Overcoming the fear of fear – a bull market analysis

Reasons to be fearful?

Equity investors have definitely had some justification to be occasionally fearful since the end of the financial crisis – the European debt crisis, China’s fiscal contraction and the collapse of the yen are among the highlights. However, during each fear, the fact that equity valuations were reasonable and that Central banks did their utmost to reassure investors meant that the damage was short lived and the recovery swift. The social impact of extraordinary monetary policy is another issue, but the key goal of financial stability has been achieved. The longevity of the current bull market is most likely to be a function of the multiple ‘mini-cycles’ that have reset market expectations on the way and triggered yet more accommodation.

One of the key observations of the mini-cycles since 2008 is that reasonable equity market valuations ahead of a correction worked to recover losses quite quickly, benefiting the patient investor with a buy-and-hold approach. Valuations today do not offer such a cushion. Valuations support conviction and higher valuations make equity markets more vulnerable to shocks. Likewise, the time required to recover capital is also likely to be longer. Unfortunately, forecasting a shock is quite tricky and just as the valuation protection is fading, market momentum takes over, greed overcomes fear and bubbles are born. Market cycles do repeat and we are collectively guilty of doing the same thing repeatedly while expecting a different outcome. The ‘madness of crowds’ applies and the challenge is to determine where we are in that cycle and then manage the portfolio risk accordingly.

Rising optimism about the global outlook

Evidence of sustained momentum in the US and green shoots of improvement in Europe support rising optimism about the global outlook. China has managed fiscal policy to support industries under pressure in the northern rust belt while progressing on a long-term plan to moderate excess capacity. Deflation risks globally have subsided in favour of better growth and higher inflation, and the Trump administration has put forward policies on tax reform, capital repatriation, infrastructure and regulation, which have the potential to stretch out the growth cycle for some time. The US economy was showing signs of solid if not stellar growth prior to these policy shifts, operating at near-full employment and experiencing a recovery in core inflation that had eluded the Federal Reserve (Fed). The extra stimulus proposed since the November elections, along with very strong economic data, reduces any remaining doubts that the deflationary forces have been assuaged and emboldens the Fed to be more active.

Downside risks in Europe also appear to be moderating, with business momentum indicators improving beyond Germany to the southern states. Job growth is healthy and exports are recovering nicely. The negatives centre on political risk and a banking system still struggling with non-performing loans, write-downs and regulation. The deflationary cycle in Europe has been prolonged by the failure of many European banks to address the legacy balance sheet issues post-financial crisis and, as a result, Europe is late to this particular recovery party. This is not unusual. Europe has a bigger exposure to late cycle industrials and strong performance in these sectors tends to signal the end of a bull market. European equity valuations also look consistently cheaper than the US because of this higher exposure to low-quality cyclicals and banks.

Politics plays an increasingly larger role

This year however, the normal European pro-cyclical sensitivity may be trumped by politics. At the time of writing, Emmanuel Macron is the favourite candidate in the French presidential race and his victory would be a clear positive for the economy in terms of tax and labour reform. It would also settle the euro group considerably. The polls put him comfortably ahead of Marine Le Pen in a run-off, but listening to polls creates a certain sense of déjà vu! The German election in September is becoming more difficult to predict given that Martin Schulz has gained significant popularity. His proposal to roll back the labour reforms of Gerhard Schröder is a concern but we would not consider Social Democratic Party-led coalition to be a traumatic event for markets. We currently have a tactical tilt towards Europe in the equity allocation of our portfolios.

Keeping a keen eye on inflation

Inflation is back – headline inflation (the measure of total inflation within an economy) in particular. The headline numbers are prone to significant base effects following the move in oil prices post the November 2016 supply cut from OPEC and currency depreciation in the UK. We expect headline data in the UK to surpass current year-end expectations and to test the resolve of the Bank of England. Ultimately, we believe the Monetary Policy Committee (MPC) will look through the data and focus on the difficult task of determining the underlying real growth of the economy when deciding policy. The current indications are that the post-Brexit boost has run its course, demand is moderating and the fiscal balance has improved. However, with so little visibility it seems reasonable to assume that volatility in the gilt market will return and current yields offer very little in the way of protection. Therefore, we remain short duration to minimise the portfolio impact of a move higher across the gilt yield curve.

Core inflation is also picking up across the world and the data will be keenly watched over the next few months. The Fed can confidently say it has met its targets on inflation and employment and it is clear that there is an increasing pace of tightening monetary policy, monetary policy being one of the drivers of financial asset prices. We currently believe the tightening process will be gradual and that the earnings picture is robust enough to support equities. However, it is also the case that we, like the Fed, have very little insight into how the money multiplier may change. The broad money data (M4) available is a lagging indicator and we prefer to focus on bank lending and credit growth information to help us gauge how this transmission process is working. Interestingly, credit growth in the US has accelerated quite markedly since the election, possibly reflecting a degree of pent-up demand, which we will need to watch. On balance, significant excess global manufacturing capacity, especially in emerging markets and the steady tightening of US monetary policy, should help moderate inflationary forces enough to avoid an inflationary shock. Even so, having gold in the portfolio is a reasonable way to manage risk.

In conclusion

In summary, the bull market in bonds and equities is long in the tooth and valuations in both are extended. It is reasonable to be wary of bonds and to favour late-cycle equity sectors with a view to reducing risk incrementally. There is no strong evidence to suggest a material negative catalyst. For now, equities will continue to benefit from accommodative monetary and fiscal policies and provide inflation protection in the form of nominal growth.