After “Red October”, and as a rocky 2018 draws to a close, is it time to hibernate?

Our last attempt to explain the madness in risk markets was in February 2018, just ahead of the first mini-meltdown of the year.  Our main contention was that, as central bankers had turned from “lenders of last resort” to “buyers of last resort”, asset prices were a work of fiction.  We also argued that any attempt to remove the monetary punch bowl would, at the very least, increase volatility and more likely, inspire corrections in over-inflated asset prices.

As we stand today, we have experienced two mini-corrections (standard procedure in normal markets!), which has seen market commentators fretting about the end of the financial world as we know it!

So, should we be diving for cover?  Taking an objective look at valuations and economics, we observe the following:

Valuations

1.       From a valuation perspective, the US is the only major equity market to be egregiously priced. Even here, the real madness has been confined to the runaway “FAANG” stocks.

2.       Developed world equities excluding the US are not expensive in an historic context.  It is true that there are pockets of madness in some mid-cap stocks, but in broad terms, the valuation picture is not alarming.

3.       Emerging markets have taken most of the pain in the last twelve months and, in fact, for the past five years. However, they are now undervalued in an historic context, with markets such as Brazil and Russia particularly compelling.

Economics

1.       There is a rapidly-growing consensus calling for a global recession. The classic early indicators - yield curves inverting and leading indicators rolling over - are causing nervousness.  However, a plateau in economic activity should not be interpreted as an impending slump.  Outside the US, monetary conditions are still very accommodative and so, while growth may be weakening, it is not obvious that the global economy is about to slide into a serious downturn.  Indeed, Federal Reserve Chairman Powell has just indicated that US interest rates are nearing “neutral”.

2.       Inflation remains a hot topic. Understandably, most people are concerned about the rising cost of living, but for now, these pressures are not feeding through to headline inflation numbers in a meaningful way.  Of all the risks to long duration assets, rising inflation is the greatest threat, as it requires a commensurate response from central bankers in the form of higher interest rates.

3.       We are not convinced that China is about to see a day of reckoning.  A centrally-planned communist economy is primarily concerned with keeping the population content.  The profit motive is very much a secondary consideration.  As such, the authorities are likely to ease back on the scale of the slowdown that they have manufactured in 2018.  They are already loosening fiscal policy again and directing banks to be more generous in their lending to the private sector.  The great unknown remains the trade negotiations with the US – watch this space.

So, what to do?

As always, the answer to this question depends on your investment time horizon.

Equities

The elephant in the room remains the US. It is expensive in aggregate terms but some of the air has already been released.  For the UK, Brexit is the great unknown, but it feels as though at least some of that worry is already reflected in stock prices.  Europe is relatively cheap, but earnings are fading and the region remains hostage to the path of global growth.  Japan is being ignored by investors, but earnings are holding up and equity prices are not demanding.  Emerging markets still represent the highest GDP growth opportunity and, more importantly, profitability is improving after five fallow years. While we fret about debt levels in the developed world, emerging countries still have positive real yields and relatively normal economic cycles.

Bonds

Bonds are easily dismissed, but we have always argued that diversification is a sensible policy in the face of an uncertain future. If inflation is the bogeyman, equities are not the place to hide (discounted cashflows from earnings price in the effects of inflation rather quickly!). Furthermore, in the event of a crisis, central banks will always save the bond market before the equity market; its demise would not just cause a recession, it would lead to depression!

Diversifiers

Gold is the asset of choice for the “inflationists” among you. However, it is not obvious that companies have pricing power in today’s Amazon-powered world and so, unfortunately for equities, margins may suffer instead.  A strong dollar and higher US yields also detract from the yellow metal, so a change here is likely to trigger a higher gold price.  To the extent that the Federal Reserve wheels back from its tightening path, gold’s time may come again.

Market thoughts and conclusion

Factors to watch in the short term:

1.       Whether the Federal Reserve blinks in December and leaves interest rates unchanged.

2.       How quickly the three-pronged attack by the Chinese authorities to ease monetary conditions takes effect.

3.       Whether the trade dispute between China and the US escalates.

4.       Watch credit and, as importantly, the CLO market, which is the true source of the corporate debt bubble.

A positive resolution to any or all the above issues could see one more run up for risk assets into 2020.

Thoughts for the longer term:

In the longer-term, generating an attractive return from financial assets is simply going to be a harder slog.  This year, the monetary tide that lifted all boats is retreating rapidly and asset prices have either stagnated or gone into sharp reverse.  Outside of the US, some equity indices have been lacklustre for a few years, but this fact is sometimes missed by sterling-based investors, who have enjoyed a currency-led boost from their overseas holdings.  (Take a look at the local currency charts of markets such as the German Dax, the Japanese Topix or the Hang Seng for the past three years to see that investors have had plenty of volatility, but little in the way of return).

In 2018, we have witnessed the break-down of the momentum trades and the love affair with the “FAANGs” and mid-cap growth companies has come to an abrupt halt.  As the froth is removed, we suspect that more active, fundamentally-driven investment approaches have a genuine opportunity to add value in the coming years.

The heavily-indebted, greying developed world will not set the tone for the next decade, rather, it is the emerging markets that will drive global growth.  In other words, we flourish if the emerging world thrives, so let’s hope that globalisation has not been cancelled and that politics is just a little less angry in the future.