Investors are gradually bidding farewell to the cushion of central bank liquidity that shielded returns from ‘real world’ events.
The bull market in everything that the central bankers created is drawing to a close and, for a while at least, cash is king.
The last quarter in world markets has reminded those of us who are old enough to recall what investing was like before the arrival of the ever-supportive hand of the central bankers.
Today’s technology and data crisis, coupled with the US-China free trade skirmish and Russian diplomatic imbroglio would, in recent years, have been viewed by markets largely in terms of the reactions they triggered from the central banks.
In this Alice in Wonderland world, bad news in the real world was often good news for financial markets, as investors assumed that easier money (or at least a delay in even modest tightening) would ensue.
Central bankers are gradually bowing out
Today though, the central banker’s ‘cushion’ is being steadily withdrawn, after the sixth US rate rise and the likely conclusion of the European Central Bank (ECB)’s massive bond buying programme.
Without near zero rates to shield them, markets are now feeling the full impact of today’s triple shock across technology, trade and international politics.
The result has been a move to ‘risk off’ with weak and in many cases negative returns across a broad swathe of asset classes, particularly when measured in sterling terms.
As central banks dial back their stimulus, the real world can feel much more painful for investors and, for the first time in several years, cash is king once more.
This suggests a change in approach to investment markets. Gone are the skills needed in the past decade that lay not in analysing events or fundamentals themselves, but rather in trying to guess how Messrs Bernanke, Kuroda and Draghi would react to them.
We fund managers became, by necessity, highly skilled US Federal Reserve (Fed) and ECB watchers and, rather like the Kremlinologists of the Cold War, we found ourselves parsing every nuance of central bank language. We read great significance into off-the-cuff remarks at press conferences and policymaker gatherings.
Indeed, so large were the balance sheets that these men and women deployed that their statements were usually more significant for markets than those of the political masters they served.
Both US president Donald Trump’s election and the EU referendum, for example, were surprise real world results, but their effect on markets was so muted by ‘emergency’ liquidity that these events actually resulted in lower equity volatility than we experienced amid the decidedly ‘mini’ wage inflation wobble in early February.
The politicians return to centre stage
But the wind is changing. Central banks are dialling back their policies and presidents Trump, Xi and Putin – maybe even Macron – are not men to be upstaged by their central bankers.
The task, then, for all fund managers is to wean ourselves off a diet of ‘Fed watching’ and return to analysing real world events, and estimating their impact on bond yields, currencies, profits and dividends.
With this in mind, what does today’s hotchpotch of political and regulatory challenges mean for global markets?
We have long known that president Trump has been itching for a trade ‘skirmish’ – his ‘America First’ doctrine has always highlighted the persistent US trade deficit and his primary targets appear to be China and the NAFTA Members.
Our hunch though is that the White House is primarily transactional in its focus (using tariffs as tools to unlock better trade deals) rather than an ideological process (in a way that could trigger long-term tit-for-tat trade restrictions along the lines of the Smoot-Hawley Act of the 1930s).
Certainly, Trump has rowed back on excluding ‘allies’ from the steel and aluminium tariffs, while already settling a new trade deal with South Korea on apparently superior terms.
For our clients at Sarasin, this means retaining our current caution on equities (valuations rather than earnings are already under pressure) while preparing for a weaker US dollar, as probably the president’s best tool if he wants a lower deficit.
A weaker US currency is traditionally good for commodities and emerging markets – there will be opportunities to add to both as the current trade talks evolve.
The negative headlines for the technology sector began with the Facebook data storm and may yet mark the high point of the free-wheeling global market for data. These evolved into a series of presidential ‘tweets’ deriding Amazon for paying low taxes and freeriding on the US postal service.
Of course, none of these issues are new, but all illustrate regulatory risks are not necessarily priced into today’s high stock valuations.
At Sarasin, we have been increasingly cautious not just of the regulatory backlash to poor data privacy but also the wider social and governance issues that it raises.
Last year we sold our entire holding in Criteo (the web-based data marketing group) on similar concerns and this month, for related reasons, we sold all of our long-held positions in Facebook (we retain our Alphabet position for the present).
The diplomatic spat between Russia and Britain (alongside the EU, US and NATO) has little immediate economic impact, but does presage a world where regional conflicts can more easily escalate, and one where foreign policy ‘accidents’ may be more common and inflammatory.
In the short term, extraordinary diplomatic corralling by the UK is probably modestly positive for sterling and adds to a general uptick in post-Brexit confidence.
Against this backdrop, the euro area does appear to be something of an economic safe haven with a strong domestic recovery (GDP + 2.7% in Q4), a very robust current account balance (+3.1%) and, (excluding Italy) a stable political calendar. For that reason, we expect to see continued euro strength.
Taken together, these issues, alongside the elevated valuations of all financial assets, have reinforced the underweight equity position which we adopted in late summer 2017.
The move was a few months early in retrospect, but our additional cash holdings have proved valuable in this year’s downturn. For a significant number of clients, we have achieved part of the ‘underweight’ by insuring up to 25% of equity holdings by buying on European and US indices when volatility was low (and hence insurance cheap) late last year.
Finally, we are not unhappy to see clients now running significantly higher cash positions not only as a defensive measure but also as an opportunity to hold higher euro balances.
The latter allowing them to capture what we see as a long-term appreciation in the currency as the euro area (finally) becomes a comparative economic and political safe haven.
Guy Monson (pictured) is the chief investment officer at Sarasin & Partners