Near-term market sentiment:. Nervous. The VIX ‘fear index’ is up from recent multi-decade lows, standing at 11.18 on Friday’s close, and reflecting last week’s slip in market confidence that saw global stock and bond markets weaken and the dollar slip 1.6% on a trade weighted basis. The trigger was fear that central bankers -particularly at the ECB- are looking to ‘normalise’ interest rates as a policy in itself, irrespective of the economic data. Since much the valuation of all assets ultimately rests on the ‘risk free’ rate (often taken to be the 10 year bond yield for professional investors, and bank account cash rates for retail investors), any upward move in interest rates by definition upsets stock and bond market valuations, and prices.
However, fear of central bank policy error is probably overdone and interest rates are unlikely to see meaningful increases over the next few years. A closer reading of statements last week from the Bank of England’s Mark Carney and the ECB’s Mario Draghi shows a continued commitment to using loose monetary policy to foster growth, they simply acknowledged the growing risk of inflation. Perhaps they should have reminded their audience in Portugal that global deflationary pressures persist (eg, demographics, automation, low productivity gains, weak private and government investment). Of the major economies, only is U.K CPI inflation actually ahead of its target (of 2%), and that is likely to be temporary once sterling’s devaluation of last summer falls out of the year-on-year CPI data.
Once last week’s market squall passes attention will re-focus on other market risks: the overvaluation of the FAANGs – being Facebook, Amazon, Apple, Netflix and Google (aka Alphabet)- and the risk of a credit crunch in China, as the authorities try to ween the economy off debt.
But there are three supportive themes for investors in risk assets such as socks to bear in mind, and if they can be maintained I suspect that any market correction over the coming months will be swiftly met with investor buying. These elements are rising global corporate earnings growth, a reduction of geopolitical risk (the turning back of right wing populism in continental Europe, and an apparently neutered President Trump unable to exert control over Congress), and continuing very loose monetary policy from central banks despite the flurry of worries last week.
Broad economic and political assumptions for rest of this year:
Trump’s failure to push through Congress simulative tax reform and infrastructure bills means investors cannot expect the 3% or 4% real GDP growth this year and next that such policies might have led to. Instead the consensus is for around 2.2% this year, still up on last year and helping to contribute to perhaps 7% corporate earnings growth in the second quarter. Japan and the euro zone are enjoying solid recoveries, with perhaps mid-teen earnings growth for euro zone regional stock market indices in Q2. All of which helps support stock market valuations.
In the U.K, sterling, stocks and the gilt market face domestic policy issues: first, there is the increasing risk that chaotic Brexit negotiations and a bias towards a hard Brexit inhibits investment and contributes to a shortage of skilled labour from the E.U, accelerating an economic downturn. Bad for sterling and U.K-focused companies, but good for gilt prices and FTSE100 multinationals whose overseas earnings will be flattered in sterling terms. Second, that the weak government abandons austerity in order buy itself popularity, and so loses the confidence of investors in gilts as they fear inflation and an oversupply of debt will reduce prices (and raise yields). But more fiscal largess would boost growth, and support the earnings of domestic-focused companies. Sterling would probably weaken as overseas investors sell gilts. Real GDP growth for 2017 is likely to come in at around 1.6%, but decelerating sharply over the second half as weak consumer confidence and negative real wage growth take their toll.
From the euro zone’s perspective, forecasted real GDP growth this year of around 1.8% represents a triumph of sorts. The region last grew at this pace in early 2011. Politics have become investor-friendly, helped by the pro-E.U and reform-minded President Macron’s convincing win of seats in the Assembly National, and Angela Merkle’s positive -if guarded- response to Macron’s call for greater fiscal unity. Polls across the region report an increase in support for the E.U, it seems that the trauma caused by Brexit, migration from Syria, the half-built euro project, and terrorism can be contained. There is even progress with cleaning up the balance sheets of Italian banks, long overdue.
A balanced fund for the long term. The chart below shows a typical long-term balanced portfolio based around 60% global equities and 40% global bonds. Financial history shows this combination to offer good returns relative to risk (ie, volatility). Investors should try to be as diversified as possible, perhaps using the 60/40 model as their guide. Multi-asset funds based on this principle are available, often with different ratios of bonds and equities depending on the level of risk suitable for an investor. Note that the chart shows neutral weightings for the long-term investor, it does not incorporate the near-term weighting suggestions of the previous paragraph.