Today we read an interesting opinion that at this point in the year investors are in two camps – those that are riding the wave of strong market sentiment, and those that are trying to call the turn. In an environment that one fund manager (PIMCO) refers to as “stable” yet insecure there are considerable causes to predict, if not call, the turn. However, there are also reasons to be more suspicious of historical precedent and look at the current economic backdrop as its own unique “animal”.
Firstly, we are now approaching the 8th anniversary of the current expansion. It is, however, an expansion that has been characterized by historically low interest rates, unprecedented political surprises, a swell in corporate profits (in the US) and rising employment, but without commensurate wage gains. The growth in evidence in the current recovery has never reached eye popping levels – it has hovered in a range of 1.5 – 2.5%. Inflation remains stubbornly low, as does market volatility, while the market strength, particularly in the US, has been extremely narrow, not broad – reflected in a few large cap, generally tech-heavy, stocks.
Inflation expectations remain extremely low – perhaps driven by the lack of wage growth. On this point, economists and commentators seem to be driven to rip up the play book of past recessions – with the first “straw man” to go being the Philips Curve, and the supposed inverse relationship between unemployment and inflation. Whether due to lack of productivity growth, the gig economy, the deflationary effect of technological advances or the “queue” of willing labor (or robots) to take one’s job, wages are barely budging. This speaks to a greater issue of growing inequality, which has spurred both increasing political divisiveness as well as a growing populist tide in developed markets.
Many investors are pointing to potential pivot points – whether it be the recent drop in corporate profits as a % of GDP or the potential for overall corporate profits to revert to the mean. P/E ratios are also at an all time high in US markets, and this, as well as other indicators suggest a correction may be nigh. Others are waiting for the “failsafe” indicator of the inverted yield curve – not yet in evidence, although the long end of the curve has proved to be stubbornly resilient – to the delight of fixed income investors everywhere.
Other commentators are looking around the corner – to the tools in the toolkit to tackle a potential recession. While corporate leverage levels are low (but inching up), sovereign leverage levels are high, and arguably there will be few monetary policy bullets (anywhere – except, perhaps, within Emerging Markets (see below)) by the time a recession arrives (if the Fed gets to 3% in 2019 the expansion will already be 10 years old). It is also apparent that there is little fiscal headroom either – years of austerity have been unpopular and patchy and the populist insurgence mentioned earlier may well have tested administrations to their limits.
When it comes to Emerging Markets, it is clear that the abject “fallibility” alleged in developed market politicians and central banks, may indeed be the gain of these regions. Many countries, such as Argentina and Peru, have actually rejected populism, and seem to be more firmly in the more orthodox reformist camp. Many have resolved their persistent balance of payments deficits, some are less dependent on trade and their central bankers have garnered more respect as they are perceived as having matured. This suggests their policies may indeed decouple from the Fed in the coming period, enabling them to have more arsenal against a Fed rate hike.
So EM may remain decoupled from DM on a fundamental basis – although, as we continue to witness, market sentiment can be highly fickle and prone to contagion, and “risk off” rallies may be universal. We continue to believe that, despite the over 17% run up year to date, there is still room for EM to match its promise and run a little longer. DM on the other hand despite the recent freeing of banks to increase dividends and buoyant corporate mood, may be close to the twilight hour of its current surge.
We will talk in a subsequent post about risk mitigation strategies, but for now diversification and even some exposure to stress seems as critical as ever. While broadbased growth may be elusive – pockets of growth spurred by innovation are likely to continue to appear. Similarly, investments in stressed and distressed areas may well bear fruit – but only if the casualty will be an ultimate survivor – again, by pulling off a remarkable feat of transformation. Forgotten assets – like European real estate – may look interesting again. For now, we are not calling a “turn”, but we do predict one. In this no man’s land, or at the halfway house, we are looking for less well trodden paths, more meandering perhaps. Taking them may leave us less likely to be caught in the mainstream stampede.