (+22%). Unsurprisingly therefore, central banks have struggled to recalibrate their monetary actions to adequate levels and markets have reacted in quite different patterns to monetary changes to what we have known historically – over- and undershooting regularly. For the moment, central banks have made it known that they will not turn to tightening conditions again until inflationary pressures have significantly overshot their 2% target. This should provide sufficient liquidity for markets to transact smoothly, while allowing longer term yield levels to rise gradually with rising economic growth rates, thereby increasing the difference between cash deposit and longer-term bond yields sufficiently for banks to be incentivised to lend more and support growth.

If the monetary and bond market backdrop gradually normalises as described above, then the (over-) valuation argument could gain validity and indeed leave certain regional markets (US) and sectors (tech/growth) at valuation levels which have historically not been sustainable.

This somewhat complex environment creates a difficult decision for us investment managers, given how difficult it is to forecast – especially the timing of changes.

We suspect that the top end of equity markets will enter a consolidation phase that could even take the form of a short-term correction, when the US central bank finishes its cash market intervention sometime in February. Given it has already signalled this will happen, it is hard to argue that this will surprise markets and therefore should have been priced in already.

On the positive side, the signing of the first phase of the US–China trade agreement has the potential to improve the 2020 outlook more than its limited substance would suggest. Depending on how much it improves business sentiment both in China and the US, there is the real possibility that growth dynamics improve more significantly than recently anticipated. This would allow corporate earnings to edge higher and thereby valuation levels lower. We have seen it before and, given how unfazed markets were in reaction to the Middle East tensions, we are not convinced that a severe enough market correction is in the offing to warrant trying to find a lower entry point for any portfolio repositioning.

At Tatton we navigate investment portfolios guided by the medium-term economic development, rather than short-term market timing. On the economic fundamentals we observe improving expectations and an increasing number of signals that lead us to believe that areas that have not done particularly well over the past years – such as emerging markets – will be the beneficiaries of improving global trade conditions. Against this backdrop bond yields fell to too low a level, especially now that a recession looks ever less likely. This puts lasting downward pressure on bonds with long maturities. In our next portfolio update we are therefore going to focus on those two areas while also looking to take some interim profits in those areas that have done particularly well in the recent rally.

Those who expected us to discuss the latest UK economic data flow and to deliberate on whether the Bank of England will cut rates at the end of the month should please open the attachment and turn to the aptly titled article “Bank of England to cut interest rates” in which we lay out why it is highly likely that interest rates will be reduced, back down to 0.5%, but why it is also unlikely that we will see more than one cut.

 

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