How can it be both the best of times and the worst of times for markets?
As the sleepy months of late summer fade away, investors put down the classics and pick up the financial pages as markets resume their usual commotion of activity.
We should use it to reflect on what has been a great year for investors, despite the recent market wobbles.
Indeed, equities continue to rally, with the US market at an all-time high, up over 17 per cent year-to-date. European equities, while not as buoyant, have also recorded double-digit gains year-to-date, while Chinese equities have soared by nearly 19 per cent.
Even the UK market with all its inherent risks is up around eight per cent. Indeed, risk assets continue to rise as the equity bull run barrels on for an eleventh year.
Yet, in stark contrast from other similarly aged bull runs, fear abounds.
Safe-haven German and Japanese bonds maturing a decade from now offer outright negative yields, part of over $17 trillion in government debt yielding below-zero at present.
Investors are clearly willing to pay out of their pockets for the privilege of lending to these governments, which speaks to their pessimism of the future.
Thirty-year gilts yield just one per cent, well below the rate of inflation, partly as fears of a hard Brexit have soared again. Gold, a crisis hedge for thousands of years, has rallied by 20 per cent thus far this year, trading at a six-year high.
But how can it be both the best of times, and the worst?
Over a decade on from the lacerations of the financial crisis, global economic growth is still insipid, despite the colossal efforts of central banks around the world.
These efforts through low rates or quantitative easing have been somewhat fruitless in achieving their primary objective of sustaining above-trend economic growth, but they continue to directly underpin bond markets.
The Bank of Japan is still actively intervening, buying government bonds, corporate bonds, and equities. The European Central Bank is running a negative base rate and has signalled it will reverse its seven-month hiatus on its quantitative easing program in September.
The US Federal Reserve reversed a string of nine rate increases, cutting its base late in July. Market expectations are for the Bank of England are to do much the same – its rate is only slightly above historic lows in any event. All of this is keeping bond prices up and yields down.
And the lower that yields are on government bonds, the more attractive equities appear in comparison. This is for two main reasons.
One is simply mathematical: future cash flows from corporate earnings are discounted less (that is, the opportunity cost from holding “risk-free” bonds is less of a drag).
Two, bonds are yielding outright negative returns in much of the world – and once inflation is taken into account, negative real returns exist in nearly all developed markets.
Very few investors are holding them as a traditional, lucrative investment, but rather as a crisis hedge.
In this context, unless one is expecting a recession or a negative shock, equities simply are far more attractive: at least you can expect a positive real return, albeit muted at this stage in the cycle.
Bleak House
A number of other economic and geopolitical risks muddy the waters further at present.
The current equity bull run have been seriously challenged as fears of a slowdown in the Chinese economy have increased.
That risk is clearly exacerbated by the ongoing trade war, with market ructions over the summer a recent testament. The developed world is also under the cloud of weak growth and anaemic inflation. This is shocking considering the monetary paradigm and low levels of unemployment.
Of course, closer to home, the UK public’s decision to sever its membership in the European Union remains as unresolved as ever.
A new occupant in Number 10 Downing Street is certainly acting as a catalyst, but to what end? Sterling volatility has shot up higher than that of some emerging market currencies, which is a clear sign of stress.
This is just one of the Eurozone’s myriad problems: weak growth, populism, poor demographics, and painful decision-making.
These are some of the triggers to equity markets sputtering, faltering or plummeting, but the list is far from exhaustive.
Great Expectations
We recognise a discomforting backdrop to global markets. Nonetheless, we remain sanguine: equities are still our most significant allocation.
Why? First, the discomfiting backdrop is itself a reason to be invested. While equity valuations now stand between fair to slightly expensive, depending on the market, the asset class is in a strong uptrend, but without the over-bullish sentiment which would be a red flag.
Having said that, we recognise that markets can move with staggering speed, and we continue to have significant allocations to government bonds, despite record low yields and high valuations. They are held primarily to diversify away from equity risk.
But that is not the only reason. Government bonds are also in positive momentum and surrounded by negative sentiment, both aspects we like.
It is prudent to remember they have delivered positive real returns over the last one, three and five-year periods through conditions similar to today – a surprise to many.
It is more than possible that they will continue to surprise, particularly given yet another turn to loosening in monetary policy from key global central banks.
It is important at this late stage of the cycle to remain well diversified, therefore we have recently added to our gold position due to the fact that historically it has tended to move with low or negative correlation to equities, especially in times of crisis.
Much like a Dicken’s novel, there is a tremendous amount of nuance. No doubt the months ahead will test our views and convictions.