A hard landing in China, a rollover in commodity prices and the misuse of quantitative easing could spell bad news for equity markets despite their strong returns over the last year, according to Tilney Bestinvest’s Gareth Lewis.
The chief investment officer says the drivers of poor equity returns during the first six weeks of 2016 haven’t gone away and, despite hopes that fiscal policy will boost economic growth, warns that disinflation could still be on the cards.
Performance of indices in 2016
Source: FE Analytics
“In 2016, the political fears that many people had came to fruition but risk assets went up anyway,” he said. “If you were bright enough or lucky enough to have predicted the outcome of Brexit and the Italian referendum and positioned yourself in the way you would have been told to be positioned, you would have lost a lot of money.”
Many investors prepared themselves for the worst during the run-up to June’s EU referendum, with fears that uncertainty stemming from a ‘leave’ majority vote would bruise markets.
Since the result was announced, however, the FTSE 100 has returned 16.78 per cent in what has been described as one of the “most hated” bull markets to-date. 
The same rang true following the shock election of Donald Trump as US president; despite much uncertainty surrounding his policies, the S&P 500 index has achieved a strong return since 8 November last year and the dollar has strengthened.
“There are two key reasons why risk assets have continued to outperform despite the political changes we’ve seen,” Lewis (pictured) said.
“In the first half of the year, people quite clearly anticipated political disruption as leading to more monetary stimulus and you saw this change in monetary stimulus in Japan, in France, you saw a very dovish Fed throughout the whole of the last year, and obviously post-Brexit we saw the re-introduction of QE.”
“The second reason is Trump. The market’s perception of what is going to happen next has changed dramatically and, rather than being a weak economy held up by monetary stimulus, the market has moved to discount a faster growing economy, greater inflation and traction of fiscal policy in a way we haven’t really seen since 2007.”
“To me, that one event marks the single biggest change in the post-banking crisis world, in that all of the preceding eight years have been around monetary policy from central banks. It’s not been about fiscal policy. In fact, fiscal policy has been tucked away in the background as politicians have failed to take up the mantle that they should have in regard to economic management.”
As such, this led to a significant rotation in asset prices during the second half of last year, with markets favouring cyclical value stocks over expensive quality growth holdings.
Performance of indices in 2016
Source: FE Analytics
Another reason markets have rallied, according to the Tilney Bestinvest CIO, is currency movement and the fact sterling has slumped since the ‘leave’ majority vote was announced, as currency-converted gains have benefitted global-facing exporters.
While Lewis believes this market trend could continue over the short-term, he warns this may not be sustainable past the second half of 2017.
“We’re in a position where the market has been supported by excessive central bank liquidity not being withdrawn and you have a market that is moving to anticipate fiscal stimulus,” he explained.
“So you have more alcohol being added to the punchbowl in terms of market expectations. While you’re in that honeymoon period where Trump can talk about policy without having to deliver it, that may well carry on.”
“But, by the time you get to the end of this quarter and possibly Q2, you’re going to have to start to see legislation announced and put through Congress, then you might start to see this challenged.”
The CIO questions whether the commodity rally seen over the last year is sustainable, as he believes the prospect of Chinese economic stimulus being implemented over the next six to nine months is ‘untenable’. He says this is reflected in the Australian Department of Industry, Innovation and Science’s downgraded forecast for iron ore prices this year from $82 per tonne to just $50.
He warns that, if commodity prices do start to unwind, the global equity rally simply won’t be sustainable.
Performance of index since 2016
Source: FE Analytics
“As fundamental investors, we don’t like buying speculative stocks, or those stocks that are very reliant on short-term stimulus to drive earnings, we much prefer fundamentals,” Lewis continued.
“One of the reasons we have been relatively cautious on the outlook from an investment point of view is we do not fundamentally like a lot of the stocks that have driven the rally. It’s fine if you’re trading these things but we’re not traders. In terms of fundamentals, they don’t make too much sense to us.”
Lewis explains that quantitative easing and the lowering of interest rates since 2008 has been allowed to continue for too long, leading to so-called ‘zombie’ companies which offer investors very little upside.
“The global financial crisis was a financial crisis and not a wider crisis because QE prevented defaults from happening,” he said. “One of the issues I have is that there’s a vast array of companies that probably should have failed post 2009 that were allowed to continue surviving as a result of QE.”
“Those companies are clogging up the global system and putting an impediment in the way of the well-capitalised companies.”
“By creating this liquidity, QE has prevented the default cycle and has become trapped in the financial system. By 2014, it has become an economically counterproductive policy measure because it was actually preventing the economy from recovering properly.”
A further repercussion from ultra-loose monetary policy, according to Lewis, is the increased wealth disparity across society. For instance, he says first-time buyers will now find it almost impossible to afford their initial deposit, while homeowners can borrow against existing assets to buy more assets.
Additionally, he warns that dragging forward equity returns through quantitative easing has lowered prospective returns for those whose pensions are in stocks and shares ISAs. He says this has created a social division and has led to the uprising of populist parties across the globe.
“The challenge is that capital markets have become reliant on central banks, so every time there’s a piece of bad news in 2016 equity markets have rallied because they have anticipated an extension or an increase in QE,” the CIO said.
“But quite clearly that hasn’t helped the global economy, the global economy requires further stimulus which is fiscal, Trump is now kicking off that process.”
“If the market is right in its response so far to Trump, which is to re-rate cyclicals and drive up bond yields, it is doing this because it thinks the Fed is probably behind the curve and that US rates are likely to rise more quickly than thought in response to inflation.”
“We believe the bigger issue in the global economy is disinflation and we still think that sits in the background. But, in the short term, the market is now fixated on inflation.”
Lewis says inflation is likely to lead to tighter policy from the US Federal Reserve and a stronger dollar. If the dollar continues to strengthen, he warns it will reduce the flow of dollar liquidity that markets have become reliant upon.
“In my view, that reduction of US dollar money supply will impact emerging market and Asian equities and, in turn, that will probably take the steam out of the rally in global equities elsewhere and commodity prices will roll over,” he warned.