Why Carmignac believes this market is reaching its limit

A clear look at the facts, separating the wheat from the chaff, reveals that the new market conditions in place since last summer persist.

Central banks’ dogged pursuit of monetary stimulus allows for significant transitory movements, hence a degree of opportunism. However, the accumulation of economic, financial, monetary and political imbalances creates asymmetric risks which are unfavourable to current market levels.

Performance of indices over 1yr

Source: FE Analytics

So, we will not be dancing on the volcano like so many others, even if it is dormant for now. We are paying close attention to risk management and concentrating our exposure on assets whose risk asymmetry still looks favourable.

False dawn: Central Bank’s stances are a recognition of failure – global economic problems will NOT be resolved by monetary policy alone:

First of all, central banks’ positions are a recognition of failure.

In the Eurozone and Japan, annual inflation rates, which are still close to 0 per cent, well below the official targets, are forcing central bankers into overkill. And in the United States, it is the economy’s fragility that has prompted the Fed to revise its predictions of gradual monetary policy normalisation downwards, two months after announcing them.

Most importantly, the markets still do not see these failures as being inevitable. The problems facing the global economy – overleveraging and insufficient demand – will not be resolved by monetary policy alone, however unorthodox it may be.

As we described under the medical term “iatrogenic”, central banks’ squeeze on interest rates is now exacerbating the situation that it was supposed to ease: it encourages governments to continue borrowing, weighs even more heavily on banks’ profit margins, and increases consumers’ savings requirements instead of providing an incentive to spend.

In this context, it would be very short-sighted to rejoice in central banks’ latest effort in vain.

Cruelly, the markets would be just as wrong to delight in the prospect of monetary tightening in the United States.

As it is, Fed chair Janet Yellen may soon have to admit that the cost of rents and staple products has started to rise in the US, which is all the more unfortunate as it not only fuels inflation, but also erodes purchasing power and therefore darkens the consumer spending horizon.

The US growth issue: Markets are not prepared for the HIGH risk of US growth dropping well below the 2 per cent mark in 2016

The debate on the US economy’s resilience clearly continues.

All and sundry extrapolate each new statistic in a kind of chartist analysis of the economy passed off as research. This myopic approach to macroeconomic analysis makes markets even more unstable.

It seems more reliable to examine the fundamentals of current economic movements, and from these try to draw lessons and identify trends. What we see is that US profit margins have dropped from 10.6 per cent at the end of 2011 to 7.6 per cent today.

So we are now, logically, seeing a lasting change in the investment cycle, with profit margins the main influencer.

Furthermore, US consumer spending has been enjoying a dual wealth effect for more than five years (through rising property and financial asset prices), which is now fading.

Performance of index over 5yrs

Source: FE Analytics

So it is natural that consumer spending on goods and services is now starting to slow, and the savings rate is rising (to 5.4 per cent from 4.9 per cent at the end of last year).

We think the risk of US growth dropping well below the 2 per cent mark in 2016 remains high, all the more so that the Fed – which is now in a monetary tightening phase – can’t intervene by easing its policy. The markets are not prepared for this.

China: High asymmetric risks and an untenable path chosen by the Chinese authorities

The path followed by the Chinese economy, which alone accounts for 16 per cent of global GDP and 25 per cent of investment, is obviously decisive for US and European activity, as well as for market risk.

This raises a serious issue, as economic rebalancing at a time of serious industrial overcapacity makes a drastic reduction in China’s rate of investment unavoidable.

Performance of index over 1yr

Source: FE Analytics

There are two possibilities that could arise from this. Firstly, the rate of investment could be quickly adjusted. In this scenario, a marked depreciation of the renminbi would be very hard to avoid due to capital outflows and the need to absorb the shock from this blow to the domestic economy.

Such a devaluation would also exert much heavier pressure on the competitiveness of the world’s other leading economies. It is the perception of this risk that opened the markets’ eyes a little at the beginning of this year.

The second possibility is for the government to continue financing only a very gradual slowdown in this investment to sustain growth. This seems to be Chinese authorities’ preferred option today.

In this case, news on growth will be reassuring in the short term and the market may be happy with this, especially if currency controls manage to limit the loss of foreign exchange reserves in the immediate future.

However, in this case, Chinese private sector debt, which has already surged from 140 per cent of GDP in 2008 to 240 per cent today, would continue to worsen.

This is due to the credit growth of between 16 per cent and 20 per cent per annum easily outstripping GDP growth, which stands at 4 per cent to 5 per cent at best. Aggravating this situation, non-performing loans in the banking sector equate to nearly a third of Chinese GDP by our estimates.

This path is therefore untenable. The markets may be able to ignore these scenarios temporarily, but we believe they require very careful management given the highly asymmetric risks that they present.

While central banks have no choice but to carry on doing what they can, their ability to take effective action is reaching its limits, as the markets started to realise at the beginning of the year.

Meanwhile economic risks have continued to build up. Then there are the new political pitfalls in Europe, which feed off each other: economic impact of the migrant crisis, security and Brexit risk.

This diagnosis is certainly not incompatible with transitional market movements. But for the moment it justifies us keeping our conviction-based investments safe under the shelter of careful risk management.