April 21, 2017

After a strong start to the year, most equity markets have come under pressure since March, with the S&P down around 1% and the EuroStoxx by over 2%. Despite the recent downward trend, YTD the markets are still up, but the news flow has been particularly bad, with fears over North Korea and Syria. Economic hard data has also under-performed survey data, which has concerned market pundits.

So, has anything changed and does the recent turn in equities concern us?

In our view, the recent sell off in US equities is more a result of how overbought and expensive the market is.  This is clearly reflected in the chart below which highlights an elevated monthly RSI (Relative strength Index) and MACD (Moving average convergence divergence – calculated by subtracting the 26 period moving average from the 12 ma).

Underlying economic data over the last month or so continues to look reasonable and supportive of our view of improving growth for the rest of the year.

Thus, while we do expect US equities to come under pressure on the short term, due to their overbought nature, we do not see this as the start of something more sinister. Indeed, we would look to use the opportunity of weakness to add marginally. We have recently increased our exposure to Japanese equities (via a long/short equity fund) and are also looking to add exposure to Europe.

We do however, remain Underweight equities overall within our balanced portfolio framework. Valuations are high and are particularly pronounced in the US. Also, as we have highlighted several times in the past, we believe the capitalist system is impaired and the easy monetary policies of the last decade are unlikely to end well. This is due to the build-up of mal-investment and overconfidence in the Central Banks’ market put.

In addition, there are other longer-term issues to consider.

For example, US baby boomers are starting to retire en masse and this will have implications for longer term consumption. Boomers have been putting it off for years but, given they are now aged between 53 and 71, they will not be able to extend their careers indefinitely. The median boomer has only around 200k USD in net assets, which is unlikely to be enough to maintain their desired lifestyle. Furthermore, many defined benefit pension plans are underfunded. That aside, as boomers retire, their consumption will decline significantly due to the lower income.

Interest rates are also vastly lower than a decade ago, so retirees will earn less interest than they had planned for. A knock-on effect of this is that they may have gone up the risk curve to improve yields, buying equities or high risk bonds which are more volatile and highly correlated.

The other factor that is likely to impact consumption and economic growth is slowing productivity improvements and the increasing use of AI (artificial intelligence) and robotics. The last few decades have seen a remarkable increase in productivity driven by IT. More recently though, such improvements have been diminishing. AI and robotics may improve productivity in some areas but will also negatively impact the low and middle classes significantly by taking jobs.

We are already seeing very clear signs of this in the case of autonomous vehicles. As overall efficiency levels will be improved, there will be fewer truck, train and taxi drivers. There will also likely be fewer vehicles, as the vehicle sharing services such as Uber will prevail.

Longer-term this will free up time for humans to focus on other areas of the economy, but there will be a period of adapting and reskilling which may take some time. This is perhaps not something we have to worry about over the next few years, but it will certainly have an impact on longer term economic growth and hence equity valuations.

In terms of fixed income, we feel comfortable having some long-term US government debt exposure and recently added to it, to take advantage of what we saw was an oversold market. From the chart below monthly RSI and MACD were looking oversold.

Longer term, we expect yield spreads to inflation to remain lower than prevalent prior to 2000. Given the current levels of debt, the Keynesian mind-set of central bankers and sub-par economic growth, we expect spreads to remain under pressure.

Conclusion:

We remain of the opinion that global growth will continue to improve for the next year or so, which will be relatively supportive to asset prices. We expect short term rates to continue increasing over the next few quarters, but that the Fed will remain dovish so as not to spook the markets. We expect the yield curve will flatten, thus meaning that long-term rates will remain low.

We don’t though see this as a time to chase the equity markets and add direct beta exposure, but are rather looking to allocate to alternative, less-correlated exposures. Business cycles always end and its prudent to be prepared for that eventuality. The current cycle has been going now for close to 9 years. Unfortunately, history shows that optimism, and hence exposure, usually peeks at the top of the cycle.