Tackling valuation risk
-The stars have aligned for faster growth and higher inflation
-Yet low levels of market stress probably don’t reflect the actual risks
-We have tempered our position towards growth assets in the short term
Our nowcasters show we are in a very positive period for the world economy, with higher than potential growth accompanied by decent to higher inflation.
However, consideration of valuations and market stress temper our enthusiasm for growth assets. We are still positive, but more cautious than we were at the beginning of the year.
These themes are the main drivers of our dynamic investment view.
We remain positive towards inflation-linked bonds and commodities, and negative towards government bonds, in particular European sovereigns.
We are, however, a little more cautious than we were at the start of the year, as valuations are higher and political newsflow (and risks) have increased.
While still overweight growth assets, we have reduced the extent of our positioning and believe it is appropriate to be selective and valuation-focused at this time, as valuations have become an increasing source of concern for us.
We have increased our Japanese yen exposure as a hedge against temporary market corrections.
We have also raised the risk contribution from relative value trades at the expense of pure beta exposure.
Relative value trades tend to be less dependent on market trends and should prove beneficial in the coming months.
For more on nowcasters, see Introduction to Unigestion’s nowcaster indicators
The stars align for growth
Growth is not just better in relative terms, it is good in absolute terms too. We are in a very positive period for the world economy, with higher than potential growth accompanied by decent to higher inflation.
Synchronised growth is even better news than fiscal stimulus in any single country. Even US fiscal stimulus would have an uncertain and limited impact over the world economy. Instead, synchronised growth across the US, the Eurozone, Japan and China is likely to act as a general catalyst for business. Such a situation has rarely happened over the past twenty years, and we think the consensus has been slow to recognise this.
Encouragingly, the strongest recovery in the US comes from investment data, the missing link in the growth chain since 2008 and a net detractor in 2016. The oil sector is now consolidating and investment surveys are spiking higher. The National Federation of Independent Business survey is consistent with a stronger investment cycle, as is the Philadelphia Fed survey of capital spending intentions.
A recovery in investment would likely be even more sustainable than consumption, the current engine of growth. Beyond this, credit conditions in the Eurozone are showing signs of improvement, while the Chinese housing market continues to consolidate after the recovery of 2016. The world’s economies are progressively healing their wounds, and we need more of that to prolong this late cycle.
One consequence of world growth which is higher than potential is inflation. Our inflation nowcaster for developed economies started to rise in summer 2016 and hasn’t stopped since, fuelled by input prices, recovering inflation expectations and labour market data as employment markets get progressively tighter. The US is leading the pack, but we also see sparks of improvement in the Eurozone and Japan and expect these to follow the US over the coming quarters.
These elements point towards a very positive period for the world economy, with higher than potential growth accompanied by decent to higher inflation. Our market stress nowcaster has now reached very low readings, with most of its underlying data at a post-2008 low.
A low reading is understandable, but we believe there is a risk of complacency. While a strong macro environment has often been accompanied by low market volatility in the past, implied volatility for the S&P 500 Index and the Eurostoxx Index is at record low levels. As a measure of price and therefore demand for hedging instruments, risk is low and risk perception even lower.
Recognising the risks
While our growth and inflation nowcasters are positive, consideration of valuations and market stress temper our enthusiasm for growth assets.
We are still positive, but more cautious than we were at the beginning of the year.
One reason is that we anticipate an increase in risk aversion by investors. While the cyclical improvement in global growth has been supportive for risk assets, the consensus is catching up fast. When we analysed the situation at the beginning of the year, we expected world growth slightly above its long-term potential. The consensus has moved from being much lower than our expectations to slightly above it, and our fear is that the current pricing for growth and inflation is a little too optimistic and could be corrected in future.
Monetary policy may also become less accommodative. While expectations for monetary tightening in the US are below the projections of the Federal Reserve, there is a real risk of a change of stance by the European Central Bank after the current spate of elections. When combined with a significant reduction in the foreign exchange reserve of emerging central banks such as China, we expect available liquidity to continue to decline, affecting the valuation of assets in general and risk assets in particular.
The chart here shows how the growth rate of central bank liquidity has weakened over the past two quarters, in-line with the recent increase in the TED spread, a direct measure of the premium investors require for lending money to banks rather than the US Treasury.
Finally, the political environment may become less favourable for investors. The optimistic scenario is a re-run of 2016, where political shocks had a temporary impact on financial assets. In this context, protection has been costly in two ways; directly through the price of the hedge, and indirectly through its opportunity cost since assets are notably higher.
Is this realistic? In France, populist candidates on the left and right represent more than 50% of voting intentions. In Germany, polls anticipate a need for change. In Italy, the five star movement could lead to a period of government instability due to the lack of a stable majority. We do not anticipate the worst, but recognise that political risk is far from zero, and this gives us grounds for caution.
Meanwhile, the broader geopolitical landscape remains fluid. Egos are on the table with Presidents Trump, Putin and Erdogan, the oil complex is a risk for Middle East stability, and ongoing tensions in the South China Sea could affect the Asian recovery. Against this uncertain background, we believe there is a high likelihood that market stress could negatively affect growth assets.
Conclusion: are the risks priced in?
However we look at it, we believe most risk premia look expensive. This, and evidence that the consensus may be complacent persuade us to temper our position towards growth and inflation-related assets.
Investors commonly utilise two techniques to establish how expensive an asset is. The first is to calculate the return from holding that asset (the carry) and compare it to history. The second is to analyse the fundamentals and form a view on what represents fair value on that basis.
Whichever method we use, the result is the same: most risk premia are expensive. While we are still far from the extremes of 2000 or 2007, this informs our decision to reduce the exposure to growth assets in place since the US election.
Meanwhile, we believe most investors haven’t acknowledged the risk of a surprise. Our analysis of positioning in the futures markets, long-only and hedge fund strategies suggests that leverage is high and protection is low.
In spite of the remarkably strong fundamental backdrop, therefore, we have tempered our position towards growth and inflation related assets in anticipation of a rise in volatility over the short term. While we aren’t expecting a major correction, we believe it is important to put some protection in place for investors, and could be tempted to buy on the dips. We remain underweight sovereign bonds and overweight growth assets with discrimination and caution.
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