The Recovery-less Recovery

The imminent conclusion of the US quantitative easing (bond-buying) programme has been cited as one cause, and geopolitical risks (Russia/Ukraine, Islamic State/Middle East, Hong Kong/China) and latterly global public health concerns (Ebola) have certainly done little to calm investors’ nerves.

Market liquidity in both bonds and equities is challenged at the moment, and those who were worried that the post-2008 contraction of the investment banks’ and broker-dealers’ balance sheets would eventually create a liquidity shortfall at some point may feel that the hens have come home to roost. Liquidity in high yield markets has been poor for some time (hence our decision to reduce exposure to that asset class in our multi-asset portfolios earlier this month). In currency markets, the dollar’s surge in Q3 was likely to provide a headwind for some risk assets (historically, there has been a strong inverse relationship between the dollar and emerging markets, for example).

Our own view is that the recent equity sell-off and the broader ‘flight to safety’ has its roots in fundamentals. The simple fact is that despite QE, near-zero interest rates for more than half a decade and the more recent commitment from the ECB to do ‘whatever it takes’ to save the euro, there has been precious little evidence of any genuine economic recovery outside the US. The growth outlook in emerging markets – for so long the engine of global growth – is deteriorating and Europe now appears to be flirting with recession again, whilst potentially having to deal with deflation, which could be hugely damaging given government indebtedness. Markets are sceptical whether full-blown QE (even if it does come) will do much to boost economic growth in the eurozone. Japan has undeniably benefited from yen weakness but its economic recovery (at least in the short term) depends largely on exports to the rest of the world, where the growth outlook now appears to be worsening. The UK has enjoyed a housing-led recovery, but question marks remain on how durable the upturn will prove to be, especially once the central bank begins to normalise interest rates (bond markets currently suggest that UK interest rates will increase after the 2015 general election, with the US potentially raising rates in Q4 2015).

In short, markets now appear to be panicking about a potential growth shock and what that could mean for earnings for the remainder of this year and into 2015. Companies have done little to allay these concerns so far as the Q3 earnings season has got off to an uncertain start. From a broad valuation perspective, it clearly makes no sense for share prices to remain unmoved when investors’ confidence in the earnings outlook is weakening. Put it this way: if earnings look like they are going to fall, share prices also have to decline in order for valuation metrics such as PE multiples just to remain stable.

We discussed our investment positioning – as we always do – at our weekly asset allocation meeting and our conclusion was that it made no sense to buy bonds at current levels. We also concluded that we would not sell equities, but neither would we add to our current holdings. In our opinion, it is only possible to make a sensible case for buying core government bonds at current yields if you believe that the world will remain in a deflationary environment indefinitely.

We do not share that view and recent US data (jobless claims, industrial production) has been encouraging (albeit largely ignored by markets). The growth outlook for the rest of the world, however, is more challenging.

For equities, we would not rule out some further short-term pain as earnings expectations re-calibrate but we would note that investors who have held equities continuously over the past three years to the close of business on 15 October 2014 have still enjoyed local currency total returns of over 60% in the US (S&P 500) and over 30% in the UK (FTSE All-Share). Other developed markets have also enjoyed good gains. Moreover, if markets do become more dovish on the outlook for short rates, as now seems likely, then equities – as the ultimate long duration asset – should be among the beneficiaries.