Since their confidence in central banks’ unconditional support started to wane the markets have been playing it by ear. 
Lacking visibility, their risk appetite fluctuates according to various data, which often contradicts previous sets, regarding growth, inflation and the Fed’s prevarications. Through this instability, the S&P 500 and MSCI World equity indices ended May at pretty much the same levels as they started. The Euro Stoxx 50 edged higher while the Chinese index lost more ground.
Long-term yields continued to ease in both the United States and Europe despite an expectation that the Fed would raise interest rates.
Performance of indices in 2016
Source: FE Analytics
It would be presumptuous to predict when this dithering will end. But as we wait for the music to stop playing, we must remain clear about the instability now shrouding the markets, as risks have become asymmetric.
Especially in the United States, investors will sooner or later have to take into account lower margins, weak productivity and increased corporate leveraging. With shares currently trading at 18x earnings estimates for this year, the US market is fragile.
Despite good figures for May, the consumer spending trend has not improved for a year, and could slip under the weight of higher energy prices and rents.
In China, the stronger economic performance brought about by the stimulus package announced in the first quarter seems to have reassured global (but not Chinese) investors.
However, it coincides with a sharp increase in medium-term financial and economic risks. Investors’ attention might awaken if the sustainability of the stimulus plan is suddenly cast into doubt, or if they realise the fragility caused by the surge in corporate debt.
While with the European Union’s economic uncertainty comes several rather existential political and geopolitical risks that it would be careless to ignore.
In the light of all this, investments must be made with extreme diligence. The great moderation experienced by markets from mid-2012 to mid-2015, fuelled by the unreserved confidence placed in central banks, has ended.
And the hope that fiscal stimulus will take over from monetary stimulus is coming up against the scale of sovereign debt, which eliminates any significant leeway.
“All-weather” portfolios with little vulnerability to economic and political hazards are now necessary, as is very active management of any market opportunities, which should be targeted with sniper-like precision.
Consumer spending: The last bastion of US growth
Although manufacturing activity is already much weaker, the United States still has a relatively enviable growth profile as its consumer spending remains strong.
However, on closer inspection, we see that the pace of this stopped improving a year ago. The same causes produce the same effects: the dip in financial and property market trends thwarted the wealth effect on US households, which had been underpinning consumer spending since 2010.
This already weakened trend is also now suffering from the upturn in energy prices and rents, which act as a tax on spending. In this respect, it is interesting to note that despite one of the mildest winters for 100 years, traditional retailers (from Walmart to Macy's, Target to Nordstrom) have, since the beginning of the year, been posting their worst results since the 2009 recession. E-commerce results are admittedly growing strongly.
However, they cannot mask the weakness of earnings announced by department stores (-47.8 per cent) and supermarkets (-14 per cent) over the first quarter. Slower consumer spending would be doubly problematic as US retailers seem ill-prepared: their inventories are now worth almost 18 months of sales, the highest level since 2009.
Further obstacles in the path of US growth: the Fed would like to resume its monetary tightening cycle as soon as the markets allow, job creation is losing momentum, the production capacity utilisation rate has been falling for a year, the number of building permits has been dropping since the start of the year, and mounting uncertainty regarding the outcome of presidential elections could weigh on investment over the second half of the year.
Performance of indices over 7yrs
Source: FE Analytics
The confidence that the markets are still showing in the US powerhouse’s resilience seems complacent.
The Chinese hazard
The Chinese economic recovery in the first quarter was spectacular but must not be misinterpreted.
Performance of index over 1yr
Source: FE Analytics
By doggedly sustaining a certain level of growth at all costs, China is merely compounding its already acute overleveraging problem. Following the current trend, the total debt rate of 240 per cent today would reach a critical level of around 320 per cent in five years, and would coincide with a marked deterioration in the ratio of bank loans to deposits.
Bank loan default rates, which we think are already very much underestimated, would accelerate even more and doubtless lead to a serious credit crisis. So either the authorities take the risk of leading the Chinese economy to the brink, or – more reasonably – they finally accept the impact on short-term growth from the need to carry out fundamental reforms, clean up the banking industry, and rebalance economic activity.
The most optimistic scenario is that China at the very least accepts a dip in the pace of growth from the second half of this year.
Political risk
The markets tend to ignore political risk, which generally has little influence over the real economy.
But maybe they should be concerned this time. Almost inconceivable six months ago, the election by the end of the year of an openly protectionist president inclined to renegotiate federal debt is now plausible in the United States.
And if the UK votes to leave the European Union, which could happen for mainly political reasons, this would at the very least present a serious threat of disruption to growth and inter-European trade. There are numerous estimates with varying degrees of justification, most of them partisan, regarding the likelihood of the events in question and their economic consequences.
But whatever happens, the important thing is that the risk here is asymmetric: at best, the elections will lead to a status quo; at worst, they could trigger a chain reaction.
This is because any vote to break away from the past would set a major precedent that would boost, and even give legitimacy to, other anti-establishment or anti-European votes.
So the markets are facing up to this new trend, which we described at the beginning of the year; one that is receiving less support from central bank intervention and is more exposed to economic and political hazards.
Changes of trend generally involve a period of instability, which for the markets has definitely already started.
This situation means we should be ready and take an accurate shot whenever the opportunity arises – but keep a carefully-chosen safe vantage point.
Didier Saint-Georges is managing director at Carmignac. All the views expressed above are his own and shouldn’t be taken as investment advice.
