Markets have been hooked on central banks and their very accommodative monetary policies for almost a decade now. What had been a vital antidote to one of the worst financial crises in history has become a hard drug on which most investors have got high and highly dependent. We are seven years on from Mario Draghi’s “whatever it takes” speech and the latest ECB meeting proved that he was ready to do so, even if it was with very little consensus. Currently, the trillion dollar question is whether central bank action is necessary and whether additional stimulus will be successful in tackling recessionary and, more importantly, deflationary forces. At this late stage in the economic cycle, ammunition seems scarce and the market reaction following the ECB announcement could indicate that “the world is not enough”. The reason behind central banks’ headache is not risk of recession (yet?) but undershooting inflation, which in turn could lead to damaging deflation. In most speeches, policy makers reckon that economic growth has been downward sloping from early 2018’s above-potential peak and that the balance of risks are tilted to the downside. Yet, they remain confident that recession is not near (in spite of yield curve pricing), particularly the Fed. Conversely, the lack of inflation is the focal point. Is it normal to have so little price pressure when growth has been strong for such a prolonged period and the influx of money mostly unlimited? There are secular forces at work weighing on inflation globally, like demographics (the effects of aging on consumption habits), automation (putting pressure on wages) and digitalisation. There are also cyclical elements missing this time around: the commodity cycle and investment. Usually, after sustained periods of growth, commodity prices reach their peak on the back of supply and demand imbalances, and negatively affect both consumers and companies suffering from higher input costs. Our proprietary Inflation Nowcaster not only indicates a deterioration in inflation conditions, it also indicates that not a single inflation component is showing signs of strength: from wages to input prices, imported and expected inflation, all are low and going lower. And it is happening all across the developed and emerging world. As a result, it provides central banks with breathing space and allows them to ease and pump as much money as possible into the system, helping the world to prolong growth and revive inflation. Expectations have climaxed and it looks like there can only be disappointment ahead. Looking at interest rates pricing, a total of 250bps cuts are currently priced in the G10 12 months ahead, with at least one to two cuts expected in every country, apart from the Nordics. In the US, investors are still factoring in three cuts 12 months ahead (from four recently). The market reaction on the ECB meeting highlights the shape and form of disappointment. Sentiment reversal hit bonds hard, sending bund yields up 10bps intraday to close the day higher, on the very day Draghi announced a rate cut and revived asset purchases. Positioning in hedging assets, especially bonds, reached extreme levels, and the fact that the decision was reached with a low consensus outweighed any satisfaction from the promise of fresh accommodation. There are now two possible outcomes that could arise from the mismatch in perception between the patients and the doctors. Sentiment could lift as macro conditions remain around potential and easing remains in place (our scenario); or a lack of confidence in the ability of policy makers to avoid the end of the cycle could prompt a correction in the price of financial assets. Regarding asset prices, valuations are rich across the investment spectrum, with hedging assets leading. Government bond yields have plummeted to historical lows, the Japanese yen has appreciated back to February 2018 high stress levels and implied volatility remains expensive, in spite of rising risk appetite. The question now is whether to think in “normative” or “pragmatic” terms when assessing if this year’s market rally is near the end and if we are getting closer to a valuation reversal. It usually needs a catalyst to trigger valuation squeezes and large-scale sector/asset rotation, and central bank surprises can be a game changer in that respect. It might be too early to call for a sell-off in overcrowded/rich positions. Indeed, the truth is that central banks have created buckets of expensiveness that some would even call asset bubbles. It is crucial to be mindful of this factor now that incremental action from policy makers (on top of what is already in prices) remains to be seen. Investors will start paying attention to the level of asymmetry and dry powder left in every asset class, and the most expensive ones could suffer heavy losses to benefit once overlooked, cheaper, out-of-favour opportunities. For now, monetary support is alive and well, and expensive risk premia could remain so while it lasts.“The World Is Not Enough” – Garbage, 1999
What’s Next?
Macro: The First Negative Inflation Surprise Ever
Sentiment: When You Reach for the Moon, the World is Not Enough
Valuation: Expensive for Longer
Asset Allocation: Risk ON, but Vigilant
The biggest fear for asset allocators is correlation distortions, if not shocks. Diversified portfolios rely on historical interaction between assets, which have been largely manipulated by quantitative easing. So far, it has been a supportive driver to most assets but mean reversion in correlations are to be anticipated, even temporarily. At the moment, hedging assets seem the most vulnerable to the combination of resilience in economic growth, extreme positioning and tense valuations. For that reason, we have reduced substantially our exposure to the asset class and have reallocated to growth-related assets, credit first. For the same reasons, corporate spreads will be supported by the quest for yield and carry, the lack of recession and positive developments in sentiment and appetite for risk. More generally, the current environment is benign for risky assets, and we have increased exposure to equities and volatility (on the short side). Our attention is geared toward assessing if the disappointment on the ECB front will follow from other central banks, which could indicate that the world will no longer be enough to keep investor optimism afloat, prompting us to trim market exposure globally.
The World Is Not Enough
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