Thinking about the future always throws up more questions than answers, and this holds for financial markets too. 
That said, in recent weeks there seems to be a higher ratio of questions to answers than is normally the case, particularly when it comes to economic, political and systemic risk. No doubt part of this is down to the temptation to reset at the beginning of the year, but also because it’s increasingly clear we’re moving into a new phase for markets.
This new phase is characterised by a stronger economic growth environment. This is of course good news but raises a number of questions, many centred around the degree to which inflationary pressures are building and how they are expressed in the wider economy. For example, through wage pressures and corporate pricing power, and what they might mean for margins and volumes.
Looking at recent data, there are already clear signs that wage pressures are building in the US and the UK, albeit not yet to worrying levels. Meanwhile, a broad-based move higher in commodity prices is adding to input costs for many businesses.
These inflationary factors all add pressure on central banks to raise rates, and on bond yields* to move higher. We think the risk of higher bond yields, and their impact on the economy, especially interest rate sensitive sectors such as housing and autos, is currently underappreciated by markets.
The political environment remains unpredictable, with Trump and Brexit the obvious wild cards. The noise from these events is sometimes deafening but let’s not forget the underlying dynamics at play.
There’s a distinct populist and anti-globalisation tone, fed over many years through growing inequality.
This is unlikely to disappear overnight and suggests further election uncertainty and also increased trade protection. For now, it’s being expressed in currency markets, which, unlike bond markets, are not manipulated by the authorities. As a result, we believe currency volatility will remain elevated.
Moving on to systemic risk, since the great financial crisis in 2007/8, systemic risk has been dampened by coordinated central bank action, specifically through lowering rates to zero and the purchase of large parts of the financial market, i.e. government and corporate bonds. This has been a major driver of lower yields.
But yields are starting to move higher. In a typical cycle, there would be a trade-off between the positives of better growth and the negatives of higher rates, with rates potentially acting as a form of ‘auto-stabiliser’, slowing an overheating economy.
However, this cycle is far from typical: debt remains extreme and debt markets remain heavily manipulated by central banks. The authorities will be keen to see a gentle, orderly, rise in rates but their credibility will be crucial in achieving this.
Many parts of central bank function are to instil confidence. The now (in)famous “whatever it takes” speech by European Central Bank head Mario Draghi worked because it was taken on trust by market participants.
What has not yet been tested is whether central banks will retain credibility in a world where bond markets might be losing money, and where inflationary pressures are building – a much less comfortable environment for investors, who are therefore less likely to be so ‘obedient’. If this were to evolve, systemic risk would likely come to the fore.
Against this backdrop, we believe there are ‘Four Ps’ vital to preserving capital and providing attractive returns over the medium term.
Pick your battles: For example, we generally look to avoid political risk. It’s opaque and often ends up being expressed through currencies, themselves very speculative in nature. Markets struggle to price political risk and part of that is because they are often, effectively, single day binary risk events. As a result, for example, we positioned our funds as outcome neutral going into Brexit and the US election.
In contrast, we’re much happier taking economic risk. Take the US consumer, there are almost daily data releases which help build a picture of how healthy this important sector of the US economy is.
Planning for a range of scenarios: Predicting the future or forecasting is not a sustainable way to contribute to performance. While we often tend to have a base case, we also have a number of different investment views that are, to some degree or another, unrelated. Currently, our base case is dominated by the stronger economic growth story but we also have exposures that are unrelated, for example our new energy theme.
Pragmatism: The outcomes we’re looking to deliver are fixed but markets are constantly changing, so we need to be flexible. John Maynard Keynes’ view on dogma was fairly simple, “When the facts change, I change my mind sir, what do you do?”. A good example of this is how we’ve moved away from our “lower for longer” theme which dominated markets for many years. It served us well, but the data changed and, therefore, so has our positioning.
Position scaling: We avoid the temptation to have bigger positions in preferred investments. Instead, we scale for risk, with bigger positions tending to be in lower risk investments and smaller positions in higher risk investments.
There is a common thread that draws the Four Ps together. They are all designed to limit the often negative impact of human behaviour on risk management. For us, knowing our weaknesses is as important as knowing our strengths.
Anthony Rayner is fund manager on Miton’s multi asset team. The views expressed above are his own and should not be taken as investment advice.
*Bond yield - The interest received from a fixed income security, usually expressed annually as a percentage based on the investment’s cost, its current market value or its face value.
Important information
This document has been prepared for use by Trustnet.
The value of stockmarket investments will fluctuate, which will cause fund prices to fall as well as rise and investors may not get back the original amount invested.
Source for data: Landsbankinn 25/11/2016. The Independent 06/01/2017. FE 19/01/2017. Bloomberg – Bond yields 03/01/2012 to 30/12/2016. FT 04/08/2015.
The views expressed are those of the fund manager at the time of writing and are subject to change without notice. They are not necessarily the views of Miton and do not constitute investment advice.
Miton has used all reasonable efforts to ensure the accuracy of the information contained in the communication, however some information and statistical data has been obtained from external sources. Whilst Miton believes these sources to be reliable, Miton cannot guarantee the reliability, completeness or accuracy of the content or provide a warrantee.
Issued by Miton, a trading name of Miton Asset Management Limited the Investment Manager of the Fund which is authorised and regulated by the Financial Conduct Authority and is registered in England No. 1949322 with its registered office at 6th Floor, Paternoster House, 65 St Paul's Churchyard, London, EC4M 8AB.
MFP17/43