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What investors need to be watching over the short and long terms

10 December 2018

The Adviser Centre chief investment officer Peter Toogood offers his current thinking on the state of the market and where it goes from here.

By Gary Jackson,

Editor, FE Trustnet

Investors face an increasingly difficult task to generate attractive returns over the coming years, according to The Adviser Centre’s Peter Toogood, but this does not mean they should be running for the hills.

The past year has seen the market endure two significant corrections – the first striking in February while the second caused a sell-off in October. The return of volatility into what had been a relatively calm market has prompted investors to question whether is time to pull back from risk assets and move towards safe havens.

Examining the question of if now is time for investors to hibernate, The Adviser Centre chief investment officer Peter Toogood said: “Our last attempt to explain the madness in risk markets was in February 2018, just ahead of the first mini-meltdown of the year.

Performance of indices in 2018

 

Source: FE Analytics

“Our main contention was that, as central bankers had turned from ‘lenders of last resort’ to ‘buyers of last resort’, asset prices were a work of fiction. We also argued that any attempt to remove the monetary punch bowl would, at the very least, increase volatility and more likely, inspire corrections in over-inflated asset prices.”

While some market commentators are “fretting about the end of the financial world as we know it”, Toogood said that investors should make a few observations about the current state of valuations and economics before running for cover.

When it comes to valuations, The Adviser Centre considers the US to be the only major equity market to be “egregiously priced”; even then, this overvaluation appears to be confined to the so-called FAANG stocks of Facebook, Apple, Amazon, Netflix and (Alphabet subsidiary) Google, which have just gone through an extremely strong run.


Outside of the US, developed world equities do not look expensive when compared with history. Although there are “pockets of madness” in some mid-cap names, Toogood described developed market valuations as “not alarming”.

“Emerging markets have taken most of the pain in the last 12 months and, in fact, for the past five years. However, they are now undervalued in an historic context, with markets such as Brazil and Russia particularly compelling,” he added.

When it comes to the economic picture, The Adviser Centre noted that there is a rapidly-growing consensus that the global economy is heading towards recession. This view is being driven by classic early indicators such as inverting yield curves and leading indicators rolling over.

“However, a plateau in economic activity should not be interpreted as an impending slump,” Toogood continued.

“Outside the US, monetary conditions are still very accommodative and so, while growth may be weakening, it is not obvious that the global economy is about to slide into a serious downturn. Indeed, Federal Reserve Chairman Powell has just indicated that US interest rates are nearing ‘neutral’.”

Inflation also remains a “hot topic” among investors but he argued that the rising cost of living is yet to feed through to headline inflation numbers in a meaningful way. That said, rising inflation is the greatest risk to long duration assets as it demands that central bankers react with higher interest rates.

Looking at the outlook for financial assets against this backdrop, Toogood said US equities look expensive but are less so after the recent sell-off; UK stocks are discounted by Brexit; Europe is relatively cheap but earnings are fading; Japan is being ignored by investors but earnings are holding up; and emerging markets are benefitting from improving profitability after five fallow years.

“Bonds are easily dismissed, but we have always argued that diversification is a sensible policy in the face of an uncertain future,” the chief investment officer said.

“If inflation is the bogeyman, equities are not the place to hide (discounted cashflows from earnings price in the effects of inflation rather quickly). Furthermore, in the event of a crisis, central banks will always save the bond market before the equity market; its demise would not just cause a recession, it would lead to depression.”

All this means investors have to keep their eyes on a number of issues, over both the short term and the long term.

The main factors to watch over the short term, according to Toogood, are:

1. Whether the Federal Reserve “blinks” in December and leaves interest rates unchanged

2. How quickly the three-pronged attack by the Chinese authorities to ease monetary conditions takes effect

3. Whether the trade dispute between China and the US escalates


4. How credit holds us and as importantly the collateralized loan obligation (CLO( market, which is the true source of the corporate debt bubble

“In the longer term, generating an attractive return from financial assets is simply going to be a harder slog,” Toogood concluded.

“This year, the monetary tide that lifted all boats is retreating rapidly and asset prices have either stagnated or gone into sharp reverse. Outside of the US, some equity indices have been lacklustre for a few years, but this fact is sometimes missed by sterling-based investors, who have enjoyed a currency-led boost from their overseas holdings.

“In 2018, we have witnessed the break-down of the momentum trades and the love affair with the ‘FAANGs’ and mid-cap growth companies has come to an abrupt halt. As the froth is removed, we suspect that more active, fundamentally-driven investment approaches have a genuine opportunity to add value in the coming years.”

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