Who to believe – bulls or bears?
Forget about interest rate rises, the potential elephant in the room which is massively under-priced is inflation risk, says Rowan Dartington Signature’s managing director Guy Stephens
All professional investors read a lot of commentary in their pursuit of trying to formulate a cohesive personal view. Filtering out the noise and the irrelevant is a key part of this and I have commented on this before, hopefully not making this commentary irrelevant in the process!
There is a lot of talk around at the moment regarding valuations of both equities and the bond market with both continuing to confound the bears who have increased cash and are waiting for the great correction. As I write, this week, the FTSE-100 is up nearly 2.5% driven by commodities mainly, which runs somewhat counter-intuitive to a belief in a large scale bond market sell-off. This would significantly raise fears regarding global growth and take the equity market with it. Are the bond markets really due a correction?
The most notable historical bond market sell-off which appears in the text-books occurred in 1994. At that time, the US economy had been expanding for 34 months following the 1991 US recession, bond yields were historically low and inflation seemed negligible. Wages were subdued and companies were terrified of raising prices. However, within seven months, 1994 became the year of the worst bond market loss in history. This followed a surprise rise in interest rates from the Federal Reserve Bank and marked the beginning of a tightening cycle due to a stronger than forecast US economic recovery and, fundamentally important, the emergence of inflation.
Fast forward to today and there are certainly some similarities but there are also some key words which don’t fit the scenario we are presented with, and this needs to be carefully analysed as a lot has changed regarding the global economy in the last 22 years.
Firstly, the last thing the central banks are going to do is ‘surprise’ investors with a rate rise. They know the damage this will do to their credibility when their whole projection over the last few years has been about open and constructive dialogue and forward guidance. In addition, this is entirely within their control and so surprising the markets by raising rates and instigating a sudden sell-off in the bond markets would signal a change in this constructive approach. This would be totally counter-productive and possibly cause a recession as market and consumer confidence would be shattered. The FOMC met this week in the US to deliberate over interest rates and this is the last time they can make a move ahead of the US election. The last two weeks has seen volatility every time a Fed official has merely suggested, off the record, that the time is approaching to raise rates. That will not have gone unnoticed and indeed, could be deliberate just to test sentiment. Janet Yellen now knows how far she can go without causing a furore, market volatility and significant personal criticism. No surprise then, that rates were left unchanged as this would have been significantly out-of-kilter with the market consensus expectation.
Secondly, many in the US would rather that domestic economic growth and inflation were stronger than currently reported. However, importantly, neither is showing any sign of gathering pace such that a rise in interest rates is necessary to slow things down. It is a desire to ‘normalise rates’ but not at the expense of current economic growth and stability. In today’s global economy, price competition and the power of the consumer via the internet has been revolutionary. We are seeing this in the UK post the Brexit vote with Sterling falling sharply and factory gate prices starting to rise significantly as our cost of imports rise. Affected businesses are having to absorb this increase in their cost base with consumer price inflation remaining subdued. Witness the comments from Primark, the John Lewis Partnership and subsequently Next last week – it is tough out there and sourcing costs are rising significantly, cutting into margins. If retailers operating within the UK dare to pass these price rises onto the consumer, the likes of Amazon and other overseas on-line retailers will clean up. So whilst there is every possibility that the US economic recovery may strengthen, consumer price inflation is unlikely to emerge due to the lack of supplier pricing power. This is principally why so many share prices of UK domestically focused businesses have been hit so hard since the Brexit vote and the situation is unlikely to improve anytime soon.
So, whilst there is a good argument that equity and bond markets look expensive based on conventional valuation measures, quite what will cause them to suddenly become better value is hard to fathom. This requires more sellers who are suddenly scared about losing capital value and a lot of investors are already underweight. Arguably, the equity market offers the most attractive returns on a relative basis for the risk and liquidity, both in terms of income and capital growth, whilst global growth remains positive. The bond markets are undoubtedly expensive but we know why – we thought the biggest buyer in history (the Bank of England) had stopped buying but suddenly this has started again along with an interest rate cut. When challenged last week as to whether he had acted too early, Mark Carney proclaimed that it was precisely because he had acted early that the impact of the Brexit vote had, so far, been muted. We will never know the true answer to that one, but he would say that wouldn’t he?
In summary, no central bank is suddenly going to start moving interest rates without ensuring this action is already expected and largely priced into bond markets. We expected no move this week from the Fed for this reason but we have also been given some definitive guidance as to whether a December move can be expected, especially as a Brexit fall-out has now waned, having previously been cited as a risk. US bond markets are not as expensive as those in the UK and Europe and so this probably won’t come as a huge surprise.
The potential elephant in the room which is massively under-priced is inflation risk. If there is the merest whiff of this re-appearing and gaining traction, the anti-QE doomsters will emerge and 1994 will look like a side-show. It is this scenario that the gold buyers believe and there have been enough of them to push the price up significantly this year. We don’t currently subscribe to this view due to the comments made earlier on global competitive pricing and that will also be the view of those buying the equity market as I write (if they are aware of it). Perhaps one of the benefits of the proliferation of technology into the global economy is the extinction of supply side inflation as we have historically known it due to consumer knowledge and power. Let’s hope so because equity investors are banking on this and if they are wrong there will be trouble ahead.