The biggest risk facing investors in the current market is that inflation and economic growth surprise on the upside, according to FE Alpha Manager Bill McQuaker, who says that while most aren’t positioned for such an outcome, there are a number of warning signs which suggest it will happen in the not-too-distant future.
While 2015 has been a very good year so far for nearly every asset class with certain equity markets delivering strong double-digit gains, bearish comments have dominated the financial headlines as concerns have been raised about slowing growth in the US and UK along with worries about a “global deflationary death spiral”. 
Those include warnings over huge distortions in the global markets from the likes of Aberdeen’s Bruce Stout and predictions from star manager Crispin Odey that another 2008-style doomsday scenario is on the cards.
“If economic activity far from picks up but falters, then there will be a painful round of debt default. We are in the first stage of this downturn. It is too early to see what will happen – a change of this magnitude means the darkness and mist is very great,” Odey said.
However McQuaker, who heads up the fund of funds range at Henderson, says the one risk he is most concerned about is that economic growth and inflation actually start to pick up as financial markets aren’t priced for such an event and investors’ portfolios aren’t prepared.
He says that while most won’t agree with his prediction, there are signs that core inflation is increasing as a result of heightened economic activity which, in turn, could cause the world’s central banks to reverse their stimulus programmes that have propped up markets over recent years.
“As ever with financial markets, it is the self-correcting process you need to worry about,” McQuaker (pictured) said.
“In terms of what I’m most worried about, it is the exact opposite of what people have been talking about over the last nine to 12 months – inflation. In fact, the worst thing that can actually happen to financial markets is that the economy goes back to normal.”
One of major reasons why McQuaker has become increasingly concerned is because of how strongly asset prices have performed since the bottom of the global financial crisis in 2009.
He says that with the likes of equities, government bonds, corporate credit, high yield debt, property and even gold all delivering very high returns of the last six years, it is the best bull market he has seen in his 30 years in fund management.
“Really, over the last five or six years, we have never had it so good,” he said.
Performance of sectors and indices over 6yrs
Source: FE Analytics
The FE Alpha Manager says there have been a plethora of factors for why that has been the case.
“Firstly, 2008/09 was truly hideous as equity markets halved, there were forced sellers in credit and private equity was decimated,” he said.
“Secondly, it caused the worst recession that I have ever seen in my career. We haven’t had to worry about inflation as there has been so much spare capacity to soak it up and unemployment had never been so high.”
“Thirdly, and most importantly, policy since the global financial crisis has been extraordinarily helpful for asset prices. The splurge in liquidity has been provided extraordinary support for financial markets.”
“However, what happens if, God forbid, investors question those policies or if fundamental developments in the economy mean central banks become less concerned about asset prices?”
Many experts disagree with McQuaker’s concerns, though, especially given that the central banks of Europe, China and Japan are still easing.
The likes of FE Alpha Manager Ian Spreadbury expect an extended period of low growth and low inflation due to overcapacity in the global economy and unsustainably high debt levels.
On top of that, most agree that central bankers will only start to raise interest rates if inflation picks up and with developed market consumer price indices (CPIs) at low levels, many can’t contemplate why monetary policy would be tightened over the short term.
Nevertheless, McQuaker is confident that inflation will start to tick up.
“If you look on the surface at headline inflation, the idea that it might be a problem seems nonsensical. That is misguided though. You need to look at what core inflation is going and that is why I think the deflation story has been significantly overplayed.”
Firstly, he says that CPIs will inevitably tick-up over the next few months as they start to “anniversary out” last year’s oil price falls. However, more importantly, he says services inflation is already picking up.
“Unemployment is falling and falling and wage inflation is showing signs of life.”
Unemployment rates in the UK, US, Japan and Germany
Source: Henderson/Thomson Reuters
“While it is not enough to freak markets yet, it is happening. When we talk to fund managers or people on the sell-side, those who are closest to the US labour market say there is more wage pressure in the US than data suggests.”
“People have talked about overcapacity in the economy, but there is now a lot less slack in the global economy than there was in 2009. That big output gap just isn’t there anymore.”
FE Alpha Manager Martin Walker argued a similar point in a recent FE Trustnet article.
McQuaker says the big worry is that the US housing market continues to recover following its huge falls during the global financial crisis.
“If the US housing market were to spark to life in any way, US economic growth would be much stronger than expected. That would mean the end of QE, end of zero interest rates and the end of free liquidity.”
The manager says that if economic growth and inflation increase, causing central banks to tighten monetary policy, it will be painful for most asset classes – similar to the situation in 1994 when the US Federal Reserve unexpectedly raised interest rates causing both bonds and equities to sell-off.
Performance of indices in 1994
Source: FE Analytics
There are already worrying signs in the fixed income market, as FE Trustnet highlighted yesterday with yields on UK, US, Japanese and German government bonds all spiking over recent weeks as economic data has been improving – causing many to suggest that a bubble in the asset class is now bursting.
“Bonds are not priced for normal economic conditions and the recent rise in bond yields is telling us what is going on in the real word – the bond market can sense it,” McQuaker said.
“It would also be an issue for equities. However, only in the short term as I think they can recover from the initial hit.”
Equities are therefore McQuaker’s favoured asset class at the moment, though he is concerned that most equity investors aren’t prepared for the upcoming volatility.
He says that while investors have been overweight the asset class, they have been buying into perceived “safer” areas of the market which are now at risk if bond yields did start to rise.
As a result, the FE Alpha Manager is targeting more cyclical funds for his exposure and has recently bought an emerging market tracker as a result.
“There is vulnerability within equity portfolios as investors have flocked towards areas which have already performed well over recent years.”
His argument is similar to FE Alpha Manager Steve Russell, who recently warned that core equity income funds were at risk of collapse given the uncertain outlook for high quality, but over-priced, defensive companies.
“Equity income is an especially dangerous area as it has an aura of safety, but in our opinion in some cases high yield stocks are just as dangerous as a biotech stock given the prices they’ve been bid up to,” Russell said.
“We have been increasingly moving out of high income stocks which we now view as extremely dangerous, because it seems that many owners of them see them as risk free. It will all end in tears.”
To protect his investors, McQuaker is currently narrowly overweight equities in his flagship Henderson Multi Manager Income & Growth fund – which has been a top decile performer in the IA Mixed Investment 20%-60% Shares sector over 10 years.
Performance of fund versus sector over 10yrs
Source: FE Analytics
The fund is also massively underweight fixed income as it accounts for just 16.7 per cent of its AUM and that exposure is limited to high yield and strategic bond funds.
McQuaker and his team have 7 per cent in direct commercial property, though they have scaled back that exposure recently due its strong run, and have roughly 4 per cent in alternatives like physical gold.
To highlight the manager’s profit taking and cautious stance, Henderson Multi Manager Income & Growth currently has 17.1 per cent in cash.
