Withdrawing historic levels of market stimulus
On Wednesday night, Janet Yellen, the chair of the US Federal Reserve, gave a hugely important press conference in which she confirmed that the Fed would start ‘the great transition’ from quantitative easing to quantitative tightening.
This was an historic moment because since 2008 huge amounts of money have been pumped into the system to avoid a 1930’s style economic depression, and where the world has benefitted from ultra-low interest rates.
The question on everyone’s minds now, is if the stimulus created asset bubbles and allowed the US to recover, what happens when the stimulus is withdrawn? This is a massive issue on how the world operates over the coming years and how we plan our strategy.
What is clear is that the US has recovered and in recent years has been one of the most robust stock markets, this year hitting its all-time high.
However, the next question is how long can this continue, in an environment where the Fed is now on a path to increase interest rates perhaps once more in December this year, and three times in 2018. This coupled with quantitative tightening, create what economists are calling ‘central bank risk’. The Fed is not immune to such mistakes, either tightening too quickly or not enough over the last thirty years, creating massive booms and busts.
There is a thought that the Fed does not need to raise rates, as US core inflation is sub 2%, and that it is anticipating another crisis or recession down the line, so it wants to be able to reduce rates in that environment. To do that it has to raise them now. A clue to this came out in the press conference where Chair Yellen said, ‘the economic outlook remains uncertain, things can change, and policy is not on a pre-set course.’ The Fed will need to be adaptive as conditions evolve, and so will we.
Why does the Fed think there could be another crisis or recession down the line? I have segmented these into the following headings,
• The rise of Populism (Trump) and a new boom bust cycle
• The Trump Trade and Political Risk and Impeachment
• The unwinding of Quantitative Easing
• The China Conundrum
Taking the above into consideration, I’ve also outlined how we manage strategy.
The Rise of Populism – how an uncertain world leaves clues for success
Last week I was at a conference where Sam Wilkin, Senior Adviser to Oxford Economics, one of the world’s foremost global economic forecasting and research consultancies, discussed the rise in ‘Populism’ and what insights this might give us on Trump and stock markets.
We discussed research from Ray Dalio of Bridgewater Associates, adviser to governments and institutions around the world, where Populism is now at its highest levels since the 1930’s.
This matters because it affects stock markets, and therefore it affects strategy.
Looking for Clues – Learning from history
It’s certainly unnerving for everyone when bravado reaches levels where rhetoric would seem more at home in the playground, than at the United Nations.
Populism is rarely seen in developed economies, but occurs after a financial crash or system failure, where the ‘common man’ is disadvantaged, wealth gaps get wider, and where the system or government is / or perceived as , no longer working efficiently for them.
So there are parallels with the past. The global financial crash of 1929 gave rise to populism in the 1930’s, and the global financial crash of 2008 has given rise to the current populist phenomenon.
It’s important because in the near term Trump and other populist leaders will play a far bigger role in shaping the world economy. Where this has occurred previously it normally results in a short term economic boost, for a year or too, but then this fades, and can result in economic crisis.
So the purpose of sharing this is so that that we can benefit from the former, and be aware of potential risks moving forward.
The Trump Trade – Political Risk
In the next few months we will be coming up to the anniversary of Trump’s election victory, and whilst he did not take over until January, markets were boosted late last year by the prospect of tax cuts. In addition our currency had taken a bit of pounding since Brexit last summer, and this had the effect of increasing values on the FTSE 100.
This was not because our economy was booming, it was because of a positive outlook in the USA, and the fact that our currency had devalued by 20%. That meant the FTSE multi-national companies earnt more money because they get the majority of income in US$.
So what’s being playing out this year, is that when our currency is weak, the FTSE rises, reaching roughly 7,500 mid-year, and when our currency regains some strength, as it has done in the last week, the FTSE falls back a bit.
Likewise in the USA, as long as markets have retained the belief that Trump tax cuts are coming, it’s been able to hold on to it’s ‘all time high’ level, with support from low unemployment.
Don’t get me wrong the USA is firmly in recovery and this is the positive news which will hopefully allow populism to fade far quicker. But we may have some bumps on the way, especially if Trump tax cuts don’t come soon, or the big risk, we have an impeachment.
But there is also another reason why the Trump Trade might pause for breath, and that is the Federal Reserve’s position on unwinding the historic levels of stimulus and rising interest rates.
The Fed Conundrum – Central Bank Risk unwinding QE
The USA is in full recovery mode and has led the world out of the worst financial crisis in a generation, at a time when China has also stimulated its economy to keep things going.
The big question over the last few years has been, how quickly interest rates will rise, and will we ever get back to pre-crisis norms?
To add an extra dimension, the Fed is now at a point where it is to start unwinding the massive amounts of stimulus it has given since 2008.
So announcements on interest rate rises are having a much bigger impact on bonds, as these tend to fall in value, as interest rates go up. For example just last week Mark Carney at the Bank of England surprised markets by saying UK interest rates might go up sooner. This strengthened the pound so the FTSE fell back a bit, but it also affected bond values which fell back too, because they go down in value when interest rates go up.
We’ve seen this before over the last few years, where its tended to work in a cycle of risk on or risk off, a short term see saw, but before long things stabilise again. This is because whilst rates will gradually rise, it’s more likely that this will be very slow and gradual over many years.
So as long as the Fed and BOE do things very gradually, then there should be no nasty upsets caused by gradual increases in interest rates and normalisation.
It does however mean that expected returns for all asset classes are expected to be lower than normal over the next ten years. I’ve recently seen research from Baillie Gifford that shows average returns above cash as low as 3.5-4% pa even for equities. Of course averages can be misleading, and this data may account for a fall in values before they recover again, but in our planning scenarios we should perhaps look at 3.5% to 4% pa as being sustainable income from capital, rather than the 5% pa rule of thumb used in the past.
In summary, if bonds become less attractive, then the danger is that more portfolio assets go into equities in search of a return, increasing the risks of capital loss, should markets catch a cold. So it’s going to be really important to continue monitoring risk, to have risk reduction buffers in place, and to be more adaptive.
The China Conundrum – Opportunities from the changing of the Guard
This autumn the Chinese Party Congress is changing, when the old leaders withdraw and new ones come in. It’s been a tradition to stimulate the economy in the run up to the change-over, to hand things on in good shape.
However, as I’ve written about before, China is a law unto itself in terms of the data the West receives, and the way the ‘communist party’ tries to control the stock market.
A couple of years ago in August 2015, China did a surprise devaluation of its currency which made stock markets around the world fall, Chinese stock brokers were forbidden from selling and companies could not sell their own stock.
I’ve just heard similar research from Jupiter that during the forthcoming changeover brokers have been told not to sell anything, they have been told they can’t go on holiday, and that they have to manage volatility so that the departing members save face.
This has led some to think that the new era may start with some tightening. If this were the case we could see some global volatility and the opportunity to drip feed.
As John Authers of the FT said 14th September ‘it’s the communist party, not the government that runs China.’ It’s now the world’s second largest stock market, but there is no democratic control over the companies that one could buy. This is the bargain that major US players like Fidelity and Black Rock have had to make in accessing this market, and why it continues to be very difficult to access in any meaningful form to western investors.
Better to access the beneficiaries of China’s economy, its trading partners and its effect on raw materials, which we can do through such things as technology and commodities, or geographical sectors such as the Far East, including Australia, as well as Africa and Latin America. But bear in mind these are risky areas effected by policy and data coming out from China. Depending upon how the Party Congress changeover goes there might be an opportunity to drip feed into such areas for those wishing to increase their non-core satellite holdings.
How we manage strategy – Total Wealth Management
Having been exposed to so many research papers this year, and where I’ve given myself more time in forming strategy I have come to the conclusion that we must continue to be adaptive and proactive. There is no one fixed fund, sector or equity solution, but rather a blend of assets to suit the changing seasons where we can adapt and take profits as things evolve.
For example with yields so low on bonds, in order to capture growth we have had to be far more proactive in culling and parking some equity profits before they dissipate again. Likewise where this year we have seen bond yields fall and their asset value increase, we have also parked some profit.
This see saw effect which I referred to earlier is going to continue for the foreseeable future as we encounter both inflationary and deflationary cycles.
We have also seen value added through our selection of non-core satellite holdings which reflect our belief in longer term trends effected by demographic issues such as an ageing population (health) or in such things as new sciences, smaller companies and technology, and where longer term, countries with a youthful population tend to outperform (Far East, and India).
Our core holdings are also evolving from the standard managed or distribution style funds into a new breed of managed volatility multi asset offerings which are far more adaptive and dynamic than the older style of funds.
I have written a white paper called ‘Total Wealth Management’ on what I believe to be our core philosophy and values and if you would like a copy, please contact Julie in the usual manner.
In summary myself and the team continue to be dedicated to providing a more personalised, proactive and adaptive approach, managing risk where we can, and preparing for next year. If you wish to discuss any of the enclosed thoughts further, then please do not hesitate to contact us.
Austyn Smith is a leading advocate of the ‘risk managed’ approach and ‘all weather’ investing, and has been featured as a Citywire ‘Cover Star’ in 2010, 2013 and 2017.
Following his work on risk reduction strategies, in 2011 he was recognized by Citywire Wealth Manager magazine as ‘Being in a position of some influence among your peer group, and likely to take a leading role in setting the investment agenda for UK Private Client managers.’
Austyn has recently contributed to leading publications by Citywire, and the Institute of Directors, and over the years has been quoted in the Sunday Times, Mail on Sunday, The Independent, and Bloomberg Markets.
With over 25 years wealth management experience, Austyn lives with his wife and children, Black Labrador and Springer, in Beaconsfield, Bucks.
Research Sources: Bloomberg, Financial Times, Wall Street Journal, John Authers, Robert Schiller.