The base case is that the market believes that the US and the UK are growing well, that Europe and Japan will catch up and that we are in a low inflation or even potentially deflationary phase. In addition, it is widely held that a weak euro and yen will be additive to growth and that the fall in oil, while problematic for oil stocks, is a net positive for global growth.
Performance of oil and oil stocks over 1yr
Source: FE Analytics
What is interesting to us is both the risks to this narrative and to what extent it is supported by the evidence. Over the past few weeks we have seen a number of data points which are not overly supportive of the global growth narrative.
Clearly the sharp falls in commodities, especially oil, can be seen as much as a demand issue, as it can a supply issue. Baltic freight rates have been also weak, which would support a declining demand thesis, as would the recent Canadian rate cut.
So, all is not as clear as at first it seems. We think on balance this market narrative will continue until the case is proven otherwise, but the risk to expectations seems to be to the downside rather than the upside.
Devaluations are a zero sum game. The thesis that the devaluing countries will benefit from their falling currencies comes with an equal and opposite effect that the non-devaluing countries must suffer. UK and US companies are already starting to complain at lost demand as a consequence of the weaker euro and yen.
Performance of euro and yen vs dollar over 1yr
Source: FE Analytics
One of our bigger worries is that the current defaults in the oil sector ripples through to tighter lending standards more widely. Whilst the puritans may argue this to be a good thing, tighter lending standards have a clear effect on future credit costs and in every case are lead indicator of a wider credit cycle.
Whether it is cause or effect doesn’t matter to us, it is a simple fact and we need to monitor the credit markets very carefully over the coming months.
The other area where we are very alert at the moment is fixed income. Our ‘lower for longer’ thesis has become very consensual and there has been a very significant flattening of the yield curve recently.
While we hold to our long-term thesis, what are the risks to that over the coming months? Much of the recent move is a result of the sharp falls in commodities providing a further deflationary effect. If prices recover as the year progresses, this could well reverse.
At the same time, if our structural low growth thesis proves correct, yet the authorities continue to attempt to stimulate economies to growth rates above what is genuinely feasible, then the consequence will inevitably be inflation.
Perhaps this will become a more plausible scenario over the coming months for the market consciousness, and can only lead to a reversal of the falls in long dated yields we have seen.
For these reasons, and others, we think there could be great swings in expectations, sentiment and hence markets over the coming months. In general, the range of plausible outcomes seems much wider around the market’s base case than is usually the case and for that reason we think this is a time for a higher degree of caution.
We have been booking gains on a number of our successful positions over the past few weeks, especially in fixed income, and now we hold an unusually high level of cash. We would expect to be running a more cautious approach until the outlook becomes clearer.
David Jane is manager of Miton’s multi-asset funds. The views expressed above are his own and should not be taken as investment advice.
