There has been considerable speculation over the past few years on just how long the bull market phase of this current cycle can continue.
The thesis that traditional and extraordinary policy implemented by central banks and governments across the developed world over the past decade has led to an extension of this cycle, now seems to be reasonably well accepted.
The debate will continue to rage as to whether quantitative easing (QE) has been successful in stimulating growth or raising levels of inflation, but an incontrovertible consequence of this unconventional policy is that asset prices have benefited handsomely from the effects of this additional stimulus.
Whether this was a planned outcome of central bankers is more open to question, but planned or not, many asset prices across the developed world are trading at valuation multiples that on a historic basis are elevated and in some cases these are at extreme levels.
With this being the case, what signals should we be looking for as a warning that the mood music is changing if not halting altogether? Well, one of these warning signs – although currently only flashing at amber – is the beginning of tighter financial conditions signalled by central banks. Before we all go off and panic that central banks are raising interest rates and this will cause the end of the world, we should perhaps try to put this into a little bit of context.
Key Points
- QE has had a big impact on asset prices.
- If QE is withdrawn slowly then markets should take the change in their stride.
- From an equity perspective, the asset class looks attractive.
The US central bank, the Federal Reserve, over the past 20 months has raised interest rates 4 times from a 0 per cent to 0.25 per cent bound to 1 per cent to 1.25 per cent, the headline inflation rate in the US in August 2017 (CPI) was 1.9 per cent and the latest PCE inflation level – the Fed’s preferred method of measuring inflation – was 1.4 per cent. What this tells us is that even with the rate rises we have seen recently, the interest rate in the US continues to run at negative real rates. This is still incredibly stimulatory policy when viewed from a historic basis.
These recent rate increases and any announcement about the beginning of the unwinding of the Fed’s balance sheet, which has grown from $0.8bn in 2007 to more than $4.5 trillion today, should be seen as less stimulatory policy. However, it is not yet restrictive in a historic sense.
Other central banks have also begun to talk about tapering of their existing QE programmes or in some cases beginning to raise rates, but again this has to be viewed in the context of the incredibly loose position of policy as it stands today.
As long as this shift in policy is gradual and measured, markets should take this evolution in policy in their stride. Global growth seems to be reasonably robust in nature, with a fast improving environment in areas of the world such as Europe.
There is always the risk that a central bank could misread the situation and make a policy error, although with the level of scrutiny on these institutions and the awareness of committee members to this, this is unlikely to happen.
All of this being the case, although this is not a particularly hawkish environment overall, it does have an impact on asset classes and the returns we can expect from them.
A rising interest rate environment, even from incredibly low levels, is not a positive environment from a return perspective for government bonds. This would also have a negative impact on investment grade corporate bonds, which are reasonably highly correlated to government bond yields.
However, in an environment of low interest rates and continued global growth, I do not foresee any significant pick up in defaults here. On this basis, high-yield bonds would continue to perform reasonably well as they are less impacted by shifts in government bond yields, and defaults would continue to be limited. From a developed fixed interest perspective, I would prefer to be investing in assets with lower interest rate sensitivity.
From an equity perspective, the asset class – at least on a relative basis – looks attractive. The macro economic environment is still reasonably supportive with positive growth and a low interest rate environment.
I acknowledge that financing costs are beginning to rise, but again these are from very low levels and many corporates have been active in the corporate debt markets over the past few years, securing longer term funding at low rates.
The main concern in recent years within equity markets is the lack of earnings growth being delivered, while prices have continued to rise – essentially multiple expansion. This has left the asset class trading on a historically high multiple.
For equities to maintain their current rating, or prices to rise from here, we would need to see companies delivering on earnings expectations and in the past few quarters this is exactly what we have witnessed. This has been most evident within European equities, which have underperformed US equities over the past 10 years by 85 per cent, but in today’s environment seem to offer a valuation opportunity in a world where few exist.
In conclusion, in an environment when extraordinary policy has been the norm, and exogenous factors can influence markets, governments and central banks, the best approach is to look through the noise and concentrate on fundamentals, however warped those fundamentals might currently seem.
Darren Ripton is head of investments at Standard Life Wealth
