Eyes Wide Open

Since our last missive, we have had the Spring edition of our Wise Man meeting, where our two “economists-in-chief” – Bob Semple and Adrian Cunningham – help us make a little sense of the wider macroeconomic picture.  As we have said many times before, these meetings are never designed to give “answers” to particular stock-picking or portfolio construction questions.  Rather, these meetings are more important in ensuring that we, as fund managers, understand the right questions we need to be asking ourselves.  Further, these meetings focus on the risks that exist to consensus expectations, or even our own set of central assumptions.  All of this helps to condition our thinking as fund managers.

As with so many of these meetings, it is the machinations of the bond market and monetary policy that was deemed to pose the biggest risk to equity returns.  The overall global macroeconomic canvas is still supportive of ongoing growth, albeit that the rate of that growth is fully expected to moderate.  In contrast to earlier periods, fiscal policy is now providing a tailwind across the OECD, challenging the economic orthodoxy that fiscal policy should be used as a counter-cyclical policy tool.  This is not just a Trump tax cut effect.  Two thirds of OECD countries will loosen fiscal policy this year.

However, nothing in economics happens in a vacuum.  Across the major developed economies, unemployment is low, and traditional measures of productivity suggest that the output gap (the level of productive capacity in an economy) is small in many places.  This is a classic recipe for inflation to rise, and for monetary authorities to respond by raising interest rates to cool activity levels.  Raise rates too far and too fast, and you get a recession.

It will be no surprise to any reader that we see this risk most acutely arising in the United States.  In the UK, the strength of Sterling in 2017 and the continued uncertainty over what kind of Brexit (if any) we will ultimately have, is keeping inflation expectations in check.  In Europe, the ECB continues to print money for now.

The monetary policy and bond market risks are numerous, and inter-related.  At the very front end of the curve, there is a “signalling” risk from the Fed that if it raises the Fed Funds reserve rate too far too fast, it is specifically trying to cool economic activity, rather than simply getting policy back to more normalised levels.  Bond markets currently think that this balance is in danger of tipping over in the wrong direction.  Whilst much of the recent headlines have focused on the rise in long term bond yields, the rise in short term yields has been much more dramatic.  This “flattening” of the yield curve (where short- and long-term interest rates come closer together) is frequently associated with impending recessions.  Further, the supply of bonds coming out of the US Treasury and Federal Reserve is set to rise even further.  For the next three years the US Federal deficit will be a little under $1trn – a 15% increase on the supply of bonds in issue.  On top of this, the Federal Reserve’s unwinding of its QE holdings will add $30bn of new supply into the market each month.  All other things being equal, this suggests higher interest rates across the board.  And as if that was not enough, if President Trump achieves his objective of narrowing the US’s trade deficit with China, this reduces the need for the Chinese to buy US Government debt.  Elsewhere in Asia, it is now apparent that the Japanese central bank has been systematically reducing its holdings of US Treasuries.

If all of this sounds potentially apocalyptic, then no-one has told other US financial markets.  The spreads for junk bonds over US Treasuries remain at cyclical lows.  Whilst 30yr mortgage rates have risen in line with the increase in longer term government borrowing costs, they are still significantly lower than long-term average rates.  Day to day economic activity is robust.

None of what has been written here could not have been deduced from reading mainstream financial press over the last few weeks.  What is less well covered is the amount of margin debt that had built up in securities margin accounts in the US.  Securities investors in the US are running a net $300bn of margin debt – a figure that has almost trebled in the last two years.  A serious shake out in risk markets, or a need to call in that margin, could cause a severe dislocation in all markets (including equities) in the short term.  Economic historians among us know that the severity of the 1929 Wall Street crash was magnified may times by the existence of margin debt in the system.

We are not foretelling the ending of the economic cycle here.  There are too many positive fundamental drivers across the globe to make that the most likely outcome.  Equity markets in general look attractive, and within that the UK equity market offers more upside than most the softer the likely Brexit outcome becomes. Valuations remain attractive.

However, we need to be aware of where the risks lie, no matter how remote –  either geographically or statistically.  We have to invest with our eyes fully open.

It is somewhat depressing for an equity fund manager to spend so much time considering bond markets, yet it is the reality we face.  James Carville, who was an advisor to the Clinton administration, is famous for the phrase “It’s the economy, stupid” (although there is some debate over whether he used the word stupid).  However, he also offered the following to the sum of human thought.

“I used to think that if there was reincarnation, I wanted to come back as the President, or the Pope, or a .400 baseball hitter.  But now I want to come back as the bond market.  You can intimidate everybody.”

Quite.