Into the Unknown

It is perhaps ironic that ending the process of “hand holding” performed by the world’s central bankers – particularly via forward guidance of the factors that will determine when and by how much interest rates will rise in the future – has generated the kind of uncertainty and volatility in markets that it was largely designed to avoid.  The role of forward guidance was supposed to give economic agents (companies and individuals) the certainty of the future cost of money in order to promote consumption and investment decisions.  Whether it had that effect or not is open to debate.  What is less debatable is that it led to a reallocation of assets in financial markets seeking out income elsewhere (which was also part of the original intention), and the “one way” nature of policy has fostered a general reduction in credit standards in many corporate and government bond markets (which was almost certainly not part of the original intention).

Another irony is that when all apparent conditions for the Federal Reserve in the US to start raising rates and normalising monetary policy had been met by the September FOMC meeting, the fear of rising rates had an effect on markets that persuaded Committee members to hold fire on actually raising them.  It further raised questions over whether we would see a repeat of the same issues come the time of the October or December meetings.  For those with a passing interest in game theory, it has some similarities to the Hangman’s Dilemma albeit in reverse (for those with too much time on their hands, the following link offers a decent exposition Will policy makers accidentally wait until it is too late for the real economy before putting rates up, because financial markets appear to be driving the policy making agenda?

The rate setting conundrum has been analysed ad nauseum elsewhere, and I am not sure that we can offer anything uniquely insightful, save for pointing out that we do expect a US rate rise at some point this year, and that the UK will follow are some point in the early part of next year.

Regular readers will know that we have approached the Autumn more cautiously and with much higher cash balances than at any time in recent years.  To the casual observer, that might have seemed incredibly prescient given recent events.  In truth, whilst the Chinese slowdown and the impact on financial markets of tightening monetary policy were integral to making that decision, there were also other factors that we were cautious over, and we did not expect it to play out quite as quickly as it has.  Perhaps more importantly, our key concern was equity valuation, which is starting to be addressed, but in our opinion swathes of the equity market are valued on the basis that policy makers won’t have the nerve to raise interest rates any time soon.

Recent meetings with investors have generally been reflective of an acceptance that our short term caution is understandable, and sitting with cash ready to pick up decent companies at good prices is a worthwhile approach.  Questions have largely surrounded the conditions that would need to exist to start to deploy that cash.  And like the decision to raise cash, the decision to deploy it will be fundamentally driven by valuation.  We do not perceive the world to be broken.  We do not see general distress amongst the companies we look at.  The UK and US economies are grinding out decent growth, and we expect that to continue.  But equally, we expect “challenging” conditions in most of the rest of the world to cause fundamentally good businesses to lower expectations for earnings growth in 2016.  When combined with general market volatility surrounding interest rate decisions, this will inevitably mean some company valuations will over-react on the downside.  In general terms, that is what we are looking for before deploying our cash.  This means that the timing is subjective, dependent on events that are as yet unknown – but the last and first month of each calendar year is normally a focal point for reappraising corporate expectations.

That the UK equity market seems to move by between 1% and 3% on a daily basis tells you that market participants are struggling to grasp what the key drivers of returns are going to be in coming months.  This means that by taking a decisive position one way means that you can look very stupid or very clever over short periods of time.  But we are paid to call things as we see it; and we see discretion as the greater part of valour in the short term.  One thing is for certain.  Volatility is here to stay until the Federal Reserve in the US cuts the Gordian Knot keeping interest rates pegged close to zero.  What happens thereafter is beyond analysis at the moment.  Retaining financial flexibility in that event will be a great benefit.