It is an understatement to say that markets everywhere have been taken by surprise by the extent of the sentiment reversal over the last six weeks. We have witnessed a rare and brutal revision of basic assumptions – and it is still continuing. So what is driving the current ‘reset’, where does it end, and how should investors position?
August changed some fundamentals in the investor mindset. Most analysts had read the global economy in mid-2011 and concluded that growth would pick up modestly through the year, thanks to lower oil prices, capex tax breaks in the US, and a post-earthquake resurgence in Japan. Markets were priced for an orderly resolution of sovereign debt problems; portfolios were built around a recovery narrative set against a background of equities looking moderately cheap and profits looking unusually strong.
That interpretation was wrong. The data flow through August showed manufacturing, inventories and jobs all pointing to a slowdown. And while these trailing data were not conclusive, forward-looking confidence data are unambiguous. The fall in business confidence signals at best a plateau, at worst a serious relapse. The total result: reset.
But there is more to this than a run of poor data. The additional factor is politics. The leadership deficit in all the key economic regions is playing a big part in sapping confidence: the US is gridlocked, Europe is fumbling, Japan is stagnant, while China’s best contribution is to jeer from the sidelines. It is not an encouraging response to what is potentially the biggest economic challenge in generations.
But for all that it is crystal clear that what markets are worried about is growth. Sovereign bond markets take a macro-economic view, and they are saying they want the stronger economies to borrow more, not less. They want investment for long-term growth, and they want governments to drive it (because it is quite clear that the private sector – however cash-rich it is – is not inclined to do that). Ultra low bond yields will eventually argue for more stimulative policy – even though that is a path policymakers fear to tread.
So where does that leave us? First, it is important to note that while there is now an even chance of recession in the developed world it can still be avoided. Some indicators, particularly manufacturing activity and final sales, are still pointing to mid-cycle slowdown rather than to recession. Second, while markets may be on their way to discounting a deflationary future, we do not think that is correct. The western economies are not Japan, their demographics and their inbuilt bias towards rapid adjustment are different.
European Equity Valuations Approaching
But there is no hiding the fact that we are left with a profound portfolio challenge. Markets are discounting a significant fall in corporate profits next year, making equities look cheap. But equities can go on looking cheap for an uncomfortably long time. It is time to invest in businesses that can deliver in a low demand environment that is averse to risk and to volatility. Today equities are unusually highly-correlated (the highest level of correlation since 1987, according to J P Morgan) – that means the good and the bad are moving together, driven by macro-economic panic. That is also a sign that we are still in the initial phase of the reset. But it won’t last, and it is important to restructure portfolios now for the coming day when markets return to sifting the strong from the weak. Macro-economic stress leads to divergent performance, and markets will recognise this.
But EPS Estimates Still Too High
Source: Bank of America Merrill Lynch, MSCI, IBES
Traditional defensives will certainly not guarantee returns unless they are the best positioned in their markets. There will be value found in non-defensive sectors with good structural growth stories, like luxury goods, emerging market growth exposures (and emerging markets will grow), and the best of the industrials. Steady stream revenues will be at a premium, episodic performance will be discounted. That is the foreseeable future: in the coming weeks there is scope for things to get worse before they get better. It is very hard to envisage a near term revival of confidence without a decisive European debt resolution and more important, the development of a credible (which means viable in terms of practical politics) pro-growth policy track.Autumnal weather is notoriously unreliable. The case for setting the sails to storm rigging has seldom been stronger.
Nothing in this document constitutes or should be treated as investment advice or an offer to buy or sell any security or other investment. TT is authorised and regulated in the United Kingdom by the Financial Conduct Authority (FCA).