What's driving markets today?​

I’m going to start this blog with a minor blast on my own trumpet.   Over the past few months, I’ve written about slowing economic growth, sideways equity markets, falling bond yields and a rising gold price.  And so it has come to pass.   In particular I stood up at a conference in early May and said that US 10 year bond yields, then 2.5%, would certainly fall to 1.5%, and might go to Japanese levels of 1% or even negative.   There were whistles of derision all round, but where are they now?  1.68% is the answer. As regular readers will be aware, the credit should really go to my friends at CrossBorder Capital, whose work on liquidity data I find an invaluable framework.  Ultimately, whatever ‘experts’ write, what moves markets is weight of money moving in or out.    That is why following ‘funding liquidity’ (i.e. credit or cash which can be used to settle a liability) is crucial to understanding markets. There are really two major themes today.  The first is driven mainly by central banks, and especially the Federal Reserve and the Peoples’ Bank of China.    Over the past two years, for different reasons, both embarked on tightening policies.  The Fed in 2017 started to normalise interest rates; the Chinese in 2018 needed to support the yuan in the light of growing trade tensions. In 2019, both have abruptly changed course.  The Fed signalled a neutral posture in January, and cut rates in August.   The Chinese in May started to inject liquidity back into their system – the yuan’s fall below 7 yuan to US$1 is simply a consequence of easing. There’s always a lag of 12 to 15 months between liquidity tightening and economic slowdown.  It is no surprise that the world’s economy is struggling today and may indeed fall into recession.  It’s worth noting here that the Chinese multiplier is both larger and more direct than the US;  i.e. the PBoC has more control over its economy. However, the seeds of exiting the slowdown are also in place with change of monetary policy.  Both central banks have accepted that easier monetary policy is the only rational escape route, and so any recession is likely to be mild.  Call it QE4 if you want. The second major theme is to do with how the private sector refinances its debt.  There is plenty of cash sitting in corporate and institutional investors’ hands.   There are plenty of corporates out there who need finance.  The problem is the mismatch between risk appetite and what is on offer.  In other words, liquidity is not fungible.  The problem has largely been skirted by the use of repos, so that lenders to riskier ventures are collateralised with ‘safe’ assets such as US Treasuries.   Financing is short-term, requiring regular refinancing and a supply of safe assets to provide collateral. The consequence of this is that the availability of liquidity and particularly of ‘safe’ assets becomes more important than the price paid.  Ironically, the need to refinance more frequently adds to the risk of systemic problems.  That in my view is a major reason behind the Fed.’s decision to expand its balance sheet.  It’s also why US bond yields are headed downwards – price matters less than availability. Both these themes lead in the same direction: QE4 of some description, a steepening yield curve, some downside protection for equities, and at worst a mild recession.   For what it’s worth, I also believe we will wake up one morning to some form of accommodation on the trade front: neither Xi nor Trump can really afford not to.

Reflections following some enforced inactivity​

As many readers will be aware, I have had ten days of enforced inactivity after a motor accident.  It has given me time to reflect on matters near and far. Nearer to home, I am humbled by the many messages of good wishes and more from so many people.  Mankind is a social species, and friends, community, and family are – in Trump-speak – the most important.  Thank you all. The emergency services took two hours to cut me out of my Subaru car, built to old-fashioned strength specifications.  I was only conscious for part, but I don’t believe I would be alive in a less strong car.  They were quite extraordinary throughout, and I hope I have the opportunity of thanking them.  If I ever drive again, it will be in a Subaru car. The NHS is an organisation under immense stress.  Everybody, whether staff or contract worker, did their best as individuals to care for me, but I hardly saw the same doctor or nurse two days in a row, and the lack of information co-ordination and management led to potentially dangerous situations.  I was alert enough to avert them, but others might not be.  There is an urgent need for a grown-up conversation about taxation, budgets, and prioritisation, as the current path is unsustainable.  Meanwhile, if you find yourself in my position, try to avoid Friday evenings. Meanwhile, while I have been in bed, the country has swung in a different direction.  The new Prime Minister is clearly channelling his inner Churchill, but he is doing it from a narrow powerbase instead of a national Government.  Parliamentary arithmetic may once again prove his undoing.  That said, a ‘no deal’, whether intentional or not, is now clearly a possibility, and it must be right to plan for it. Markets?  At a global level, I remain sanguine, simply because both fiscal and monetary policy is generally supportive.    Yes, institutions can flee to cash, and I shan’t be surprised if short to medium bond yields fall further, but the yield gap between equities/property/infrastructure and bonds is a powerful disincentive to selling risk assets.  Unless there is a major geo-political shock, I see markets broadly going sideways.​

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.​

Upcoming events

Please find below a list of events that William and Mukesh are attending or speaking at: 10 October 2019 - Investing with Impact Summit - London - William will be attending this summit organised by DG Publishing in conjunction with Pensions for Purpose.  7 November 2019 - LGPS Asset Allocation Forum - London - William will be a panellist on the topic of using consultants in a pooled environment.   

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.​

Mukesh Malhotra attends MJ Hudson Allenbridge and M&G Investments DB dinner

On 26 June 2019 Mukesh attended this reception and dinner on DB pension schemes and end game planning in London.

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.​

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