Wealth Management: Market Perspective – What will we leave behind? – The political pendulum

19/03/2019

Kevin Gardiner, Global Investment Strategist, Wealth Management

Declaration of interest: 60 years ago, the German SPD - the Social Democratic Party - came up with a statement that I think has yet to be improved, about how best to organise an economy: “markets where possible, governments where necessary”.

If society moves far from this mixed economy mid-point in either direction, things get worse. If policies focus mainly on markets, and on making the cake bigger, the result is intolerable inequality. But if the focus is mainly on government intervention, and on slicing the cake equally, the result is a much smaller cake.

The biggest departures have been in the direction of bigger government and collectivism. There have been no libertarian experiments to match those in the USSR, China, North Korea, Cambodia and elsewhere. Without exception, the big experiments ended badly - in lower living standards, and worse. There are few empirical laws in economics, but this seems to be one.

We are usually wary of 'big picture' analysis. For example, we've argued that Trump and Brexit represent nothing more profound than a populist wish to 'stick it to the man' - a backlash against a complacent establishment that might yet fade as quickly as it arrived. But on both sides of the Atlantic, we see the pendulum perhaps swinging quietly back towards collectivism - even as the Venezuelan experiment sadly delivers the usual result. Are future generations going to have to re-learn that economic law all over again?

We think not, but this could be a closer call. On the one hand are the enlightenment values of reason and empiricism. But on the other are unthinking belief - and kitsch. And we are all watching cats on the internet.

Current investment conclusions

We thought stocks' sell-off in late 2018 was overdone, but the bounce now may have used up much of 2019's headroom. We see corporate profits pausing, not going into reverse, but it may be some time before that is clear; meanwhile, the Fed may have paused its monetary normalisation too soon - we would not be surprised to see US rates rising once again later in the year. Corporate creditworthiness also seems more likely to fade as the cycle matures further. Overall, we still see stocks as capable of delivering long-term inflation-beating returns - in marked contrast to most bonds - but cyclical conviction must be lower now than it has been since the market rally began exactly 10 years ago.

We still see most bonds and cash as portfolio insurance, not as likely sources of real investment return.
Most government bond markets look expensive, especially as US yields have fallen back, and offer little compensation for inflation and duration risk. Few high-quality yields exceed current inflation rates.
After their rally, we no longer favour high-quality corporate bonds to government bonds in the US. In Europe, where the ECB has now stopped buying, spreads are less tight (over much lower government yields).
We favour relatively low-duration bonds in the eurozone and UK, and now in the US too. We still see some attraction in US inflation-indexed bonds. Speculative grade credit did not reach sufficiently attractive levels in the sell-off, and the markets have now rallied - and supply has returned. We still see little appeal in local currency emerging market bonds for multi-asset portfolios.
We still prefer stocks to bonds in most places, even the UK (where the big indices are really global in nature), but after their rebound, we see tactical risk from the ongoing earnings slowdown and/or a rebound in US rates. We have few regional convictions, but still believe emerging Asia's structural appeal remains intact, trade tensions notwithstanding, and US profitability seems set to stay high. We still mostly favour a mix of cyclical and secular growth, but the balance has tilted more towards the latter.
Trading currencies does not systematically add value, and there are currently few big misalignments among the majors. The Fed's softening of tone hurt the dollar, but we expect economic growth and current interest carry to boost it. In contrast, the euro faces both sluggish growth and an even more doveish central bank. The pound is hostage to Brexit tensions in the short term, but is competitive, and on a long-term view is capable of rallying (eventually) even after a no-deal exit.

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