In our latest Global Insights publication we stated that the uncertainty surrounding potential US policy leaves US equity valuations priced for perfection whereas we believe European equities are under-estimating the strength of the eurozone economy and over-estimating the political risk. Since the French Presidential victory by Emmanuel Macron populist fears have largely been priced out of equity markets with European equities hitting a year’s high the following day coinciding with the VIX volatility index on the CBOE, known as the markets fear gauge, dropping below the psychological 10.00 level despite the chaos emanating from the White House.
The VIX Volatility Index Year-to-Date
Source: Bloomberg
This highlights that highly liquid conditions created by the different levels of quantitative easing implemented by Central Banks have been highly supportive of equity markets. Central Banks have been big buyers of financial assets creating more predictable markets and altering long standing asset class correlations. This has made portfolio diversification more difficult for long term investors and created an environment where macro-driven hedge funds have struggled to make the risk-adjusted returns that made them so popular. Furthermore, it could be argued that the increasing use of the $4tn passive investment market through exchange traded funds has created further indexation of investments and under-pinned many over-valued sectors of markets through blind investing.
Companies have accumulated significant cash on their balance sheets, which has been steadily returned to shareholders through share buybacks, dividends and M&A. As a generalisation, this wealth has accrued to the better-off members of society with a lower propensity to consume meaning it has been re-invested into financial markets creating worsening inequality and seemingly a de-coupling of financial markets from the real economy that seems to have coincided with the rise in populism.
According to Absolute Strategy Research (ASR), in their Equity Strategy Weekly publication dated May,18 2017, over the last 111 years major market corrections have often had part of their origin in inappropriate rate rises which removed liquidity from equity markets. This time the risk of raising headline rates is with the US Federal Reserve and China is also tightening policy but further the reduction in the pace of QE in particular the potential for ECB tapering. ASR attributes much of the rally in risk assets in 2016 to growth in both US and Chinese M1 money supply rather than political events and M1 money growth has decelerated as policy has tightened in 2017.
Ideally excess liquidity leads to improving economic fundamentals and constructive government policies to justify higher asset prices. We are currently focusing on three medium term possible headwinds for markets, the clearest being the US political environment raising doubts over the implementation of the President Trump pro-growth agenda.
Equally, Beijing will continue to try and cool the housing market and run the economy at the official target growth rate of 6.5%. This was reflected in the significant slowdown in PMI and Industrial Production readings in April along with a marked deceleration in Private investment growth to 6.9% from 7.7% in April, all consistent with moderating growth momentum.
Thirdly, a European government bond taper tantrum in H2 17 along the lines of the US taper tantrum in 2015 would be significant with so many European issue trading in negative territory. Interestingly the market seems to have more confidence that hard data will eventually mirror sentiment in Europe. Eurozone PMI’s hit their highest levels for 6 years in April with business expectations the main driver showing broad based positive sentiment across the Eurozone. President Draghi is questioned at every ECB meeting Q&A session to comment on the potential for changes in monetary policy as the European economy shows signs of continued recovery.
Unusually low interest rates and quantitative easing have boosted market liquidity and supported financial markets and as this liquidity is constrained there is a reasonable possibility that risk assets will moderate.
Our investment strategy committee, which consists of seasoned strategists and investment managers, meets regularly to review asset allocation, geographical spread, sector preferences and key global market drivers and our economist produces research and views on global economies which complement this process.
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