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Guy Monson: the end of a fairy tale

Guy Monson: the end of a fairy tale

The Goldilocks economy – ‘not too hot, not too cold’ – has been the backbone of the five year bull market, but might it now be fading? 

Economic growth feels too hot for increasingly nervous central bankers, but a bit too cold to sustain today’s ambitious profit forecasts. 

For our clients, this suggests more cautious portfolio tactics, including higher cash balances and disciplined profit taking across higher valuation holdings.

In talking with clients this quarter, we have made much of the fact that after nearly a decade of austerity and restructuring, a synchronised global expansion is at last a reality. 

Led by an American upturn that is already one of the longest on record, US employment continues to rise, despite the risk that Donald Trump’s programme of deregulation and tax cuts may be running into the Congressional sand. 

In China, there is a much needed crack down on excessive credit, but for the present, economic growth of between 6% and 6.5% remains realistic.

Meanwhile in India, prime minister Modi’s currency reforms have done little to dent a growth rate that has returned to nearly 7% per annum. 

It is in Europe though, where healthy growth has finally returned and the positive global profile made complete.   

Mr Macron’s election and the victory (albeit slim) of other pro-EU politicians seems to have lit a spark under business and consumer confidence.  Particularly notable are the recoveries unfolding in Spain and Ireland, leaving just Italy and Greece, as Europe’s remaining problem children.  

Looking out for the three bears: interest rate risk, the shrinking of central bank balance sheets, and an ever more competitive ‘Amazon’ economy

While better growth prospects will have economists breathing a little easier, equity and bond investors need to be more circumspect. 

Synchronised global growth also implies a simultaneous desire to tighten policy after nearly a decade of universal super-loose conditions. 

Until very recently, central bankers appeared relaxed, even as unemployment levels collapsed in the US, Japan and now the UK to levels that economists would historically have expected to trigger inflation. 

In recent months, though, some have started to argue against this complacency, suggesting that today’s breakdown in the Phillips Curve might only be temporary.    

The US has begun the process of interest rate normalisation, with four 0.25% upward rate moves (to 1.25%).

The Bank of England will probably be next.  Although withdrawal of ultra-loose policies is being carefully calibrated by central banks, world debt levels are high and interest rate sensitivity is therefore uncertain.  

In addition, while modest rate moves seem unlikely to radically alter consumer or business behaviour individually, collectively they could induce an ‘air pocket’ in global growth. 

Moreover, it is policy around vast central bank balance sheets that holds the greatest risk for financial markets. 

These bloated holdings of bonds, acquired during the financial crisis and almost unprecedented in size outside of wartime, have been acting like financial shock absorbers.  They have cushioned the global economy from events like the sudden collapse in commodity prices in late 2015 and the UK referendum and US election  results in 2016. 

They have blessed financial markets with extraordinarily low levels of volatility. Arguably, they have also bred an element of complacency among both bond and equity investors.

 Again, the US is at the forefront of ‘normalisation’. The Federal Reserve has indicated that it would like to start the process of shrinking its balance sheet – albeit at a pace so slow that some have likened it to watching paint dry. 

Europe and Japan would like to follow.  

These moves will likely compound the tightening in global liquidity that has already been introduced by policymakers in China, who have become concerned about the sharp acceleration in house prices. 

Is UK inflation too hot?

UK inflation has accelerated from 1.6% to 2.9% this year for the headline consumer price index (retail price inflation stands at 3.7%), prompting calls by several Bank of England Monetary Policy Committee (MPC) members to raise the bank rate.

Yet ten-year gilts yield a mere 1.29%, and comparable maturity single-A corporates just 2.2%. Either yields are too low, or market participants have unshakable confidence that the recent inflation rise will be temporary.

Inflation should ease back provided there are no ‘second round’ effects. It will stick if there are compensatory rises in wages and firms attempt to sustain profit margins.

So far, there are no signs of wage inflation, but it may just be a matter of timing, as Jeremy Corbyn’s proposals on public sector pay trigger a wider debate. The answer to this question will be unknown until pay bargaining and annual pay reviews begin again in late autumn and progress through the winter.

But is the economy still too cold for profits?

While global economic growth has been gaining momentum, parts of the industrial world still appear to be under the grip of secular deflation.

The climate agenda and increases in the productivity of US shale continue to depress oil prices (crude is down almost 20% year to date). 

Although the wider commodity sell-off is much smaller than during previous oil price declines, nickel, silver, natural gas, sugar and orange juice are all down this year. 

In the auto-industry, confusion over the future of diesel and the excessive levels of auto loans have depressed annualised US car sales from 18.3 million in January to 16.4 million today (a level last seen in mid-2014).

Meanwhile the ‘Amazon effect’ continues to damage the conventional retail sector and associated property assets (especially US malls).  In some cases retail weakness is compounded by falling real wages and little room for further personal leverage.

In short, significant areas of the global equity markets are off limits to growth investors, and their capital continues to be channelled into the more highly priced secular growth stories (for example IT, social media, automation and semiconductors).   The result is that though equity prices have continued to rise, they have grown significantly faster than underlying earnings.

Preparing portfolios

We are therefore entering unchartered territory - one where the global liquidity tide is starting to go out but where corporate profits expectations are already very full. 

Moreover, with central banks highlighting the over valuation of financial markets, a small setback in financial markets is unlikely to halt their carefully drawn plans for policy normalisation - in fact it may even be seen as desirable.  

After the strong rise in equity markets this year we are continuing with our programme of gradual risk reduction. 

In May of this year we increased the credit quality of bond portfolios.  In June we reduced the equity exposure of multi-asset portfolios below their long-term strategic neutral position. This was not a decision taken lightly, given the paucity of returns from government bonds, credit and cash. 

We have lifted cash balances, added to alternatives (primarily infrastructure and gold) and have made steady reductions in our technology and associated internet holdings. 

We have continued, though, to add to US and European bank stocks as a hedge against higher rates and because regulators are permitting higher dividend pay-out ratios.

Our current caution stems from concerns over the transition out of the Goldilocks economy.  We expect a bumpy period for financial markets as the central bank liquidity blanket is gradually withdrawn.  

The ‘not too hot, not too cold’ economy was never going to last forever.  So be prepared for heightened volatility, take profits early and don’t be afraid of holding cash (ready to buy future dividend streams at lower valuations) as the monetary fairy tale reaches its final chapter.

Guy Monson (pictured) is chief investment officer at Sarasin & Partners

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