Watch out for the rise!

Sorry if you thought we mean stockmarkets rising.  We don’t.  We mean liquidity.  Here end-June data from our friends at CrossBorder Capital is showing a significant jump, much in line with our predictions over the last few months.  It’s happening where investors aren’t looking – in Asia and the private sector.  In Asia, the PBoC has clearly taken its feet off the brakes again, perhaps in consequence of the slowing economy as per yesterday's headline.  There’s a sub-theme we’ve mentioned before here too – the Bank of Japan seems to be easing in line with China, bearing out our view that Japan has for several years now targeted currency stability first and foremost rather than foreign currency. The real theme of the latest data is the surge in private sector liquidity around the world but particularly the US.  This is not all good news, as it may be corporates building up cash before an economic downturn.  But it does increase the likelihood of steeper yield curves.  In theory that fits neatly with our general view predicting a bullish steepening with short term yields falling alongside US rate cuts.  However, the facts don’t all fit.  Historically, this late-cycle environment is associated with rising term premia, suggesting that longer term bond yields may in fact rise, and a bearish steepening.  At the same time, one of the worries we have had over the past few months, the fragility of corporate bond markets, seems to have eased off a bit, so the bulls expecting the US to cut rates may be premature.  So, while we expect the curve to steepen as liquidity supply increases, we are less confident which end of the curve will move. QE4 is starting but it seems that the US Fed may be the laggard rather than the leader this time round.  It suggests that Emerging Markets will, at some point quite soon, have a run of some sort but once again not all the facts fit.  CrossBorder flows of capital are running clearly away from emerging markets, and particularly the larger ones such as China, into safer havens mainly in Developed Markets.  Liquidity may well be on the rise, and highly valued US equities may be underpinned by that, but we’re not sure that adds up necessarily to further gains in global indices. If you’d like to see the underlying data, please contact the team.​

William looks at the prospects for 'value' if there is more qe

Regular followers of our blog will be aware that we think the Federal Reserve has given up on interest rate normalisation, and will meet any serious threat to either the economy or the financial system with rate cuts.  It’s noteworthy that US 10-year yields have fallen from 2.7% to just above 2.0% in the past three months and we expect them to go lower. What does that mean for equity investors and value investors in particular?  They have suffered from QE, as lower discount rates have pushed up the valuation of longer duration assets such as growth stocks, and also from investors’ desperate search for income in an ultra-low bond yield world.  In May 2019, some 11% of global stocks traded at more than 30x and a further 12% at below 10x.  In Japan, the numbers were 16% and 22% respectively. That tells a story of investors buying quality and growth and shunning value.  Will it continue if we do indeed find ourselves staring down the barrel of QE 5, 6 and 7?  At the moment, we don’t see much to stop the trend continuing.  The shortage of safe assets is pushing bond yields down and we suspect that genuine ‘quality’ equities, i.e. those which can credibly promise steady income growth over the long term, will benefit in turn. However, no trend lasts for ever and there are things in the offing which will ultimately lead to change.  The first is that, almost universally, the highly rated companies are large global entities in sectors such as consumer goods, pharma and increasingly technological.  The threats will come from increasing friction in global trading, and determination by governments to clip their wings and stop them becoming too powerful.  Who remembers the currency controls in place in the UK until 1979? The second, at the other end of the spectrum, is the growth of private equity.  The FT reported this week that there is US$3.5 trillion of ‘dry powder’ waiting to be invested.  Some of that will be aimed at the unloved and lowly valued tail of listed companies, which should in time give valuations a fillip. In conclusion, another phase of loose monetary policy may look like the 2009-2017 period to start off with and indices may well carry on rising.  But we believe it will be just a little more friendly to the value end of the spectrum too.

william participates in asset allocation panel at lapf strategic investment forum

On 3 July 2019 William participated in a panel on asset allocation at the LAPF Strategic Investment Forum in Hertfordshire.​

Recession or no recession?

Talk of a recession in the US is again in the air.  Last autumn, when the Federal Reserve was on its path of ‘normalisation’ by increasing interest rates, we thought a recession close to inevitable.  The authorities have changed tack abruptly, and we commented in January that it might or might not be too late to prevent a US downturn. More recently we have had that classic sign of recession, an inverted yield curve, as US longer bond yields have fallen beneath short rates.  As a result, recession talk has risen.  We have two reasons for believing that, while it is certainly a possible outcome, it is not yet baked in.  We have written before why there are technical reasons for the sharp fall in longer term US bond yields, which are more to do with the financial system’s demand for ‘safe assets’ and less to do with risk appetite.  We also note that our friends at CrossBorder’s major liquidity index at the end of May was still just above recession level, and policy stance at both the Fed and PBoC in particular are close to neutral.    That said, what we have noticed is a sharp fall in investors’ risk appetite as measured by cross-border flows and investor sentiment.  It looks as if more investors have already positioned themselves for an economic downturn, which suggests the market impact of one may be less dramatic than expected.  We also believe, as we have commented before, that the Fed would react with a new QE programme.  This would aim to limit the extent and impact, much as in 2008/9. So, recession or no recession?  We don’t know the answer and we don’t wish to sound overly complacent.  However, we are not yet convinced that a recession in the US is certain and we do believe that, if there is one, the impact on markets will be short-term rather than extended.​

Whither markets? Are we looking at QE 5, 6, 7, 8...?

We pondered the different messages coming from equities (generally rising) and bond yields (falling) three months ago, and concluded that bonds were more likely to be right in predicting a downturn.   We have consciously shifted our ground since then - we make no apologies for doing that.  For us the importance lies not so much in the Fed’s short-term shift to a neutral position, which makes a benign outcome more likely.  Instead we are more focused on the longer-term message the Fed is giving: that normalisation of interest rates is going to take a great deal longer than you first thought. In our view the key implication is that the Fed is less concerned about inflation, and more so about risks to the financial system, in particular the lack of ‘safe’ assets such as T-bills which are used as collateral across a range of wholesale transactions.   If that is the case, whither markets?  We suggested a month ago that US bond yields would fall further, perhaps dramatically so, and the 10 year yield has responded by dropping 40bps in four weeks.  It is still well above the 1.5% yield reached in 2016 but looks headed that way.  We’d like to think that the shortage of ‘safe’ assets is behind this buying and that it is not a precursor to an economic downturn.  But bonds have a strong record of predicting recessions and the yield curve is not far off flat at the time of writing.  So we are wary of positing that this time it is different.   If there is a significant downturn, it seems to us almost inevitable that the Fed will turn on the printing taps again with QE4, 5, 6 or whatever it takes.  That makes us more confident that 10 year US bond yields will, at least initially, carry on falling, quite possibly to new lows. And equities?  On the one hand lower or negative economic growth should depress stocks, especially as valuations are (sky) high.  On the other hand, lower bond yields may force income-seeking investors to purchase blue-chip equities as they did in 2015 through 2017.  Our best guess is that, in the absence of geo-political convulsions (trade wars etc), they broadly trade sideways.  Any dip would be fairly quickly covered by buying but the upside is limited by low dividend growth and valuations. Perhaps the most troubling aspect of not normalising is the distortions that cheap money brings to markets.  Asset prices such as housing remain excessive, zombie companies are not put out of their misery, while the incentive for profitable companies to invest in new capital reduces because returns are competed away.  The new normal may seem more comfortable than an old-fashioned recession but it is certainly not nirvana.​

William Bourne moderates Panel on listed vs. unlisted infrastructure strategies

At the Private & Public Pensions Summit at Pennyhill Park, Surrey (2nd-3rd May 2019), William moderated a panel on listed vs. unlisted infrastructure strategies.

The importance of the Fed's change of heart in January

Last autumn we were confidently predicting that US 10-year yields would go above 3% and, for a short while, they did.  Today they are at 2.5% and we are equally confident they are going lower.  What has changed? The short answer is the facts.  The US Federal Reserve’s change of heart in January was in our view much more than a simple move from a tightening pathway to a more neutral position.  We think it was an admission that QE is here to stay for the long-term and that interest rates are in today’s world not able to perform their traditional function as a policy tool.  If so, that means investors have to think radically differently going forwards. Perhaps, we should first ask why?  Our friends at CrossBorder Capital think the catalyst is the frailty of corporate bond markets and particularly at the bottom end of the investment grade credits – BBB.  Institutions and corporates have been looking for safer, and perhaps higher, returns for their cash than they can receive from banks.  One response has been to invest in money market-like funds, which in turn lend to different corporates via repurchase agreements (“repos”) in order to minimise risk.  However, these repos depend on the availability of collateral in the form of ‘safe’ assets such as short-term government bonds.   Quantitative tightening means the latter are in scarce supply, accentuated by demand from some central banks (eg. Bank of Japan) for their own QE programmes.  CrossBorder’s data suggests that the average net supply of ‘safe’ assets’ over the last six years has been roughly one third of the 2010-2012 period and it is increasingly concentrated in the United States. The implications are numerous.  In the bigger picture, the Fed will use its balance sheet rather than interest rates to steer the economy.  We call that QE4.  While it may not inflate asset prices in the way that QE1, 2 and 3 did, it does provide the equivalent of a Greenspan ‘put’ for investors.  The US bond curve is likely to fall, possibly in an extreme case to levels similar to Japan, though in practice we doubt that.  In turn that may propel equity valuations higher as investors seek return. Inflation is a tougher question.  The history of QEs 1, 2 and 3 was that consumer inflation did not take off.  Today the employment background is tighter and society is less cohesive.  Governments may decide that inflation is the lesser of various evils and be prepared to accommodate some.  Far be it from us to suggest that that would also help them inflate their indebtedness away. If we are wrong, the brunt is likely to be borne by those lower down the debt hierarchy – BBB grade, non-investment grade debt and equity holders.  It’s no secret that not all BBB rated credit is worthy of its rating but if collateral for repos becomes scarce or unavailable even companies with unimpaired credit could find themselves struggling to refinance their existing corporate debt.  That could trigger a much sharper funding crisis as (shades of 2008 GFC) rating agencies find themselves re-evaluating their ratings. We see the path of the next few months as critical.  It all depends on whether the central banks are watching the right balls.  If you’d like to discuss this in further depth, please give us a call on +44 20 3637 6341. 

Times they are a'changing

We’ve spent most of the last two years or so marking how tight the monetary environment is.  It is not just that the US Federal Reserve and to a lesser extent other central banks have until very recently been withdrawing liquidity, it is also how the private sector has been less willing, or able, to use or extend credit.  That has been behind our bearish stance on the market and also western economies. But times they are a’changing and, in Bob Dylan’s words, ‘the slow one now will later be fast’.  Most obviously, the Federal Reserve has changed course from its path of steady tightening to a more neutral position.  That can now be seen in the end February and early March data.  More discreetly, the ECB and Bank of England have become more accommodative while the PBOC, until now the loosest central bank, is tightening.  The reasons are not hard to seek: the US economy was previously, as we have said, heading for recession while Europe is drifting in the same direction.  We’d argue, as we did in our last blog, that Abenomics needs a reboot and we can expect significant policy action from Japan too. Though equity markets have risen in reaction, we’re not sure this can be maintained.  Valuations, at least in the US, remain extremely high by historic standards.  That doesn’t mean they will necessarily revert to the mean in the short term: that may have to wait until bond yields normalise.  However, equity investors are unlikely to get more than the yield (3% globally, a juicy 5% if dividends aren’t cut on FTSE 100) +1% or so growth.  There simply isn’t room for valuation expansion and there is significant room for valuation contractions if things go wrong. So times they are a’changing but our views on equities remain biased to the negative.  In the short term we prefer investments which are priced off bond yield curves.  In other words, we remain risk off.​

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