Iveagh’s Chris Wyllie sees reasons to maintain a neutral allocation to risk
Despite the risk of stuttering growth and a possible collapse in confidence, factors such as corporate profitability and cash generation mean investors should take a neutral rather than negative view of risk, says Chris Wyllie,CIO at Iveagh.
We entered September as nervous bulls. September is known as the worst month of the year for equity markets, and with markets having already rallied over the summer, there were a number of events ahead which could trip them up. However, with a little help from the Fed and the ECB, markets continued to climb the wall of worry and the bear squeeze continued.
The event risks mentioned above revolved around central bank policy and European politics. The ECB President’s vow to do whatever it takes to protect the Euro had got markets rallying at the end of July and there were quite a few who doubted his ability to make good on that promise. A bond-buying plan was deemed technically too difficult, and even if these problems could be overcome, the Germans would stop it, so it was said. In the event, the plan Draghi came up with was about as much as anyone could have hoped for in terms of scope and ambition. Perhaps the most important thing was that it came in spite of German objections.
It seems that, with the Germans no longer in charge, we can expect a more pro-active and less cautious ECB. Of course, the ECB will never have the freedom of action afforded the Fed, and will always be hobbled by the lack of a coherent pan-European fiscal and monetary policy framework (although, to be fair, the US “fiscal cliff” shows that even in the US the structures are creaking under the strain of today’s economic challenges). This creates policy drag, the likes of which is playing out now as we are forced to wait for a political decision in Madrid about a bailout request before a much-needed monetary policy (Draghi’s bond-buying plan, “OMT”) can be implemented. Nevertheless, the ECB can now be awarded an A for effort.
What is our investment process telling us?
Our process signals have not changed very much:
– Valuation still makes a strong case for equities over bonds.
– US equities are the only ones that look relatively expensive compared to other markets and, to some degree, their own history.
– The Achilles heel of the equity valuation case is the lack of earnings momentum, and the fact that profits have started to fall.
– Markets cannot continue to make sustainable progress unless we at least see some stabilisation in these trends.
Outlook for growth
This brings one back to the growth debate. The good news is our macro models are still not signalling any kind of growth collapse. However, we are now yet seeing an inflection point which would shake us out of the current earnings torpor. The stubborn persistence of the present mild deceleration, which can be traced all the way back to the fourth quarter of 2010, is disconcerting.
We need something to change this glide path or else we will sink deeper into sub-trend growth and eventually confidence could crack.
The outlook, therefore, is not uplifting but we are comforted by the fact that this comes as no surprise to investors. Government bonds priced at depression-era levels are testament to this, and our market intelligence indicators confirm that caution abounds. The last two horrible bear markets were preceded by extreme risk-taking in first equity and then credit markets. Today, we find the opposite, with the most obvious cases of potential overvaluation in “risk-free” assets.
The growth outlook is soggy, but, notwithstanding the caveats above, we don’t think it is bad enough to pose a significant threat to corporate profitability as things stand, and decent cash flow returns continue to provide support for equity markets.
As long as this is the case, we are inclined to maintain at least a moderate to neutral allocation to risk. However, markets have made rapid progress over the summer months, so we have taken the opportunity to take some profits in areas where they may have run ahead of themselves in the short term, such as in private equity.