Investors should consider shifting some of their portfolio into safer assets such as cash and moving away from growth stocks, according to Wermuth Asset Management, which warns that the likelihood of a significant correction is growing. 
The decade since the start of the financial crisis has seen unprecedented amounts of monetary stimulus unleashed to shore up the global economy, with measures such as ultra-low interest rates and quantitative easing having the added effect of pushing stock markets onto record highs.
But despite the fact that global growth appears to be on a more stable trajectory and many parts of the market seem richly valued, this stimulus remains in the place. The US Federal Reserve has been attempting to normalise its policy since December 2015 but has only managed to move the policy rate from 0.1 per cent to 1.16 per cent so far – well below the neutral rate of around 3 per cent.
Performance of indices since 2007
Source: FE Analytics
Dieter Wermuth, head of macroeconomic research at Wermuth Asset Management, said: “Monetary conditions remain very easy. Why doesn’t the Fed tighten more rapidly?
“This reminds me of the goldilocks environments of the Greenspan and Bernanke years. At the time, the central bankers hesitated to take away the punch bowl when (almost) everybody was happy with things as they were, including strong growth, low inflation and booming stock markets?
“It could not last. March 2000 and September 2007 marked the end of the two previous stock market rallies. They were followed by corrections of the S&P 500 by 46 and 48 per cent, respectively. Both stock market parties thus ended in tears.
“The current rally began in March 2009 and has driven the index up by no less than 224 per cent since. A repeat of the large corrections seen in the past gets likelier by the day.”
Wermuth’s outlook revolves around is assessment of central banks’ likely actions. As noted, the Federal Reserve has moved slowly with policy normalisation while the European Central Bank – despite appearing to prepare markets for a tapering of QE and eventually higher interest rates – has little incentive to act given the low chance of target inflation being reached any time soon.
One issue that has confounded economists and central banks in recent years is how rising employment and stabilising GDP growth have failed to lead to strong wages and inflation – especially when there is a backdrop of aggressive money printing.
The head of macroeconomic research argues that the most plausible explanation is advanced economies are still operating “significantly below” their potential output. A consequence of this view is that he does not buy the argument that advanced economies are currently operating near to full employment, unlike many central bankers.
Furthermore, globalisation is exerting downward pressure on prices as goods and services flow across increasingly porous borders. This means inflation is likely to remain subdued, to the point where it is almost independent of monetary policy.
Both the Federal Reserve and the ECB down-play the two above points, predicting that the usual relationship between real growth and inflation will eventually resume. Wermuth, however, believes that these factors are strong enough to prevent rates moving to pre-crisis levels any time soon.
Global stock market indicators
Source: Bloomberg, Wermuth’s calculations
“Let’s assume the two counter-arguments above are valid. Investors would then have to prepare for a long period of very low wage and consumer price inflation, accompanied by historically low policy and market interest rates,” he said.
“My standard analysis of stock and bond markets would be worthless – since real long-term interest rates will be extremely low for many years to come, stock markets are not overvalued but cheap, while bond yields are about right. It’s the ‘this time is different’ argument once again. The reasoning may make sense, but my gut feeling is that the risk of another major financial crisis continues to increase.
“Let’s start with the traditional market analysis by looking at the usual stock market indicators. Under the assumption that central banks are right about the eventual return of inflation and rising policy rates, they suggest that investors should get out before everybody else does.”
Although markets have risen in the eight and a half years since the very bottom of the financial crisis, the recoveries have been very different depending where you look, Wermuth noted. US and German markets have done the best, closer followed by Japan.
“As a general rule, markets that have performed very well in the past are unlikely to be the future winners. Hands off expensive assets! Investors should rather increase the weight of neglected markets such as Spain, Italy and China,” he added.
Other valuation measures offer a mixed picture. Price-to-earnings ratios suggest the UK, the US and Switzerland are expensive while nothing looks cheap; from a risk premia point-of-view only US and Chinese stocks are expensive while the rest are attractively priced; and price-to-book puts US and Swiss equities in overvalued territory with most of Europe looking cheap.
“To sum up, the picture that emerges from the above analysis is confusing. Some stock markets, especially in America, are overextended and should be avoided,” the strategist said.
“As a minimum, I suggest to reduce the share of volatile and expensive stocks in US portfolios. Relatively safe alternatives are the European laggards Italy and Spain, countries which are finally overcoming the financial crisis and their deep and long recessions. Japan and Germany are not so cheap, but they have safe haven qualities.”
Where does all this leave investors? Wermuth predicted that inflation will remain subdued for at least another year, pushing back any sharp monetary tightening that could stop the bull market in its tracks; equities will remain well-supported by low real policy rates and accommodative monetary policies in general.
Furthermore, GDP growth in the main economies – apart from the UK – appears to be robust and synchronised, which offers another leg of support for stocks. The strategist said the main economic indicators suggest “we are indeed living in a goldilocks world”.
However, this might not the positive that it looks like at first glance, he warned.
“It is precisely at times of complacency and supportive economic policies that crises begin. Expensive assets such as stocks, bonds or real estate imply that the scope for future capital gains is limited. When financial investors become aware of this simple arithmetic, some of them will try to lock in their paper gains and take profits,” Wermuth concluded.
“A downward spiral begins as the herd follows the leaders to the exit. The process would gain momentum if central banks also decided that it was about time to raise interest rates more aggressively. But this is not a ‘sine qua non’ for a major market correction. Market forces alone can be strong enough if the disequilibrium that needs to be corrected is large enough. This is the case today.
“Markets can move in the wrong direction for longer than one would reasonably expect. ‘Shorts’ have often been entered prematurely and investors following that strategy have lost their shirts. It may therefore be enough to start by moving funds into money markets where price risks are near zero, to shorten maturities in general, to look for ‘boring’ and neglected yet solid markets, to exchange growth stocks for dividend, i.e. income stocks, and to reduce debt. When the big sell-out starts one day, these will be ‘crowded’ trades which are not as easy to realise as today.”