“No mountain is worth dying for” – attributed to Walter Bonatti
Stocks have outpaced other assets – including high yield credit – by more than enough to compensate for their higher risk. The S&P 500 is within 5% of its October 2007 summit, and pundits are talking (again) of investor complacency. Should we worry?
In a trading context, markets look ‘overbought’. After rallying by 13% from November’s pull-back, the chart of the main Continental European index looks a little exponential: some vertigo is understandable. Profit-taking would not be surprising, and there are some obvious potential triggers. For example, the US government may not be able to meet its bills from around mid-February; the Italian elections in late February could break the market truce over the euro crisis (and some euro officials have been sounding a little complacent); geopolitical risk is still very visible, most recently in the tragic events unfolding in Algeria.
For investors who are in the market and nervous, but don’t want to close their positions, the cost of portfolio protection is relatively low. The so-called ‘fear index’, the VIX, has been trading at its lowest levels since 2007. But no-one likes buying insurance, and we doubt it is worthwhile now for investors with moderate risk appetites and composure. And we would advise caution in actively trading volatility itself. It has been in a bear market since early 2009 – a point missed by many, but really not surprising given the wall of cheap insurance implicitly written by central banks. When the VIX rises these days, it spikes. Blink, and you’ve missed your turn.
In a longer-term context, and after allowing for inflation, stock prices don’t look so exposed. Taking corporate profitability into account, valuations seem undemanding (and the results season in the US is not suggesting that our expectations there are too high – if anything, rather the opposite). We’d view a market setback as an opportunity to add to positions.
Most investors are not complacent, but are still concerned at the ability of the global economy to grow in the face of its many headwinds. The questions we receive focus almost unanimously on what could go wrong for consumers, companies, and currencies, and the articles and third-party research that we’re asked to comment on do the same. More objectively, the 10-year US Treasury yield remains below 2%: the largest bond market in the world is telling us loudly that investors remain more confident in disinflation and crisis than in those storm clouds lifting.
Postscript: The UK’s evolving relationship with the EU is sparking interest (there is a keynote speech from the PM pending). Leaving the EU would likely be moderately bad for business. The UK needs easy access to the (almost) single EU market (in goods, services, labour and capital). It’s the sort of thing that could affect the UK’s structural growth rate – maybe trim it by a decimal point or two – and damp sterling. That said, it would not be catastrophic – Switzerland manages reasonably well – and we judge the likelihood of leaving to be low. Just as the UK government is sounding determined to offer voters a choice on the topic, a formally two-speed EU is looking more likely. Markets are urging the eurozone to press on with deeper integration, making it easier perhaps for the rest to drag their feet while staying within the single market. If such an outcome were acceptable to UK voters, it could leave the economic outlook effectively unaltered. Of course, in the last resort, the EU is a political project, not an economic one….
Kevin Gardiner, Head of Investment Strategy EMEA