Many equity and bond markets have enjoyed long bull markets with limited corrections.
The cliché “Don’t fight the Fed” has mostly worked.
We have become accustomed to below-average volatility over an economic recovery underpinned by extremely accommodative monetary policy. Negligible interest rates and quantitative easing have created the conditions for return-seeking cash holdings to be redeployed into higher-yielding investments.
However, as the post-crisis recovery proves longer and more gradual than many expected, those predicting normalisation in economic growth and market pricing have been confounded. As a result, they crowd into the few trades where they can gain conviction.
This leads to the creation of ‘rational bubbles’, as investors see no attractive option other than investing in assets, even as they appear increasingly expensive.
For how long will these distortions continue? In our view, this environment is unlikely to change significantly in the short term. The global economy remains burdened by high debt levels. As with previous banking crises, the work-out process is likely to prove long and gradual, requiring continued policy support for many more years.
It is highly likely that the extent and longevity of policy support will continue to stoke mini bubbles in a large and rotating number of asset classes. Healthy performance over recent years is already forcing investors to make judgements on markets that appear fairly valued or expensive but continue to rally.
At the start of 2015, US equities had never been so expensive based on the price/earnings and price/cashflow multiples of the median stock, but the S&P 500 rose by 3.4 per cent over the first seven months of the year. Biotechnology stocks in the US have gained more than 45 per cent since Janet Yellen warned last year that valuations appeared “substantially stretched”.
Investor crowding contributes to a dynamic whereby volatility is contained for a long period of time. It is then especially painful when these bubbles burst, leading to bouts of extreme volatility combined with unstable correlations. This was evident in the second quarter, when German bunds endured a savage reversal that incorporated their largest four-week sell-off in more than 20 years.
Similarly, China A-Shares collapsed by more than 30 per cent in under one month in June-July. They had earlier returned more than 120 per cent in less than one year.
From an investment perspective, we believe it is particularly important to understand which trades are crowded and consensual. We look to diversify portfolios with sensible contrarian opportunities when they are supported by detailed strategic research.
The unusual investment environment is likely to be in place for a prolonged period of time and creates opportunities as well as pitfalls, as long as it is understood.
We are also mindful of behavioural risks. As Robert Buckland at Citigroup wrote earlier this year, “a weary client once defined a bubble [as]: ‘Something I get fired for not owning’”.
Working in a stable environment with a long-term business strategy is important in mitigating such risks.
Mark Harris is head of multi-asset at City Financial
