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July 26, 2016

Is there a paradigm shift in financial markets?

What if there a real paradigm shift taking place in financial markets that is not yet reflected in the price of major asset classes? We are seeing the first signs that the global economy is transitioning from a regime that was dominated by monetary stimulus and deflation fears to one which is pointing towards reflation. A paradigm shift means that the winners and losers of the last regime are unlikely to be the same in the next.

The last two regimes – monetary stimulus and deflation

Following the financial crisis of 2008, there were two main regimes that impacted the performance of key markets:

  • 2012 to mid-2015. The central banks of the major industrial countries supported the economic recovery with very lose monetary policy. We are referring here less to low interest rates but more to various programs of quantitative easing via bond buying. The US Fed kicked of this phase with its program of open-ended purchases of mortgage bonds in September 2012 (so-called QE3). Japan followed next with Abenomics in December 2012 and finally the ECB got in line with its own quantitative easing program in November 2014. As a result, virtually all risky assets performed strongly, from high-yield bonds to equities. The MSCI World index increased by approx 15% annualized over that time frame.
  • Mid-2015 to today. It all came to an end on May 18th, 2015. That day the MSCI World peaked and started a long decline. The weakness was driven by fears about deflation and worries about global growth. In this period, safe government bonds performed strongly while other risky assets including commodities struggled and were hit by bouts of volatility.

The next phase – back to reflation?

In markets, we can often observe one behavioral mistake: persistence in trend is a primary ingredient in a consensus belief. The longer a market trend goes on, the more investors gain conviction that the story behind it is true and that the trend will continue. Now, after many years of declining inflation and erroneous calls for higher bond yields, most market watchers have simply given up and jumped on the „lower for longer“ bandwagon. While they may be correct, we are seeing signs that make us step back and question whether the consensus view is not missing some important data-points (additional charts at the bottom of this comment):

  1. Economic indicators are picking up. Data from both the US and China have recovered from earlier weakness while recessions in some emerging markets such as Brazil and Russia are abating.
  2. Inflation rate no longer falling. The deflation fears from 2012 to 2015 were real as the inflation rate dropped in most major industrialized countries. Since the end of 2015, the data show a bottoming and now an accelerating inflation trend in the US, Eurozone and UK.
  3. Commodity prices have bottomed. Commodity prices were in an ugly downward spiral until 2015. Since early 2015 we have now seen most commodities rebound. The price for some key commodities is now significantly above the levels seen only 9 months ago. This is true for oil, copper, aluminium, steel and iron ore.
  4. Wage pressure keeps rising. In the US, wage growth keep rising and has now reached the highest level since 2008. Interestingly, the more responsive sub-category of the „job switchers“ is showing even faster wage growth, currently 4,3%.

Beware the winners of the last cycle

To be clear: it is too early to say with certainty that we have entered a new regime of reflation dominance. But investors would do well to guard against the impact this would have on their portfolio. Many investors are, often unknowingly, heavily tilted towards the winners of the last cycle. This is because they tend to buy what has worked best most recently.

The strategies that have benefited from the previous regime of quantitative easing and lately deflation fears:

  • Income producing assets. At a time when most current accounts and government bonds yield virtually zero, investors have scrambled to find yield in other places such as corporate bonds and so-called „quality stocks“ with a high dividend yield.
  • Safe assets. We are now 7 years into the recovery from the last financial crash in 2008/9. The S&P 500 has reached a new record high last week. But are investors cautious or euphoric? Clearly a cautious tone still dominates and it is therefore no surprise that defensive balanced funds have seen the biggest money flows in Europe during 2015. In 2016, so-called „low-volatility“ funds have been the most popular category for smart-beta ETF in the US; this is just another play on the „safety-first“ mentality. Nothing wrong with safety, but investors need to realize that these popular asset classes have become crowded and are often trading at a historically high valuation. Safety comes from low valuation first and foremost!

Summary and conclusions

Is your asset allocation too much geared towards the previous regime? Nobody knows for sure how the next 5 years will play out but investors should make sure that their portfolio can do well in all scenarios.

If you would like to discuss an all-weather portfolio, please don’t hesitate to contact us.

 

Charts:

1. US economy performing better than expected (Citi Econ Surprise Index)

Citi econ surprise index

2. Global growth is picking up

1 Gavyn Davies

3. Inflation is bottoming

2 Jim Paulsen

4. Commodity prices are bottoming too

3 Commodities

5. US wage growth is looking strong

4 US wages

6. Defensive stocks are trading at historical highs

5b defensive valuation

7. Low-vol ETF are extremely popular

low-vol

Sources:

http://blogs.ft.com/gavyndavies/2016/07/03/global-economy-firm-as-brexit-shock-hits/

https://www.wellscap.com/pdf/emp/20160714.pdf

https://www.frbatlanta.org/chcs/wage-growth-tracker?panel=1

http://www.kkr.com/global-perspectives/publications/adult-swim-only-2016-mid-year-update

http://theirrelevantinvestor.com/2016/07/10/bizarro-world/

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