Wealth and Investment Management Blog

“We get there when we get there” – Mr Incredible

Another week, another post-crisis high for developed stocks (and another all-time high for the S&P500). How much further, realistically, can they go? The MSCI World index has now risen  21% in six months without even a 5% setback, which seems unusual. Many pundits go further, arguing that there is a big “disconnect” between stock prices and the real world, and that they shouldn’t be rising at all. We will not be surprised when the setback does arrive – but we doubt it will mark the end of this investment journey.

The last two surges in stock prices were followed by dramatic reversals. We think this one need not be. In 2000, stocks looked egregiously expensive: dotcom mania convinced many that scarcity had been abolished, and the rest of us just didn’t “get it”. In 2007, stock valuations were unremarkable, but a toxic mix of expensive and complex credit instruments was poised to bring markets down. This time around there are fewer excesses needing correction. 

That doesn’t mean there are none. Investment and speculative grade credit spreads may be inside historic ranges, but the absolute level of yields is of course much lower even than in 2007, and government – and central bank – involvement in the markets is bigger. Moreover, there are some signs of credit froth as “payment in kind” and “covenant-lite” instruments reappear, and in the use of leverage by some investors (though not the corporate sector itself). 

It would be wrong to describe fixed income markets as being in a “bubble”. When dotcom stocks and toxic CDOs went bust, investors lost practically everything. Now, however, the bulk of the nominal worth of today’s bond market is underpinned by credible par values. Meanwhile, the banking system is less stretched than in 2007. Stocks themselves look positively inexpensive now – and could remain so even when bond yields trend higher.  

Stock prices should trend higher alongside corporate profits and dividends – otherwise their yield would rise indefinitely – and there is no practical ceiling for these. They can grow as long as the global economy does, and despite worries about natural resources – or China’s pollution – no economist has yet been able to identify a limit to long-term growth (and lots have tried). 

Of course, recessions can hit the economy and profits: the damage they do is short-term, but it can be big. And the economic rebound from 2008’s trauma has been lacklustre. But there is less of a disconnect between the economy and stocks of late than you might think: global GDP regained its real pre-crisis peak in late 2009, and has since been nudging steadily into new territory (as it usually does – and on a per capita basis too). Despite all the worries about a “great deleveraging” and the “new normal”, core US private spending has grown in real terms by 3% for almost three years, and the labour market is improving steadily if slowly. Europe continues to languish, for sure, but overall, global growth exceeds its stall speed. And in our view, the sharp decline in stock prices after 2007 more than made good the earlier excesses in credit markets: much of the rally to date has been a catching-up, not a leaping ahead.  

Conclusion? The rise in stocks to date is still not especially surprising or outlandish, and we think the overdue short-term setback will likely prove an opportunity for long-term investors.

Kevin Gardiner, Chief Investment Officer, Europe

Filed under: Uncategorized | Leave a Comment »

“Football’s got nothing to do with shorts.” – Golden Gordon (Palin/Jones)

Having saved the world in 2008/9, the big central banks’ financial fire-fighting morphed into a more cyclical, pro-growth stance that has extended into 2013. Thus the Bank of Japan recently pledged an aggressive wave of quantitative easing (QE), and the Federal Reserve says it will remain flexible with its ongoing, substantial QE. The Bank of England is not currently buying bonds, but it holds more than a quarter of the gilt market, continues to ignore its inflation target, and has been asked by the Chancellor to find ways of being even more lenient. And now the European Central Bank has cut euro interest rates further, and is considering more unconventional monetary support, including negative interest rates (it can’t easily do QE). Against this backdrop, the S&P 500 has hit new nominal all-time highs, and bond yields have dipped back towards historic lows. 

The liquidity provides useful – and inexpensive – portfolio insurance for investors, and given our glass-half-full view of the global economy and risk assets, we are glad to have the central banks on our side. But many pundits go further and argue that the global economic and stock market rally since 2009 has been entirely due to central bank support – the inference being that as soon as it stops, economies and stock prices will collapse. We think this overstates the case, and understates the resilience of the US consumer in particular.

The direct economic impact of QE is likely small. The money central banks are trying to “print” can’t easily find its way onto the high street because many consumers and large companies don’t want to borrow, and because some banks – most notably in the eurobloc – need to conserve liquidity and capital. Indirectly, lower bond yields could boost growth by encouraging people to spend more of their incomes, but this effect is surely tiny, whatever econometricians say. If growth is disappointing, it’s probably not because there isn’t enough liquidity in the system, or because interest rates are a few basis points too high. People are likely still nervous.

After the immediate danger of financial meltdown was averted, economies were able to gradually recover, not least because the need for a so-called “great deleveraging” has been hugely overstated (and not just because two US profs got their spreadsheet in a tangle). The rally in stock markets has reflected a sharp, and unsurprising, rebound in profits – mostly driven not by cost-cutting, but by the modest economic recovery and the fading of bank write-downs. The post-2008/9 waves of unconventional central bank support coincided with all this, but didn’t cause it. The confusion of correlation with causation is of course one of the oldest logical fallacies – and one to which financial analysis is especially prone.

Of course, this doesn’t mean that QE has had no impact on markets. Our economists estimate that a combination of QE and reserve accumulation will more than mop up this year’s $2 trillion of global issuance of the highest-quality government bonds. Bond yields are lower than would otherwise have been the case. This will also have helped stock markets – where, intriguingly, there is a less-noticed net retirement in high quality issuance taking place as cash-rich companies buy back their stock. But the strongest case for long-term investment in either bonds or stocks is based on fundamentals, not QE. We look forward to monetary conditions eventually normalising – even though it will doubtless cause short-term volatility – because it will signal confidence in the ability of the big developed economies to stand on their own two feet. That is why we expect the primary trend in stock prices to remain positive.  

Kevin Gardiner, Chief Investment Officer, Europe

Filed under: Uncategorized | 2 Comments »

“Golden slumbers fill your eyes; Smiles await you when you rise” – Lennon/McCartney

Received wisdom has taken another knock in the last week. We may not have expected events to unfold quite as they did, but we have long felt that the conventional view of the crisis and its aftermath needs rethinking.

First, the sudden, sharp drop in the price of gold may cause the newer “gold bugs” to think twice about the emotional allure of the metal, and what it can do to portfolio performance if held in large amounts – say, more than a percentage point or so of a balanced portfolio for long-term investors with moderate risk appetite.

We comment more carefully on the fall below: we think the price can stabilise, but in the wider context that’s not the point. Precious metals do help diversify portfolios, but they are not a foolproof hedge against anything, and the monetary claims made recently in respect of gold have been overstated. Two or three thousand years as an independent store of value is an impressive track record, but not a very practical one. There have been decades (doubtless centuries) during which gold has not kept pace even with modest inflation. Many pundits have argued recently for big positions in gold because they think QE leads to hyperinflation, and/or because they see paper money as a house of cards (as it were). Both worries are likely overstated.

Second, the need for a “great deleveraging”, and its impact on growth, has been undermined by the revelation that one of the most influential papers on the topic is flawed (for basic, data-related reasons). The claims made (often by others, to be fair) for the work of Reinhart and Rogoff always looked a little excessive. Their work is a daunting feat of compilation and scholarship, but in drawing stylised conclusions from a mass of very different historical episodes they had to cut a lot of corners, leaving little room for analysis of cause and effect, or of context (a tendency visible, for example, in their reading of Ireland’s external indebtedness). Data issues aside, they may be more generally mistaken – their genius notwithstanding – not because it’s different this time, but because it’s potentially different every time, and a template based on “eight centuries of financial folly” is of limited use.

In our view, the rigid caricature of conventional thinking about the crisis is slowly softening into an acceptance that it was first and foremost a financial event – not a wider economic one – whose origins can be traced back to a succession of embarrassments for deregulated capital markets from the mid-1990s onwards. If we’re right, it’s potentially good news for investors, who can focus on the global economy slowly returning to business as usual, but not of course for the financial sector itself. So we continue to focus on ongoing economic growth and resilient corporate profitability, and on the medium-term attractions of investments in equities, not debt. Neither China’s Q1 GDP data, nor US retail spending figures for March, have altered this big picture as we see it.

Finally, for more historically-minded readers this week we can confirm that the FTSE has never fallen in a year in which Cardiff City have been promoted to the premiership.

Kevin Gardiner, Head of Investment Strategy EMEA

Filed under: Uncategorized | 1 Comment »

“It’s all we’re skilled in; we will be shipbuilding…” – Elvis Costello, 1982

 “For us she is not the iron lady. She is the kind, dear Mrs Thatcher” – Alexander Dubcek, 1990

Apologies for the indulgence, but as a Taff who was studying economics when Mrs Thatcher took office, and who has been working subsequently as an analyst watching the changes reshaping the British economy, I can’t help but be in a somewhat reflective mood this week.  

Times are tough now, but the difficulties we faced in 1979 were qualitatively worse, and had been brewing for many years. Tackling them was horribly divisive, but few of us want to see again those levels of inflation, interest rates, taxes, (un)profitability, nationalisation, controls and industrial relations, let alone the Iron Curtain and Mutual Assured Destruction (though as we’ve noted before, the music was better then). Measured unemployment had been lower in the 1970s, but much was hidden: the peak reached in the early 1980s was half as high again as today’s rate. Bear this in mind the next time someone tells you that “Things haven’t been this bad since the 1930s”.

Manufacturing was a bigger part of the economy then, but in contrast to popular belief we do still “make things” in the UK (including well over a million cars a year, most of which are exported). The value we add per unit of output in the sector is higher today. Politicians trying to create jobs should be careful what they wish for: services are more labour-intensive, and where most new jobs will be. Most wealthy economies see manufacturing’s share of GDP decline.

More specifically, today’s fiscal austerity should be viewed in the light of the response to – and subsequent outcome of – the hawkish budget of 1981, which raised taxes and cut spending plans in the teeth of a much fiercer economic gale than today’s. It was greeted famously by an open letter to the Times from 364 economists arguing that it made little sense economically (to be fair, they were reflecting the consensus at the time). It was followed, however, by economic recovery as the private sector and the monetary climate more than offset the fiscal squeeze. Regular readers will know that this is one of the reasons why we argue that the current austerity programme needn’t push the economy into reverse.

Finally, today’s inflation hawks, wondering how on earth the Bank of England is ever going to reverse its QE when it needs to, might take a look at the early 1980s policy of “overfunding” the budget deficit, which mopped up liquidity equivalent to around 5% of GDP.

All these historical reflections remind us (again) of the importance of perspective in matters of economics and investing, and of the need to question received wisdom. As Mrs Thatcher herself once remarked, “There are dangers in consensus”.

Meanwhile, another week, another new high for the S&P. As we keep saying, a setback seems overdue, and there is no shortage of possible candidates – how do you solve a problem like Korea? But the resilience of the US economy is still overlooked, the Eurozone is not in freefall, the European Central Bank offers some financial backstop and valuations remain unremarkable. We still feel the primary trend in stock prices points upwards, and corrections may not be large or long.

Kevin Gardiner, Head of Investment Strategy EMEA

Filed under: Uncategorized | Leave a Comment »

“And always keep a-hold of Nurse, For fear of finding something worse” – Belloc

What do you think of an investment trading within a whisker of its all-time high, at a valuation never seen before, which is potentially volatile if interest rates start to rise and which is all but guaranteed to deliver a fall in price and a negative real total return on a 10-year view?

Welcome to the weird and wonderful world of the gilt market. With the exception of War Loan, all conventional bonds, including now the 1¾% 2022, are trading above par – that is, above their redemption price. Yields out to 2025 are below the Bank of England’s inflation target of 2% (a target that has been exceeded, on a rolling 12-monthly basis, since 2005, and likely will be until 2015 at least). And this week it went up further. 

Many other bond markets are in similar territory, essentially because their holders remain scared, and are willing to tolerate such return-free risk simply for fear of finding something worse. With the Bank, the Fed and now the Bank of Japan committed to owning a large portion of their local markets, and with Italian and Spanish bonds seen as risky, the free float of high quality government bonds has shrunk. It doesn’t take many new buyers to push prices higher.

There is of course plenty to be scared about. The eurobloc economy is flat-lining and Spain’s budgetary progress is again disappointing. Many commentators continue to question whether the US can grow its way out of the (alleged) Great Deleveraging. North Korea’s idiosyncratic foreign policy is managing to embarrass both the US and China, and the risk of a military accident in the peninsula looks even higher than usual. Avian flu has broken out in China. Several central bankers are warning of complacency and the risk of a sell-off in stock markets.   

Even so, the insurance provided by government bonds at these prices looks prohibitively  expensive to us. Euro angst about Cyprus at least should have eased a little as Mr Draghi has said explicitly what we’d assumed was the case, namely that the policy of making depositors there pay is not a “template” for wider resolution of the current crisis (beyond 2015, in future crises, things may be different, and we’re not convinced that bank depositors will ever see themselves as bank “investors”, but that’s another matter). The US economy seems to have grown in Q1 by 3-4%, twice as fast as originally pencilled-in, and it would be remarkable if there weren’t now some slowing in Q2. The latest labour market data are not game-changing.

Events in the Far East are difficult to call: the antagonist is unpredictable (perhaps because its  internal situation is more precarious than it  looks), but its big neighbour will probably keep it  from the edge, as it has to date. Meanwhile, South Korean stocks may be volatile, but we think they remain a good long-term play on that ongoing US recovery.  

Stock prices have rallied a long way, and in some cases are also historically high. But in contrast to government bonds they look inexpensive: their yields are not particularly low, because profits and dividends have been rising too. We still meet few complacent investors (and as noted, the  behaviour of bond markets hardly suggests general complacency). A setback in stocks remains  overdue, but it’s bonds that seem to us most likely to underperform strategically from here.   

 Kevin Gardiner, Head of Investment Strategy EMEA

Filed under: Uncategorized | Leave a Comment »