A fortnightly look at global financial markets – 25 October 2016
The following is a detailed commentary and analysis from deVere Group’s International Investment Strategist, Tom Elliot regarding: Is U.S credit the next crisis? A downgrading of Siegel’s Constant? Brexit, or ‘I’m sorry I haven’t a clue’. Capturing President Trump.
Q4 asset allocation preferences (unhedged US dollar-based, updated at start of quarter): neutral equities vs. fixed income relative to benchmark. Prefer emerging stock markets to developed. Longer term outlook is to be pro-risk assets.
Equity and bond markets both appear weak at present, nervous of a list of political and economic risks. These include a rise of nativism and anti-globalisation in western democracies, personified in the figure of Donald Trump, policy error by central banks as QE and ultra low and negative interest rate policies come under attack, a China slow down and/ or currency devaluation, and the negative effect of Brexit on the U.K economy and global financial markets. A relatively new one to the list is that of a blow-up in U.S non-financial credit (see below).
The MSCI World is down 1.4% so far this month, the Barclays Global Aggregate bond index is down 2.5%, while gold is down 6.8% (all in USD terms).
There seems nowhere to hide, cash returns -the usual refuge against uncertainty- are negative in real terms (ie, after taking into account inflation) in most major economies. Gold, which might have been expected to have benefited from this uncertainty, has instead weakened in recent months in response to a stronger dollar.
But I do wonder if recent weakness on capital markets is mere market noise, amplified by the financial press. Have any of the problems cited above become materially more bothersome this month?
The IMF recently estimated that this year’s global real GDP growth rate will be around 3.1%, towards the bottom of the 3-4% range they consider desirable, but not outside of it. Third quarter U.S earnings releases have so far been good, suggesting that the run of four consecutive quarterly falls in reported earnings from S&P500 companies has come to an end. Hillary Clinton is ahead of Trump in the U.S opinion polls. China reported another steady quarter of 6.7% y/y growth last week. And so on.
So, what are investors to do in such a uncertain environment? Remain diversified. Regular readers of this note will know the medication: take only small bets against a balanced multi-asset benchmark. If we assume a 35% bonds / 55% equities / 5% cash / 5% commodities split as our ‘lode star’, our neutral benchmark, I would suggest that for a long term investor we might change that to 30% / 60% / 5% / 5% split since equities outperform bonds and cash over most long term time periods. For a short term investor, with just this quarter’s returns in sight, I suggest sticking to the benchmark split and avoiding active bets
Is U.S credit the next crisis?
- Looking at the agendas of some recent financial seminar and conferences in London, and a feature article in last Wednesday’s Financial Times, it seems that we have a new bogy man to scare us all. , which is fear that U.S credit may be the next financial crisis waiting to happen. It joins the list of things we investors are worrying about that I list in the introduction of this note.
- The argument goes that the U.S non-financial credit market has grown too fast of late, and too much of the debt is held by inexperienced investors in bond funds that will face liquidity problems should the asset class fall out of favour. $1.84 trillion of cash held by U.S non-financials masks an astonishing $6.6 trillion of debt (source: S&P Capital QI).
- How will this sector of the bond market cope against a rise in the risk free rate, and a fall in bond proxy share prices which would boost their yield levels to relative to those offered by credit markets? Was this the problem that Fed chair Janet Yellen was hinting at in August, when she told her audience at Jackson Hole that the Fed stood ready to inject 300bps worth of non-interest rate policy easing in the event of a shock to the financial system?
A downgrading of Siegel’s Constant
- Despite the best efforts to raise inflation in the West, and restore ‘normal’ interest rate environments, the central banks have failed to do so because of these demographic trends that were already driving down inflation and interest rates well before the 2008 financial crisis, and a savings glut in Asia and from baby boomers in the developed world. There is pressure on many governments to loosen fiscal policy in order boost aggregate demand – this may happen, but I suspect it will prove as ineffectual in face of long term and global structural forces as it has been in Japan, which has been experimenting with both lose fiscal and lose monetary policies for years.
- Therefore worries over the next U.S rate hike, and the impact on asset classes, are overdone. But equally, long term growth rates – and corporate earnings growth rates- will be lower in the future than those we grew up with. Consequently we should assume lower real returns from stock markets than in the past -perhaps 3% on average, against the often cited ‘Siegel’s constant’ of 6.5%. This is the rolling 30 year average real return that U.S financial commentator Jeremy Siegel identified, going back to the mid-C19th, in his book ‘Stocks for the Long Run’.
- It’s worth noting that lower long term inflation expectations will keep real bond returns positive. Financial history suggests U.S Treasuries struggle to make real returns over long holding periods only when inflation in America averages over 4%.
Brexit, or ‘I’m sorry I haven’t a clue’
- It appears that, four months to the day of the E.U referendum, the U.K government still has no coherent plan of what it wants from Brexit negotiations other than to limit labour migration from other E.U countries. It claims that it is not revealing what its Brexit plans are, for fear of losing tactical advantage in the upcoming negotiations with E.U partners, yet the scatter-gun proposals made public so far suggest little coherence or a sense within the government of a shared end-goal. Philip Hammond, Britain’s finance minister and in favour of a ‘soft’ Brexit, las week floated the idea of enabling certain sectors to remain in the single market (such as autos), while the rest of the country leaves. This suggests a very confused Brexit with a great deal of administrative oversight required, and at odds with Prime Minister Theresa May’s stance that Brexit means complete withdrawal of the E.U.
- At last week’s E.U summit it was reported that a growing number of fellow E.U leaders believe Britain will eventually decide to remain in the E.U, given the range of problems created by leaving the organisation and the shock created by the recent fall in sterling. Indeed, an under-reported survey at the time of the referendum found that two thirds of those who wanted to see curbs on E.U immigration into the U.K would not, however, support any measures that would make them poorer by a single pound*.
- Theresa May’s government is buffeted. On the one hand are the Remainers who argue that Parliament must have a greater say in the Brexit process (believing that Parliament will veto anything but a ‘soft’ Brexit). This group includes some senior Conservatives and the majority of MPs; they point out the irony that the Brexit was supposed to be about Parliament regaining sovereignty over British laws, yet no one has asked Parliament it if it wishes this. The government last week conceded a Parliamentary vote on the terms of any agreed Brexit deal.
- Meanwhile Conservative grass-roots campaigners demand that Brexit means a complete withdrawal from the E.U, including the single market and the free trade area, leaving the U.K with less market access to the E.U than Turkey. The ‘Economists for Brexit’ group are back on the warpath, arguing for unilateral free trade as the means by which Britain counters its emerging imported inflation. This would pose significant challenges to British manufacturing and agriculture, and re-opens the ‘order’ versus ‘’openness’ divisions within the Brexit camp.
- Ten days ago, Nicola Sturgeon, leader of the Scottish National Party, again raised the prospect of a second Scottish independence vote should there be a ‘hard’ Brexit and the U.K leave both the single market and the free trade area. This would result in a second hard border in the British Isles being created as a result of Brexit, with a profound psychological as well as material impact (Northern Ireland and the Republic of Ireland being the other).
Capturing President Trump
- The polls are in Hillary Clinton’s favour, though not by as much as one would have expected given how low Donald Trump has gone in his efforts to secure the White House.
- Republicans in London assure me that, in the event of a Trump victory, we have nothing to fear. Trump will appoint sober advisors. Both the House of Representatives and the Senate will likely be controlled by equally sober Republicans. However, they concede that the Republican party have already failed to ‘capture’ Trump in the Primaries and to make him their man. That the Tea Party interests that he represents will find another figure head to lead them, should Trump become more mainstream. And that as long as this element exerts pressure within the Republican party, it will fail to win over the women and minorities that it needs for its long-term survival.
*Comres Poll, June 2016: ‘Three in five Britons (61%) say that they would be willing to accept a short term economic slowdown in order to tighten controls on immigration. Although British adults would not be happy if this hits their own pockets; with two-thirds (68%) saying that they would not being happy to pay any of their own personal annual income to tighten the control Britain has over immigration and reduce the number of EU migrants entering the UK’.