In this Q&A Guidance note, we put forward our thoughts on some of the puzzling questions of the day:

• There were good reasons to be pro-bond, but what now?
• What equity bull market?
• Continued largesse from central bankers and the implications for assets.
• Possible routes to a change of regime.
• Thoughts for portfolio allocations.

Roll up, roll up, for the bargain of the century:  a sovereign bond that matures in 100 years and gives you the princely yield of 1%!

This bond was a recent (re-opened) issue from the Republic of Austria, a country that has seen more than its fair share of trauma in the last 100 years.  We’ve nothing against Austria of course, but paying 154% of face value for a bond that matures in 2117 and guarantees you a negative return in real terms is an astounding concept.

How did we get here and why are such “investments” are in demand?

You have had a pro-bond stance in recent years.  Why?

We have indeed been advocates of bonds, but not always for the same reasons cited by others.  The reasoned argument is that the global marketplace in the virtual world is indeed disinflationary and this probably means that inflation expectations should be anchored lower.  In turn, this should be reflected in lower bond yields (perhaps not negative ones however!).

The more cynical reason to be pro-bonds is that global central banks, in their largesse, have printed over $22 trillion of digital money to buy an array of government and corporate bonds, in the vain hope that this would instigate a higher level of credit creation globally - a big fail there, by the way.

The old mantra of “don’t fight the Fed” was always a sound one, until it wasn’t - see 2000 and 2008 for reference.  However, as central bankers moved from being the lender-of-last-resort to the buyer-of-last-resort (at any price), it certainly hasn’t paid to stand in their way.  Climb aboard the good ship “Negative Yield”!  The bond bull market ends when central bankers call time, so good luck guessing when they will stop their antics.

How long has this equity bull market got to run?

To answer this, we should clarify what bull market we are discussing.  Local investors with money in Asian, European or Japanese equities could be forgiven for thinking that “bull” is simply a shortened word for another kind of “bull”.  To describe the bulk of equity markets in these areas as meandering in the last five years is a very generous interpretation of the actual outcome; dissatisfying might be closer to the truth.  For sterling-based investors, the joys have been derived chiefly from currency-related gains.

Undeniably, the US has been the standout performer, but the same techniques of monetary abandonment and strong doses of fiscal stimulus have been the drivers of this result.  That said, the picture here is hardly exciting over the past 12 months; the US indices are barely higher in value and this is after the current President pushed through a fiscal stimulus package that was larger than the fiscal boost of 2009, the year after the global financial crisis!

Investor behaviour in relation to equities been entirely logical given the collapse in bond yields.  The re-rating of what are now termed “bond proxies” is to be expected when investors are seeking out stable and defensive cashflows in a lower growth world.  The same handwringing about the valuation of bonds can be applied equally to these “safe” stocks, but, when the game is rigged, you don’t get a choice but to play.

When we reflect on the more aspirational corners of the equity markets, we cannot help but be nervous about the “new disrupters on the block”.  The very fact that Uber admits openly in its IPO documents that it may never make a profit sums up the distorting effect of excess money chasing too few ideas.  This is not a gripe against the FAANGs - they are genuinely disruptive - but even here, investors worked out last year that Amazon was probably not worth 100x earnings.

So, what do we do in the near term?

Currently, we are moving back towards a global easing cycle, with some fiscal stimulus in the wings.  This is just another example of press and repeat.  While the world has spent its time focusing on the US, the reality is that China has been the marginal driver of growth for the past ten years.  (Indeed, China now accounts for 30% of all luxury goods sold across the world - wow!)  However, it is very clear that the economy is spluttering and this has implications for global growth.  Germany has caught a cold on the back of this slowdown, as have many other exporting nations, driving home the point that, in practice, the genuine growth opportunities lie in the hands of very few.

So long as central bankers persist with their monetary largesse, there is little reason to deviate from the momentum trades that they elicit.  Bonds have no natural sellers at present and, as such, are supported.  Equally, “bond proxy” equities are favoured, while the FAANGs are busy tearing up the normal rules of engagement for commerce, albeit at a fancy multiple.  Given the safety-first factor and a belief that the US authorities will do what it takes to keep the party rolling, it is hard to see the US giving up its title as leader of the pack.

What is the catalyst for change?

Despite ten years of jawboning, printing and now heckling, the harsh reality is that the authorities have singularly failed to generate a self-sustaining economic recovery.  They have been successful in lowering the cost of borrowing to a point where the patient is stable, but still there are no obvious signs of sustained revival.  Therefore, we must assume that the next phase of treatment will be more extreme and, dare we say, more experimental...

However, before this next act, we are witnessing the “beggar thy neighbour” phase.   The US administration’s accusations of competitive devaluation (which, in this instance, is not about the US having a stronger economy, but is - apparently - a deliberate act of sabotage by the Europeans, Japanese and even us Brits…) is the latest storyline for the “make America great again” camp.  Let us hope that these are nothing more than verbal utterances, as trying to weaken the US Dollar through direct action will allow us all to see how the 1930s really looked.  For now, stability is a phoney war and we remain just a Presidential tweet away from the next mad moment.

In the long term, the grand bargain between the central banks and the asset markets is doomed to fail.  You cannot create a boom without creative destruction and the idea that the authorities are able to, not only cancel the economic cycle, but also choose its amplitude to the upside, is beyond laughable.  Every century, yet another genius discovers how a printing press works, but the truth is that devaluing paper money has, and always will, end in tears.

Our best guess is that upon the next breakdown in equity markets, the response by central banks will be overwhelming and we may see another mean reversion trade into unloved value stocks.  There will be no longevity to this trade as, yet again, the printing press will not engender a shiny new credit creation cycle as the world is already tapped out on debt.

When this trade falters - and falter it will - the grand bargain will move to the importance of targeting nominal GDP and then we will see how inventive the authorities can really be.  Expect a People’s Bank, an infrastructure boom and the Corbyn (or Boris) “magic money tree” to be in the mix.  Then, the hope factor in asset prices will deflate and the process of creative destruction will begin in earnest.  Finally, a proper bull market in assets, linked to productive (rather than fictitious) leverage, can begin.

How do we allocate our portfolios?

Until the equity markets show a serious and sustained deterioration, there is no reason to switch away from the bond proxies and growth stocks.  Even if a serious downturn emerges, it is not obvious that we see a big value switch; value stocks are not obviously cheap, as they were in 1999, they are just less expensive than growth stocks.  Furthermore, in the first phase of a downturn, it’s all about safety first.

Bonds are likely to remain the focus of furious buying as central banks try to staunch the bleeding, which means there is little incentive to sell them either.

Thinking about the longer term, as the “it’s time to focus on nominal GDP” mantra becomes reality, a gradual shift to real assets makes sense.  This would point to holding more gold (and, dare I say, silver), plus having higher cash weightings to pick up opportunities as they emerge.  Bonds will be a gradual sell as the focus shifts from asset market purchases to the funding of real economic growth.

Finally, if the above thesis is correct and the money-for-nothing party is drawing to a close, we are likely to see the return of a real cost to raising capital, which will undermine the flakier business models and the zombie companies that should have expired already, or in fact, not existed in the first place.

And then, finally, active management will have its chance to flourish again.

Safe travels one and all.