Wednesday, December 5th, 2018
The use of hindsight can be a convenient approach when attempting to write knowledgeable explanations of market movements. However, these explanations generally oversimplify what happened and often ascribe reasons for price changes which have no actual causal relationship with the events. In the following discussion we will no doubt fall foul of the same tendency but, here goes.
The past two months have seen a dramatic correction in global equity markets, commodity markets and some currencies. (Figure 1).
Figure 1. Selected Markets, 3 Month Returns to 29th Nov.
Despite knowledgeable explanations, the truth is nobody really knows why a market reacts at a particular moment, nor why the magnitude of this move is large or small. Global investment markets are inherently complex, interconnected and significantly influenced by human behaviours (and associated cognitive biases). The human tendency to try to simplify complex things has a purpose in guiding our thinking and allowing us to cope with multiple stimuli and threats and make fast decisions – a helpful evolutionary feature. These days this manner of thinking may as often instead lead us into error.
Acknowledging these issues, we have ourselves been trying to explain short-term swings in global investment markets and how this aligns with our longer-term view of global macro and market conditions. Our central thesis remains unchanged. Specifically, the long slow global economic growth cycle, coming out of the Global Financial Crisis, steadily continues.
In this context, the Australian economy from 1990 to 2001 provides an example of the “typical” economic cycle. Notably, the slowing of growth in 1995 shows the impact of raising the RBA cash rate midway after the recovery from 1991’s recession. (Figure 2)
Figure 2. 4 Quarter change in Australian GDP, 1990 – 2001 vs RBA Official Cash rate (in that quarter).
In a “normal” economic cycle growth takes a hit in a recession – generally caused by central banks attempts to head off rising inflation by raising interest rates and over-compensating and causing a decline in output. Then we observe a gradual recovery in economic growth as rates are eased and credit growth returns. Banks start lending more to businesses and households who are attracted by improved lending rates/terms. Economic and earnings growth improves, governments increase spending to bolster the economy. This is the first stage of the cycle.
Next, we see central banks start to normalise interest rates – tightening monetary policy and reacting to the perception of rising inflationary expectations (not actual price rises but expectations that prices will rise). Often government spending continues to rise through this phase – in part assisted by higher tax receipts as growth increases taxable incomes of one form or other. The rise in rates often causes a period of mixed asset returns as repricing, based on a change in interest rate regime, can cause dislocations and rotation between economic sectors.
Once this repricing phase is over, we tend to see a return to rising earnings and GDP associated with rising official and market interest rates until rates reach a level where they essentially stifle growth and usually cause the next recession. A feature of this period is that the yield curve is usually positive i.e. short-term borrowing costs are lower than long-term costs. The assumption is that long-term rates price in inflationary expectations more directly and therefore remain higher than cash rates.
Our view of the current economic cycle is that it would be longer and flatter than previous examples. We feel this is a result of the severity of the recession which ended the previous episode – the Global Financial Crisis. The global economy has taken longer to recover, longer to re-balance, governments have been slower to loosen tighter fiscal policy and central banks are overall still operating an expansionary monetary policy. We believe this remains the case today. Economic indicators are showing signs that, globally, growth rates are slowing, not that global growth is at an end. Inflation has not yet appeared in any meaningful way in developed economies, company earnings outlooks remain positive and, in most countries, employment is not yet at the level where wage growth becomes a general feature. (Figures 3a & 3b)
Figure 3a. Global Investment and Trade, actual and forecast
Figure 3b. Unemployment and Wage Growth in Advanced Economies
In this long-term context, we feel that markets are experiencing the dislocation associated with the mid-cycle (within-the-cycle) adjustment phase, not the traditional speculative blow-off that presages a sharp rise in central bank interest rates and a subsequent recession. For a period in the last two years, we benefited from synchronised growth – many countries were experiencing the recovery phase and consequently, there was a relatively stable environment and unusually low market volatility. However, economies are at separate phases of the recovery. Notably, the US appears to be at the leading edge with Fed cash rate rises bringing the adjustment phase we noted above. Similarly, China could be said to be past the cycle peak since fiscal and monetary stimulus were wound back last year to reduce indebtedness and ensure steady growth continues in the long-term. (Figure 4)
Figure 4. Net Money Supply not Shrinking yet but Central Banks are less Expansive
Source. Fed, ECB, BoJ, BoE, Haver Analytics, DB Global Research
Figure 5. US Policy Rate Expectations have moved higher
Figure 6. Emerging Economy Policy Rates
Overall, we feel the world remains reasonably placed in terms of growth outlook. (Acknowledging Turkey in Emerging Europe is not in a good position and markedly raised policy rates in an attempt to defeat currency weakness). The IMF’s recent outlook supports this central thesis, having only marginally reduced the growth estimate for 2019 of 3.7% in the October Economic outlook while highlighting the risks we have already alluded to;
“The steady expansion underway since mid-2016 continues, with global growth for 2018–19 projected to remain at its 2017 level. At the same time, however, the expansion has become less balanced and may have peaked in some major economies. Downside risks to global growth have risen in the past six months and the potential for upside surprises has receded.”
October World Economic Outlook, www.imf.org.
This simple model of the world is, of course, subject to the caveats noted above. A simple framework seldom truly describes a complex set of interactions. In addition to the “typical” cycle described above, we have the usual collection of wars, refugee and economic migration and reactions to it, the impact of ageing populations, energy market change and environmental stresses. Presented this way, it may sound like a lot but is probably no more than has been experienced in previous cycles (cue human cognitive biases). It all serves to camouflage and distract when investors are attempting to discern the path forward.
In summary, we believe that we remain in a positive economic cycle of steady global growth. For a variety of reasons investor uncertainty and resulting volatility is elevated. Market conditions are a little bumpier than was previously the case. Some of this volatility may be due to the higher share of investment funds now represented by passive / Exchange Traded Funds (ETFs), quantitative and other trend-following funds. This feature of modern markets may to some degree be accentuating the magnitude and velocity of security price movements as these strategies add/remove capital to securities which are trending. With the benefit of hindsight, we may eventually find out whether volatility has been increased, not reduced, by these types of funds.
Figure 7. US Conference Board, Index of 10 Leading Economic indicators – No sign of recession.
Source. Bloomberg, Conference Board
We reiterate our investment approach, which is consistently applied through the cycle in a considered manner and takes advantage of improved valuations when available. Our strategies have raised cash and reduced selected positions where there has been a fundamental change in outlook. They have also used the opportunities presented by market volatility to selectively deploy capital into most favoured securities. We continue to relentlessly seek out high-quality investment opportunities. It is likely that the elevated volatility of current market conditions continues as investors adjust to the US Federal Reserve’s tightening program. While potentially uncomfortable in the short-term, we encourage investors to remember the wise phrase ‘this too shall pass’.
We thank you for your continuing interest in and support of Clime Group.