If you are sensible and have a life you don’t follow Markets in real time, and are not immersed in the emotional push and pull of daily news and commentary.
It is a conundrum we struggle with, we know it’s not productive to get caught up in the sound and fury of the moment but at the same time we need to understand the overarching narrative, and this requires granular context.
I mention the above because the first four months of 2018 have been excessively noisy and emotional, such calm in 2017 replaced with materially extreme sentiment.
Why
In my last blog I tried to explain how negative rising interest rates can affect markets.
Think simply of the interest rate as an anchor to profits; the higher they go, the greater the resulting drag on momentum.
The US Federal Reserve has been telling markets that there are likely to be between 5 and 7 quarter point rate rises by the end of 2019.
The US 10-year treasury yield has risen to over 3% and the likelihood is that it goes above 4% in the next 18 months, which is close to 100% higher than its low point of mid-2017.
It is further likely that Europe and the U.K. start to unwind their QE programmes over the next couple of years.
What does this all mean
Against the negative effects of the above is the reality that profits are generally booming.
The latest quarterly profit announcements have seen companies blow past estimates, but in some cases their shares have fallen as a consequence which is initially perplexing.
This can be attributed however to the market reaction to the accompanying comments on their future outlook; as an example Caterpillar, which said maybe they have reached a peak for the cycle. Markets no likey that!!
Context
One of our core beliefs over the last 5 plus years has been the global economic growth of around 2.5% pa which was decried by many as anaemic and signalled a broken system, was in fact simply a sustainable long-lasting level, unlike the previous cycles of boom and bust.
Over time and on average, all prices are going to increase by a fairly predictable level.
In fact this is best illustrated by house prices which over longer periods are generally only able to increase by around 2-4% above inflation. This is not the case for prime London property, which the wealthy of the world bought for multiple reasons, unconnected to needing a place to live, because if they rise by more, consistently, they become unaffordable.
The housing market has historically tended to go through periods of boom which are followed by downturns; generally it simply averages out at a 2-4% above inflation return.
The reasons for more muted growth were all connected to the financial crisis of 2007/8 which:
- Meant banks were less willing to lend
- Meant everyone was hyper vigilant about watching for excess
- Meant companies were far more conservative
- Meant risk appetite was suppressed
2018
We suspect that therefore what we are now seeing, especially in the US markets is just the next phase of the recovery, now emotional as much as actual.
- Rates are going up, and this is a change of which markets are naturally suspicious. Does it reveal (as it has in the past) excess behaviour in the better times as an example?
- How do rising rates and possibly inflation affect future growth and profits?
- What happens to debt markets as rates rise?
I could go on, but the central point is; markets are unsure what happens next and this makes them nervous and skittish which leads to much higher volatility as a result.
What really gets you is the thing you’re not looking for!
The main reasons we remain positive about the world’s economic health and therefore general corporate strength are.
- As long as markets are fearful they will correct ahead of potential problems, most of which don’t actually come to pass as feared, this is therefore healthy. Conversely it is the times where markets see no danger that the big hits occur (see title above)
- The US is benefiting from tax cuts, massive profit repatriation and the new option to offset 100% of capital expenditure against profits. If this increases profits by 20% this takes the markets’ valuation back to the beginning of 2017 on a P/E ratio of 15/16 so there is no real runaway overvaluation. Again, the market is being careful ahead of time, which is far better than hyper positive followed by hyper negative
- Emerging markets do not have the QE unwinding issue and nor does China, which by the by has no business actually being within the emerging market category, it’s close to being the largest economy in the world. It’s a bit like saying Anthony Joshua is an emerging boxer, was once true, certainly isn’t anymore
- Japan and Europe will likely reduce central bank assistance but only very slowly and interest rates are not rising much anytime soon
- The UK is stuck in neutral until it works out a Brexit agreement. The Government’s problem looks similar to Trump’s Republican Party issue, the small majority is insufficient to prevent either the radical Brexiteer or the Pro Europe wings from scuppering any vote on an agreement because neither will accept what is the bare minimum; the other will. This makes any meaningful U.K. rate rises quite unlikely unless inflation really accelerates, and this isn’t obviously happening
Conclusion
As we said at the beginning of the year, a high double digit annual return in 2017 was most unlikely to be repeated in 2018.
Indeed, if it had been, we would in all likelihood get a big correction.
So, these markets are reasonably acceptable in that they are processing the economic changes and trying to decide what are fair values for assets going forward, which is a sign of a correctly functioning and sustainably priced marketplace.
Note: This is written in a personal capacity and reflects the view of the author. It does not necessarily reflect the view of LWM Consultants. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.