“It was the best of times, it was the worst of times.” – Charles Dickens
“We must expect reverses, even defeats. They are sent to teach us wisdom and prudence, to call forth greater energies, and to prevent our falling into greater disasters.” – Robert Edward Lee, commander of the Army of Northern Virginia in the American Civil War from 1862 until his surrender in 1865
“Some risks that are thought to be unknown, are not unknown. With some foresight and critical thought, some risks that at first glance may seem unforeseen, can in fact be foreseen. Armed with the right set of tools, procedures, knowledge and insight, light can be shed on variables that lead to risk, allowing us to manage them.” – Daniel Wagner, co-author of Global Risk Agility and Decision Making
In Our Thoughts On and Investment Ideas for 2018 we struck a distinctly bullish tone reflective of our top convictions over a six to twelve month investment horizon. We would be remiss, however, to ignore the potential risks that could stop this bull market in its tracks.
The MSCI All Cap World Index is up fourteen months in a row and barring a calamitous fall today, it will extend this unprecedented streak to fifteen months. While the bull market can continue, the momentum of month-over-month gains is unlikely to last. It is in the moments when this momentum breaks do we need to assess whether it is an ordinary market correction or a shift in market regime. Below, we consider some of the key events that we think would signal a shifting regime and not just a mere correction.
- The European Central Bank (ECB) tightens earlier than expected
The path forward for ECB monetary policy has been clearly laid out. The ECB will first end its asset purchases and only after that will rate hikes commence. Mario Draghi, at the Governing Council’s meeting on 25 January, indicated that based on current projections, the first rate hike could occur around mid-2019 with a very low probability of a rate hike in 2018. His admission that the asset purchase programme could end entirely in September this year instead of being tapered over the course of the fourth quarter, however, does create some policy uncertainty.
Given the robustness of the Eurozone’s recent economic performance – stronger than what the Governing Council expected for the second half of 2017 – and the potential for rising wage pressures, particularly in Germany, if the ECB abruptly ends asset purchases in September, as opposed to tapering, and starts to hike rates ahead of schedule, equity markets could face strong headwinds.
Germany – Unemployment Rate vs. Wages & Salaries Annual Growth 
Sources: German Federal Statistical Office, Bloomberg
Take, for example, the case of Italy, which has seen the absolute cost of servicing its debt drop by 7.7 per cent between 2010 and 2016 while general government debt outstanding has increased by 19.8 per cent. Crudely speaking, the ECB’s asset purchase programme has translated into a 23 per cent reduction in the interest rate Italy pays on its debt. By the same token, the ECB also holds close to a fifth of all outstanding Italian government debt. Monetary policy normalisation by the ECB could send Italian debt servicing costs meaningfully higher and severely dent Italian growth and business sentiment, both of which are at their highest levels since the Euro crisis. By extension, under such a scenario, the same challenges would apply to other peripheral states in the Eurozone.
Italy – Interest Expenditure vs. General Government Debt Outstanding 
Sources: ISTAT, Bloomberg
As discussed in Europe: A Domestic Recovery Story, given the still high levels of unemployment across the Eurozone and relatively low levels of friction in European labour mobility, we expect nominal wage growth to remain subdued until there is a significant tightening of the labour market. And this, we think, will keep the ECB from abruptly ending its asset purchases and raising short-rates ahead of schedule. Moreover, with coalition formation negotiations underway in Germany, there is the not so trivial possibility that Chancellor Angela Merkel will have to forfeit control of the finance ministry in favour of the pro-European Social Democratic Party of Germany in order to secure one more term. If this indeed does happen, German policy is likely to be far less hawkish than it was under Wolfgang Schäuble, which may well serve to embolden the ECB in prolonging or at least seeing through their accommodative policy. We, therefore, see little risk of the ECB abandoning its accommodative policy ahead of schedule.
- Rising oil prices
The sharp drop in oil prices in late 2014 has had a huge impact on global liquidity. Part of the money previously used to pay for oil imports has been redirected towards productive investments as well as increasing consumption, which in turn has contributed to a revival in global trade and capital investment. While oil at USD 70 per barrel will not derail the synchronised global economic growth we are witnessing today, a major supply disruption or rising geopolitical tensions in the Middle East boiling over to armed conflict may well push oil prices over the USD 100 per barrel level and that would put a real squeeze on global liquidity.
A 40 to 50 per cent increase in oil prices from today’s levels would result in inflationary pressures picking up and force the Fed, the ECB and quite possibly the Bank of Japan to tighten monetary policy. An environment of rising oil prices and tightening monetary policy tends not to be favourable for financial assets.
We think being long equities of non-Middle Eastern oil exporters, such as Russia and Malaysia, is the simplest means of neutralising this risk.
- Inventory build-up causes the business cycle to roll over
Business cycles do not die of old age. They roll over when businesses are forced to liquidate excess levels of inventory and write-off excess capacity built up during periods of strong economic growth. The prolonged prevalence of deflationary forces, however, has discouraged businesses, particularly in the developed world, from making capital investments and acquiring excess levels of inventory. While at the same time, access to cheap capital, has encouraged businesses to, instead, undertake financial engineering. A lack of capital investment and low levels of inventory mean that there is little excess capacity to write-off and no surplus inventory to forcefully liquidate. Without write-downs or liquidation, the business cycle continues, albeit unimpressively.
US tax reform, higher short-term interest rates and rising commodity prices, however, have tilted the balance in favour of making capital investments and building up inventory as opposed to undertaking financial engineering. Given that business inventory levels are depleted and productive capacities have shrunk, especially after Chinese supply-side reforms, if companies become overzealous to the extent rising commodity prices lead to rising demand the business cycle would in all likelihood come to an abrupt end.
- The Fed gets ahead of the curve
“[U]nexpected reversals of monetary policy seem to be the rule, especially when inflation accelerates, and if uninformed rulers try to react to consequences not foreseen by them. As a consequence, one can expect no damage from inflation in the real economy only as long as it remains small and smooth.”
– Excerpt from Monetary Regimes and Inflation, Peter Bernholz (2003)
Most of the commonly followed leading indicators for inflation and wage growth are signalling that the Fed’s two per cent inflation target is likely to be met by the end of 2018 and barring a recession exceeded in 2019. The Fed, however, prefers to remain data dependent, choosing to be reactive as opposed to pre-emptive in its policy making. This approach is unlikely to upset the apple cart. If, however, the Fed decides to get ahead of the curve this would in all likelihood be negative for risk assets, while being positive for long-dated bonds.
The last great secular bond bear market in the US started in 1946 and lasted up until 1981. We have been in a secular bond bull market since. One of the more fascinating aspects of the last bond bear market is the fact that short-term rates bottomed in 1941 and started rising. While long-term rates continued to decline all the way until 1946. Making 1941 to 1946 a rare period of history where short- and long-term rates moved in opposite directions for a prolonged period of time. To us this curious period is symptomatic of how long it can take for a deflationary mind-set to be overcome.
Psychological inertia at mass or institutional level is a powerful force against change. Although the behaviour of the Fed under new leadership is likely to be different, we struggle to imagine a scenario under which the Fed frees itself from the shackles of the deflationary mind-set that prevails today without sufficient data confirming that deflationary forces have given way to inflationary pressures.
- Chinese reform goes too far
At the 19th Party Congress in October last year, Xi Jinping made it clear that economic growth alone would not be the determinant of success. Softer facets relating to the social well-being of its citizens such as the level of pollution, reduction in wealth inequality, and increased access to quality education and healthcare would carry much greater weight in measuring China’s development.
While the probabilities are low, we worry that this shift in policy may incentivise government officials across China to pursue policies akin to the “battle for skies” with great fervour causing a sharp slowdown in Chinese economic activity.
Investment Perspective
Invoking Occam’s razor we try to search for the simplest solution to any problem. So if your problem is that you are worried about this market, our proposed solution to you is neither to short this market nor is it to buy protective puts. Instead, if you want portfolio protection, buy two-year Treasuries. Why? Well as they say a picture is worth a thousand words:
US Two Year Treasury Yield vs. S&P 500 Index
Source: Bloomberg
This post should not be considered as investment advice or a recommendation to purchase any particular security, strategy or investment product. References to specific securities and issuers are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.