New article from Tatton Investment Management: Pre summer-holiday investment check

14 July 2017

As we head towards the summer holidays, it’s worth checking on some of the expectations we had at the start of the year.

Last December, we wrote that much would depend on politics; would “populism” spread from the Anglo-Saxon nations across the Western World (we thought growth and culture would see off the threat); would an unorthodox US president Trump undermine global trade (a negative which we thought unlikely); would he unleash fiscal stimulus and deregulation benefits on the US economy? (a positive but we thought even less likely given intractable US domestic politics).

So far, in these respects at least, our central case has largely played out.

Populism across Europe appears to have been set back by the reality of a populist in the White House. Furthermore, Trump’s administration may have already turned into a ‘lame duck’ presidency, resulting in little policy progress regardless what the president may tweet to the contrary.

The global economy’s momentum has continued, buoying economic regions with the higher catching up potential – especially in the Eurozone and Japan. But, as is always the case, unexpected headwinds emerged.

Concerns arose over slowing growth in China. Their formidable stimulus of early 2016 got the global growth momentum rolling in 2016 in the first place. However, this encouraged “off-balance sheet” lending. Having achieved some stability, China needed to regain some control over these “shadow” banking markets.

The resulting monetary tightening had the potential to lead to significant economic activity curtailment. To our surprise, thus far this has not been the case, as the Chinese authorities appear to have been able to deploy other policy levers successfully enough to prevent the feared fall in Chinese demand in global markets. 

The second reappearing market ‘demon’ was a weakening in “hard” commodities, especially oil.

The collapse of the commodity price bubble back in 2014 had led to painful capacity adjustments in the resource industries. The consequent decline in industrial and machinery production around the world led to another bout of deflation fears.

This does not appear to be happening this time. Price declines are smaller (oil has fallen from $50/bbl to around 45; in 2014 it fell from $110 to $45).

Consumer price inflation has reduced somewhat, but not enough to seriously bring back deflation scares (yet). Additionally, it is mostly oil that has come under pressure, affected by volatile supply conditions rather than worries over a fall in demand.

The third concern had been for a further strengthening of the US$, upsetting trade flows and weighing down developing economies through their $-denominated debts. This has also not happened and indeed the US$ has weakened as we expected, rather than strengthened as had been consensus.

So, at the beginning of June it could have almost been a return of a ‘Goldilocks’ market environment; stable low growth, low but positive earnings growth, low inflation; and, therefore, really low interest rates.

At this point, a familiar market demon re-enters the scene: fear of rate rises. At the beginning of the year this was only a US topic and even there, the tightening through the slow rise in rates by the US Fed was largely neutralised by continued easing by the European Central Bank.

Now central banks of across the Western hemisphere have started to get more vocal: ‘economic normalisation has to be accompanied by normalising monetary policy’. The central banks of North America and Europe announced (equivocally) that extraordinary monetary stimulus is likely to be coming to end sooner rather than later.

Such marked shifts in policy frameworks tend to be associated with changes in financial market “regime”, especially when conducted in concert – a definite increase in risks for the second half of 2017.

There is some potential for a disorderly reaction in bond markets. Low current yields mean there is no “carry” benefit in holding on during price falls; bond holders can’t recover as quickly from losses as in the past. This could mean large numbers of bond investors suddenly heading into cash, pushing yields up far more quickly than they came down.

Equity yields valuations would come under pressure, given that the major justification for high P/Es is low bond yields. In addition, one would expect some impact on growth in the economy which, in turn, would reduce expected company earnings growth.

No wonder then that the central bankers equivocated; any reduction in monetary support would be small and very gradual, hoping to reassure bond investors that the risk of capital losses through rising yields should be small.

For us, this slight change in outlook scenario has diminished our attraction to bonds. We had previously extended duration to offset the possibility of an equity market correction in face of high valuation levels against slowing economic growth rates in Q2. Now we may increase cash levels in portfolios.

If this is not really the sort of pre-summer-holiday reading one might want before departing, then it’s comforting that, over the past 18 months, markets have become far more measured in their reactions. And, while the above scenario’s probability may have increased, for us it remains an outlier.

Our central case is for a continuation of a steady, if somewhat below average, growth normalisation. Over the mid and long-term, equity investments should continue to outperform lower risk asset classes. The return outlook for fixed interest bonds has taken a turn for the worse – and that’s welcome if this tells us that almost 10 years after the Financial Crisis began we are slowly returning to more normal economic conditions.

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