17 Apr 2018
These are some of the messiest, least-predictable market conditions for years. The rules that applied during the long period of near-zero interest rates and quantitative easing are being re-written on the hoof. For a long time, investors had a ‘playbook’ – a number of rough and ready rules of thumb suggesting how to respond to a given change in the economy or monetary policy. That playbook is now being ripped up.
Given the complexity of the plumbing that underpins the financial system, it should not be surprising that the end of a decade of unconventional monetary policy is having complex, unpredictable effects. Investors are looking at various indicators to see if the plumbing is still working. The US Federal Reserve is shrinking its balance sheet and growth in the money supply (‘M2’) globally is rolling over. Meanwhile, the dramatic widening in the difference between unsecured lending rates and overnight swap rates (the Libor-OIS spread is its widest since 2008) has scared the market; it is a signal of stress somewhere in the system.
This is interacting with a political environment characterised by sudden and unexpected events – the abrupt eruption of trade wars, Trump’s broadsides against Amazon or the rapid escalation of tensions with Russia – and so intensifying the uncertainty.
To return to fundamentals, the global economy is still growing, if not quite as quickly as it once was. The most recent ISM survey showed that US manufacturing grew in March – but at a somewhat softer rate than in February. That lent weight to a worry we have mentioned before: that this could be ‘as good as it gets’ for the global economy. We have hit a soft(ish) patch and the debate is whether the economy will re-accelerate given trade wars and monetary tightening. Meanwhile, corporate earnings have generally been fine. But the driver of the market is no longer the economy or earnings. If we think in terms of the market’s most common valuation yardstick, the p/e ratio, earnings (the ‘e’) are not the market’s primary concern (although any company whose earnings fall short will be punished). Instead, as liquidity is withdrawn, concern has shifted to the multiple that is being paid for those earnings. And in the eyes of many, higher inflation and lower growth must mean lower p/e-multiples.
As the market worries about multiples and higher real rates, crowded trades are being unwound. Yet although we have long been aware this was likely (and have been explicit about our desire to avoid crowded trades) it is not always possible to be certain which areas are crowded until after the event. That the iconic FANG stocks would be vulnerable to a regime shift was obvious – they had become almost universally consensus overweight positions. What was less obvious was that technology stocks trading on far lower valuations – those that might be considered to be cyclical ‘value’ rather than secular ‘growth’ stocks – would be punished alongside the FANGs.
It was also predictable that companies (even those in traditionally defensive sectors) that had become reliant on ever-greater leverage would be punished. After years of being largely indifferent to steady increases in debt across the corporate sector, the market is waking up to the fact that real rates are going higher. Compared to many of our peers, we have lower weightings in classic ‘income’ sectors such as healthcare, real estate, utilities and consumer staples. We anticipated that stocks in these (long-duration) areas would begin to lose some of their appeal as bond yields rose. Many companies in these sectors have spent the last decade piling on debt to fund share buybacks and rising dividends. As risk-free rates go higher, companies with a lot of floating-rate debt are underperforming. So avoiding these stocks and the FANGs has been helpful for our performance.
We are conscious that conditions have moved in a more ‘risk off’ direction and that our portfolio is not positioned for lower bond yields and slower growth. And although it is not our central expectation, we accept that it is possible that growth could cool more quickly than we had expected, particularly as tariffs on trade are imposed. While the tariffs themselves will probably have a somewhat negligible effect on global growth it is in the increasing risk premia that the cost of trade wars are really felt. We are questioning whether our pro-risk stance remains appropriate and are open to the possibility there is a defensive shift for which we are not currently positioned. As part of this, we recognise that our overweight in US banks has not worked as well as we would have liked. So despite their recent weakness, we are not adding to these positions.
At the same time, however, we don’t see a recession on the horizon and hence we are not ready – yet – to depart from our somewhat pro-cyclical positioning. We are conscious that there has been a pattern in recent years whereby growth in the US has disappointed in the first quarter of the year only to rebound through the spring and summer. Whether this is a statistical quirk is beside the point: markets respond to it. So although we are prepared to change we are not, at this stage, repositioning the portfolio. We aren’t rejecting value or cyclical stocks outright. We may even add to these areas again, but that will depend on the data – and the news on earnings – that emerges over the coming weeks. As ever, the shape of our portfolio remains – like the Fed’s decision-making – data-dependent.
Jacob de Tusch Lec manages the Artemis Global Income Fund; visit the fund page for further information about the fund, its performance and current positioning.
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THIS INFORMATION IS FOR PROFESSIONAL ADVISERS ONLY and should not be relied upon by retail investors.