It has been an extremely positive six years for asset owners: equities have experienced their strongest and longest run since the end of the Second World War and the credit bull market is not far off its best historical run. Yet a deep scepticism pervades capital markets that the recovery from the Global Financial Crisis is an illusion, with acolytes of secular stagnation seeing “lower for longer” interest rates as the new normal. Notably, private and institutional fund flows have overwhelmingly favoured bond funds since mid-2007. What if investors are wrong about their asset allocations?
An unusual cocktail
We are in the very unusual position of experiencing both liquidity support and economic recovery at the same time – and it is difficult to predict how long this overlap will last. What we do know is that the growth outlook is the best it has been since 2010, and that the recovery is broadening and deepening. A number of key factors have altered to favour continued expansion. Among them, global fiscal policy tightening as a percentage of gross domestic product (GDP) is diminishing, notably in the US and Europe. Additionally, oil prices have more than halved since mid-2014 and should be viewed as a global tax cut for consumer nations.Volatile headline inflation data masks steadier core figures – and oil’s decline should begin to wash through the former measure.
We see evidence in economic releases that conditions are improving and could, in due course, engender a rise in inflation. One key barometer is developed economies’ employment figures, as wage growth tends to accompany labour market tightening. Another area that we are following closely is the US housing market because it provides growth and jobs across multiple sectors.
A 2007 Jackson Hole paper entitled “Housing is the business cycle” posited that residential investment consistently and substantially contributes to weakness before the recessions and that, similarly, the recovery for residences begins earlier and is complete earlier in the cycle than other areas of spending investment. Looking at US housing starts, the numbers of new residential construction projects started each month are still around their 1990s lows: this suggests that the cycle has yet to fully kick in. If it does, investors could be potentially wrong-footed in their bearishness.
The missing ingredient
For the recovery to gel, however, we do need to see the stronger resumption of corporate confidence. In the wake of the financial crisis, companies turned their attention to shoring up their balance sheets and driving down costs to help their bottom lines. The upshot was increased efficiency, and higher levels of profitability, but the overhang has been businesses’ desire to hoard cash. Companies have the ability to borrow at incredibly low rates of interest, so it is puzzling that we have not seen a more substantial pick-up in mergers and acquisitions activity. We would suggest that many investors are ill prepared if (or when) ‘animal spirits’ make their comeback.
The potential for a central bank policy error and the notable rise of dissenting political voices across Europe arguably pose a threat for risk assets, but we are inclined to be more sanguine about economic growth strengthening to take the baton from stimulus as the markets’ driver. The upshot in this scenario is that equities are, for the meantime, the best place for us to be.
Bill McQuaker is Co-Head of Multi-Asset at Henderson GI.