The last six years or so have had their surprises – the scale of the euro crisis, and the US credit downgrade, in 2011, for example – but generally the investment call has been a clear one. The great financial crisis (GFC) fostered an overly pessimistic consensus outlook, even as the stage was being set for a rebound in growth and risk assets led by the US. Six years, however, is arguably pushing it: is it time now for one of those periodic convulsions, the next black swan perhaps?
Performance of indices over 6yrs
Source: FE Analytics
Many pundits perennially predict bad news: the economy is allegedly either in recession or on the brink of one, and capital markets are either bust or about to be. Impatient for the convulsion, the economy can’t move forward without them summoning that destination to mind. Parents will recognise the insistent question from the back seat: “Are we nearly there yet?”
We have been more patient. We think the conventional account of the GFC has been misplaced – we saw it as a crisis of liquidity, not systemic solvency. We view growth, driven by ongoing changes in productivity, not by government or central bank policy, as the norm, not the exception. ‘Muddling through’ hasn’t sounded an enticing journey, but when so many voices have been suggesting disaster as a probable and imminent destination it has proven a very profitable trip – so far.
Are we pushing our luck? There have been several remarkable developments of late. Could they each be somehow related to a pending change in the economic climate?
These potential straws in the wind include:
• the continued weakness in oil prices
• a more recent weakening in copper prices
• the (re-)emergence of outright deflation in the euro area, with US and UK CPIs poised to follow
• bond and equity prices seemingly telling different stories
• rising volatility in stock, bond and foreign exchange markets
• a strong dollar, and a firm gold price alongside it
• big inflows to the Swiss franc, leading to the dramatic abandonment of the SNB's cap
• the confirmation that the ECB has found a way to untie its hands and join the would-be money-printers
• renewed concerns about euro fragmentation after the Greek election
Meanwhile, the sad and distressing events in Paris have perhaps added to a wider sense of unease.
Some of these issues are indeed related. Much of the deflation, and hence some of the strength in bond prices, reflects the weaker oil price – but it is a weakness that is essentially benign, because it is likely telling us more about excess supply than about an imminent collapse in global demand for oil. Episodes of deflation need not be bad for growth, and have not always been so historically.
Performance of oil over 1yr
Source: FE Analytics
Strong bond prices caused by a supply-driven slide in oil prices are not in fact disagreeing with strong stock prices: the latter may be looking beyond the near-term hit to oil company profits and towards the wider stimulus that cheaper oil brings, even as inflation stays low.
And while the ECB’s capitulation on buying bonds may be a little disappointing to those of us sceptical of QE’s direct impact, and keen to see investors stop viewing growth as being in the gift of governments and central banks, it is at least unlikely to do any immediate harm.
We cannot ignore all of these straws. The euro crisis has always had the potential to flare up again. We think the single currency and its ECB guardian are better placed now to weather a Greek exit than in 2011/12 (though we still doubt it will come to that), but the possibility that the Greek election will influence Spain or Italy is a real one. Yet mostly we believe the wind in which these various straws are blowing is a passing gust, not a changing financial climate.
The latest data again suggest that while global growth may be lacklustre, it is far from moribund. Cyclical indicators show manufacturers’ expectations in the larger economies still pointing to growth, at a level of global GDP roughly one-fifth bigger than at its pre-crisis peak (and one-tenth higher even in per capita terms).
Lower oil prices are now redistributing spending power at an annualised pace of 2 per cent of world GDP from producers to consumers, and the cutbacks in spending by the former group should eventually be more than offset by extra spending by the latter. (Some say that the deflationary climate means “it’s different this time” – we disagree.)
The US continues to lead the developed world expansion, followed by the UK, with the euro area and Japan lagging well behind. Almost unnoticed, estimates of US growth in the second half of 2014 have drifted above 4 per cent, and a reappraisal of the ‘below par’ expansion may be imminent: excluding government spending, the US economy has grown at a compound rate of 3.6 per cent since mid-2009.
However, even the euro area continues to move forwards, albeit at a glacial pace, and to create new jobs. The euro’s slide is now moving the competitiveness dial, which further argues for giving local growth the benefit of the doubt. (The corresponding loss of competitiveness for the US is occurring, as noted, alongside upwardly revised domestic growth expectations there).
Within the emerging world, China’s ongoing slowdown has yet to pull the official growth rate below 7 per cent, and the bloc as a whole of course continues to outpace the developed world comfortably, though the gap is narrower.
As hinted above, monetary policy divergence remains pronounced. Despite the possibility of negative US inflation – even as the domestic economy gathers momentum – the Federal Reserve still seems set to raise interest rates later this year. (A further large rise in the dollar might yet change its mind, of course).
The Bank of England now seems unlikely to move, however, while as noted the ECB has finally cast caution and German scruples to the wind by embarking upon a programme of potentially open-ended bond purchases. This is unlikely to have much if any direct impact on Europe’s economy, but it would not be surprising if business surveys were to start to pick up of their own accord – the lower real exchange rate will help.
We do not usually second-guess the financial weather and try to time the markets tactically. But if we felt the financial climate were changing, we might alter our strategic advice. Those straws in the wind notwithstanding, we doubt it is – if anything, ongoing growth with no inflation is an investment outlook that many of us used to dream about, and equity valuations, while not cheap, remain reasonable.
Our long-standing advice remains in place: growth-oriented return assets should comprise the bulk of long-term multi-asset portfolios. The sheer depth of the GFC has argued for this being a relatively long cycle, and even six years into it we’re thinking it probably has further to run. Stay patient: “We get there when we get there.”
Meanwhile, diversifying assets such as bonds are even more expensive than they were, but may stay so for as long as there is no inflation (and possibly for a while even when there is).
That said, we do not have the nerve to advise adding to duration at these elevated levels, and our macro views point towards relatively short-term – and conventional – holdings, with euro area bonds likely to continue to outperform, even with US-German spreads as wide as they are. Credit looks preferable to government bonds, but investors have to be happy to consider holding the bonds to maturity: liquidity is not what it was even for sovereigns, and could evaporate in a falling market.
We think stocks in the US and continental Europe should continue to offer the best long-term value, and prefer both regions to the UK and developed Asia ex-Japan.
We remain largely indifferent about emerging stocks relative to developed markets, though within the emerging bloc we have a clear ongoing regional preference for Asia. Paradoxically, a slower-growing China could eventually offer better returns if the government is reducing its hold on the economy, allowing more top-down growth to filter through to the corporate bottom line than has been the case to date.
Currency conviction must remain low, but even after its recent run we think that the dollar will stay top of the pecking order, followed by sterling, the yen and the euro. A setback feels overdue, but the dollar is not yet expensive, and the US expansion is the most convincing.
We were wrong to believe that the Swiss franc’s peg would stay in place, but it is now very expensive, and on a long-term view we think it might be bottom of the major currency rankings.
Swiss franc vs sterling over 3 months
Source: FE Analytics
We do not advise investing in commodities directly, and see no reason to try catching the falling knife that is the crude oil price at present. Short-term oil demand is very insensitive to changes in price – how much more petrol have you bought because it is cheaper? – and big changes in prices can be needed to clear small imbalances in global supply and demand (of the order of 1-2 per cent currently).
Admittedly, a small reduction in supply – if Saudi Arabia changes its mind, for example – could at some stage deliver an equally dramatic spike, but even the industry experts are unable to second-guess such an event.
What we can say, however, is each day that crude prices stay at current levels increases the likelihood of the muddle-through scenario extending further – and that the prices of oil company stocks have now on some measures fallen to relative valuation levels not seen for two decades.
Even allowing for the rising cost of extraction over this period, this looks overdone, and we would no longer recommend avoiding the sector if we were running conventionally allocated top-down portfolios.
More focused investment ideas consistent with our muddle-through outlook include technology; capital spending; the US housing market and financial rehabilitation (we think the sell-off in US financial stocks may be a good long-term entry point); M&A; and, for the brave, euro area banks.
Kevin Gardiner (pictured on page one) is global investment strategist at Rothschild Wealth Management. The views expressed above are his own and should not be taken as investment advice.
