Risks rise as markets move higher and economies strengthen
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Financial assets have made good progress, with a 65/35 portfolio of global equities and government bonds having moved strongly higher since mid-2011 and markets have been supported by strong and accelerating global industrial production growth; easy financial conditions; expectations of further dovishness from key central banks; US growth that is just weak enough to make a “no taper” story credible; a reduction in fiscal concerns; and a consensus view of accelerating global GDP growth in 2014.
But it’s important to focus on contrarian views and many of the current positive factors for markets may be reversed by early next year, and any further significant short-term strength in equity and credit markets could be self-defeating by worsening valuations, putting upward pressure on yields, and increasing policymakers’ concerns about financial stability.
In terms of the risks to data, global industrial production (IP) momentum may well peak in December between 7.5% and 8.0% and whilst global IP will not slow much and ultimately will grow at a solid pace in 2014, at momentum peaks, negative economic and earnings surprises tend to occur, driving risk appetite lower. Equally, the positive forward outlook for US growth suggests that conditions might heat up to levels that are uncomfortable with the lagged downward impact on inflation from the global slump in 2012 now eroding, and supporting the likelihood of steeper yield curves in the months ahead. This means that by the time global growth momentum begins to slow visibly (Q1), it could be that financial conditions, particularly in the United States, will already have tightened, consistent with the late stage of a long ‘risk’ rally. We may also assume that in that period, tapering of Fed Quantitative Easing will be back on the agenda, with many economists looking for the first reduction in the rate of asset purchases in January, with some expecting full wind-down of QE by Q4 of next year. This may be way too adventurous, but even if there’s only renewed talk of tapering rather than substantial action, this risks rising rates which in turn risks another illiquidity flare-up in credit markets, perhaps similar to what was seen in June. It certainly seems likely that tough talk on financial stability, such as the recent statements on leveraged loan conditions, will probably be insufficient to stop credit markets from experiencing further oscillating bouts of extreme strength, as at present, followed by temporary flare-ups of illiquidity given limited dealer inventories.
Although equities have done well year to date on the basis of value against credit, they don’t appear to have made huge strides, and this is in part because recently both risky and safe assets in developed markets have performed well in risk adjusted terms.
We can consider equity valuations in three contexts – absolute, and relative either to bonds or to economies. The absolute valuation of equities looks reasonable – but is dependent on continued corporate profitability and profits streams, which any hiccup in growth may affect. On the relative valuation front, for equity valuations to look more stretched against bonds, we need either a sharp further increase in equities and/or a large backup in yields, with the latter a distinct possibility. Against economies, the US market cap to GDP ratio is now back to 2007 levels, and eventually, the economy may start to outperform the market, for a change.
We need not shift to an outright cautious stance, but we recognise that the fundamental support for equities in early 2014 may look far less positive than it does now, even as developed market GDP growth appears to be picking up. The problem is that the unusual combination of accelerating global IP momentum with both low bond yields and accommodative policy expectations is fundamentally unstable and must end before long. The result is that we should be concerned that stronger US GDP growth may turn out not to be a source of equity market strength but rather a headwind as it brings on normalisation of financial conditions.
James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla
