In terms of the real economy, though slower growth has been our central view, we are concerned that the odds of a more volatile cycle of economic growth in either direction, are underestimated. The current sharp reversal in US residential real estate, for example, could well lead to a more marked economy-wide slowdown. In contrast to the UK, which is often cited as a model for the trajectory of the US housing market, the US has experienced both a house price boom and a residential construction boom. The additional boost to the economy from higher construction activity that has left an overhang of unsold homes means that the down cycle could have a more significant economic impact.
At the current time, however, economic data emerging from the US could equally support the view that sectors outside housing and autos could help the US economy to retain its remarkable momentum. Indeed, if the downturn in housing is confined to residential construction activity as some suggest, the US economy could even accelerate during 2007. This, combined with very strong rates of growth in the developed world and continued recovery in Germany and Japan, would see global growth barely missing a beat. Clearly the above scenarios would produce very different expectations about inflation. This is another area where messages received from economic data and financial markets seem mixed, and risk surprising investors.
Consumer price inflation data globally remains remarkably well-behaved. The overwhelming consensus view among investors is that inflation will remain low as a result of globalisation, technological change and a belief that central banks have mastered the art of fine-tuning economies. Central bankers themselves, however, have been variously signalling their discomfort about the current level of core inflation (US Federal Reserve), the potentially inflationary implications of very strong growth in credit (European Central Bank) or both (Bank of England). Indeed the Bank of England has noted that the deflationary benefits of globalisation may be diminishing. Rhetoric about further rate rises may well not be converted into action, but on balance, major central banks are still signalling that rate rises are probable.
A further crucial variable that could provide a surprise in 2007 is corporate profits. On this metric the current cycle has been nothing short of remarkable (Wall Street has just seen its 14th successive quarter of double digit earnings growth). US corporate profits as a proportion of GDP are at a 55-year high with profit margins at 14.6%, nearly 50% above their longterm average.
It is conceivable that in today’s globally-integrated world, profits have reached sustainably higher levels. Indeed more bullish forecasts suggest that, though the rate of profits expansion will moderate from here, this, combined with a benign interest rate outlook, could mean that equity markets can be re-rated in a similar manner to that seen in the second half of the 1980s and 1990s. This means that investors will be willing to pay a higher earnings multiple for a slower earnings for a growth profile. The risk with such a view is that evidence from the past strongly suggests that profits are ‘mean reverting’ (i.e. they revert towards an average level). To see good value in equity markets, one needs to believe that both levels of corporate profits are sustainable and that government bond yields (and therefore inflation) will remain anchored around current levels. The reason for focusing on potential instability in the economic outlook is that investor behaviour, particularly as regards the pricing of risk and the use of leverage, is assuming that the future will exactly mirror the recent past. In short, capital markets rely heavily on the assumption that nothing will alter the current economic and financial stability.
The driving force for such a bet is the environment of excess liquidity, which we see as the defining feature of the current financial landscape. Why the world is awash with cash and credit is open to debate, but loose monetary policies in the major blocs, a glut of savings in the developing world (where the economic crises of the 1990s are still fresh in memories) and the reluctance of corporates to commit capital to new plant and equipment have certainly contributed.
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In addition to this, it is clear that profound changes have taken place in world financial markets during this cycle, as a result of globalisation, financial deregulation and a quantum change in the use of complex financial derivatives. Though central banks still create money, they no longer control the ultimate supply of credit available in their economies; the market place is now able, by various means, to multiply the effective leverage available to participants. Moreover these structures and trades recognise no national boundaries. Both the Japanese yen and the Swiss franc are being used, for example, as sources of cheap finance (because of very low domestic interest rates) for international carry trades (by which investors invest the funds raised in higher yielding areas) which have been crucial to demand for many asset classes globally.
Excess liquidity has seeped into all asset classes, raising prices and reducing yields, and therefore expected returns. With plentiful cheap credit and expectations of a stable economic backdrop being seen as more or less permanent, corporates and households have been encouraged to gear to ever higher levels and pools of leveraged money (such as private equity and hedge funds) have been the fastest growing sectors in asset management.
The sheer weight of money chasing yield has reduced risk free rates particularly on securities, where UK 30-year index linked bonds have a real yield of only 0.7%. In turn, this has forced investors to adopt more risk in order to meet return objectives, narrowing spreads between what are considered to be more risky corporate or emerging markets bonds and relatively safe government paper. Excess liquidity also appears to have had two further effects of which investors need to be aware. First, it has contributed to a sharp rise in the correlation between various financial assets – which clearly reduces the diversification benefits for traditional investors. It has also led to a marked reduction in the volatility of markets such as bonds, equities and currencies.
A simple analogy for these effects might be to imagine that excess liquidity is like a stream in flood; so much water is flowing downstream that it carries everything within it. At the same time the volume of water flowing hides any rocks lurking below the surface. Low volatility measures in financial markets imply that investors are currently perceiving, equities (and other asset classes) as lower risk than historically. This may well reflect a rational view that the current mini cycle environment is indeed permanent. Another explanation is that many investors believe that, the US economy in particular, is just too highly leveraged to allow the central bank to pursue a tighter monetary policy. Federal Reserve policy is therefore widely seen as asymmetric; policy makers are willing to tolerate higher asset prices in the economy, but will cut interest rates should these prices fall. In such circumstances all manner of leveraged structures and trading strategies could be considered low risk activities.
It is easy to see how relatively long periods of stability can condition investors to behave in ways that, in time, are likely to produce just the sort of bubbles in markets that threaten the very stability on which they are based. The crucial factor is, of course, timing. Though the risks in the system are rising, so profitable is the credit creation and leveraged investing machine, that if economic and financial conditions do remain just right the momentum could drive assets much higher from here.
Stepping back from the financial markets, one does not get the feeling of a particularly low risk world (or indeed a low inflation one, for that matter!). In addition to the economic uncertainties, geopolitics, energy supply, climate change and terrorism are all wild cards that could trip up markets priced for benign and stable outcomes.
Portfolio policy against this background naturally needs to be a balance between heeding the risks discussed above and the realities of today’s liquidity-driven market place, which will tend to support most asset prices. In a practical sense, this means favouring equities over the debt markets and focusing exposure in less cyclical industries and in larger capitalisation stocks. We believe such defensive portfolios suit an environment of slowing global growth while at the same time having the best chance of weathering the more volatile scenarios that we might encounter during 2007.
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