Market Commentary – 10th January 2018
Onwards and upwards…
The equity markets are gaining record high returns and continue to surprise on the upside over-and-over again. We can’t predict when the next downturn will be, however we are able to position our investment strategies and take into consideration various barometers to see how strong investors sentiment is. Right now, the economic and political risks we saw last year are subdued and not priced into the markets, whilst investors’ sentiment is strong. Economists expect the markets to demonstrate some volatility throughout this year as the global economic cycle starts to slow down.
As a good gauge to see how close we might be to the end of the cycle, we can look at price-to-earnings ratios, which are a relative measure of share price value. The US stock markets has only ever been this high at current levels twice in history, firstly in 2000 just before the dot-com bubble burst and secondly, before the Great Depression. There is a risk of a ‘sharp correction’ which could raise borrowing costs around the world. The current upswing in global growth will fade away eventually.
Expansions don’t die of old age
As we work our way into 2018, the global economic climate looks healthy backed up by strong economic data. We are happy with the current economic fundamentals as the global cycle has entered the new year in rude health. While the current expansion is longer than historical averages in some economies, it’s still some way off the historical maximums. The expansion, like any other, won’t simply die of old age. Low trend inflation and macro volatility as well as extremely well-anchored inflation expectations, are likely to keep discount rates and term premia low for yet another year. Hence, we will probably need different benchmarks to judge bubble valuations. US prices are closest to what would be described as bubble valuations. But a growth resurgence amid low discount rates makes a melt-up in valuations likely. This, in economists’ view, will be very positive for catch-up by cheaper markets. The same schools of economists still prefer a larger weight for equities, given the rise in equity risk premia over 2017. Equally, they like the idea of small portfolio hedges, based on the prospect of higher volatility this year.
Although many advanced economies, such as the US, have not had recessions since the global financial crisis in 2007/8, the stretches of uninterrupted GDP growth in most economies is far from exceptional. Notably, previous expansions have been longer than the current ones, implying the recovery won’t simply die of old age this year. Economic indicators that typically signal warnings do not suggest that a slowdown is imminent. Meaningful economic slowdowns often coincide with falls in the employment-to-working-age-population ratio and/or increases in inflation. However, neither trend is apparent in the major advanced economies, and recent activity surveys continue to paint a positive picture of near-term growth prospects. The flattening of the US yield curve could be a bigger reason for caution. A flat or downward sloping yield curve is often cited as a reliable indicator of tough times ahead. US recessions have usually occurred after the yield curve has been as flat as it is now, but the lags have typically been long and variable, suggesting that it would be unwise to expect a US recession soon. Economists think the flattening may partly reflect low macroeconomic and financial market volatility, and the shape of the curve may thus be a misleading guide of recession risks. Corrections in corporate credit, equity or housing markets could all trigger an economic slowdown. But while some measures suggest that asset values in these markets may now look stretched, they do not seem to pose a major risk of imminent danger. While geopolitical risks warrant monitoring, the overall risk environment looks more broadly balanced than it has been for many years.
Economic data points to more gas in the tank
The real reason to worry about long recoveries is not due to their length per se, but because it increases the risk of vulnerabilities building up or overheating. So, are such warning indicators flashing red? An obvious warning sign would be evidence of little or no economic slack. But post crisis, output gaps are subject to even more uncertainty than usual. Economists and policymakers have been persistently revising up the amount of potential in certain economies. Economists would therefore place little emphasis on the size of point estimates for output gaps to judge whether economies may be at risk of overheating. Other economic indicators can perhaps provide some clearer insights. So far, recent activity indicators, such as business surveys, point to little risk of an imminent slowdown. In fact, they suggest that global growth may have gained momentum around the end of 2017. But while the surveys typically provide a good indication of the near-term growth performance, their ability to predict whether growth will be gaining or losing momentum in six months’ time is limited.
Slowing investment growth can often be a trigger for weaker GDP growth, given its especially sharp cyclical fluctuations. But both near-term indicators and earnings developments point to a rosy outlook for investment. Another indicator that weaker growth may lie ahead is typically building inflation pressures. Recessions in the US and other advanced economies have typically occurred after a period of accelerating inflation, which eats into real incomes and prompts tighter monetary policy. But for now, inflation pressures remain weak and core inflation in several advanced economies has recently eased. This suggests that building domestic price pipeline pressures in advanced economies are unlikely to trigger an imminent slowdown. Economists remain unconvinced that stronger inflation pressures elsewhere in the world will feed through into much higher CPI inflation in advanced economies. Economists are also sceptical that weakness in emerging markets (EMs) will prompt advanced economies’ expansions to fizzle out. Economists do expect a modest slowdown in China this year, and there are potential downside risks related to Asia, with some recent trade indicators having softened. But we see healthy global trade growth continuing and non-China EMs gaining momentum. The upshot is that there is little in the economic data to suggest that advanced economies are on the cusp of a sharp slowdown.
For anyone who wants further data to substantiate the position please review the attached Global Economic News Document.
Model Portfolios & Indices
Over the last week we have seen the benchmark indices that we track all increase and reach new record highs. One that stands out is the Nikkei 225, which hasn’t been trading for most of the start of 2018 and when the market did trade, we saw the index achieve strong gains based on Japanese traders playing catch-up to the US equity rally and benefitting from a cheap US Dollar. With the US, its without a doubt that stocks and bonds are highly priced, and the World Bank has too highlighted this early this week. As markets have rallied into 2018, we do expect them to come down, erasing most of their gains, such as Europe as I write this, which is very normal.
With our portfolios, some of our positions have already hit their 3 months expectations in the first week of January! But this also raises the million-dollar question: how long will this rally last? We are cautious of what the markets are currently doing, with reaching new highs, and our OBI portfolios are positioned for a correction based on the equity and non-equity split. By adopting this strategy, we are able to cyclically adjust OBI to make it work given the economic cycle.
The data above will not directly correlate to the indices as there is always a delay in pricing because the US markets close significantly later than the European markets and the Asian markets. The data set above reflects the last close and much of the days movements will not yet be reflected in the portfolios due to pricing delays. You cannot therefore directly correlate indices to the portfolios. The value of investments may fluctuate in price or value and you may get back less than the amount originally invested. Past performance is not a guarantee of future performance. Performance figures quoted include the fund manager charges but exclude other fees such as adviser, custodian, switch and/or discretionary investment management fees. Unless otherwise instructed and accrued, income is reinvested into the portfolio.
This Day in History
On this day in 1863, The Metropolitan Railway opens in England as the world’s first subway, with steam engines pulling wooden carriages lit by gas lamps. Later officially called the ‘London Underground’, its warren of tunnels will be more popularly referred to as simply “The Tube” which millions of people rely on each year.
As always have a wonderful week and stay safe.
Jason Stather-Lodge CFP, MCSI, APFS
CEO & Founder
Chartered & Certified Financial Planner
Chartered Wealth Manager