From the start of this year, we have taken and followed a very non-consensual view of how the economic recovery is unfolding, driven mainly by our views on the US.
We previously commented that 2014 started with the widely accepted view that we were on a path of normalisation. Using history as a guide, the general expectation was for developed market equities to perform in line with earnings.
The natural conclusion of this view was themed ‘the great rotation’ and a wide array of investors positioned accordingly. However, we espoused a very different view. We could see that many facets of the recovery might look normal, but there might also be many that would confound and confront participants’ expectations.
It is now very evident that this has been the case and that bonds and equities are pricing two very different environments. Consequently, we are conscious there is a great deal to worry about, and we have seen few convincing expositions that identify where we are in the economic cycle.
There are some challenging items such as capacity utilisation being lower than ever, real wage growth being anaemic in spite of a marked pickup in employment and productivity year-on-year rises being just more than 1 per cent in the past four quarters.
Capital expenditure (non-residential fixed investment) is also running 15 per cent below the 1990 to 2007 trend.
Add in the fact that US Federal Reserve chairman Janet Yellen has been articulating a new set of policy ideas and it is not surprising there is a feeling of malaise.
To further illustrate these points, recent readings offered up very conflicting signals on US wage growth that confront the Federal Open Market Committee’s contention that “there remains significant underutilisation of labour resources”.
The second quarter Employment Cost index was up strongly and reversed first quarter weakness, but the July employment report showed average hourly earnings flat with a small uptick in the unemployment rate.
While short-term economic indicators may be strengthening, we continue to question the sustainability of this recovery. It is our contention that there remain deep structural issues that will challenge growth and job creation.
For our outlook to be incorrect, either companies will embark on a major capex spend or global economic growth markedly accelerates.
As we approach 2015, there will be more focus on interest rate changes as investors battle with challenging data.
In spite of all of this, institutional investors appear to have stubbornly remained short duration, hedge funds appear to be increasing their short positions in bonds and individuals have poured money into exchange-traded funds, which have amplified bearish positions on longer-term US Treasuries.
We feel that the chance of policy error will be heightened as we move closer to 2015 and, if confronted with further changes, markets will react violently.
The keys to unlocking this conundrum lie in understanding the fine detail, being able to identify the unique drivers in this cycle, and forecasting capex spend, productivity, growth in employment and wages. We feel we have some clarity on these issues, but believe many investors are wildly adrift.
Mark Harris is head of multi-asset funds at City Financial
