Mar 12, 2016

What the markets are discounting


In the last months we have explained why financial markets seemed very fragile to us. I remember the January 2015 article where we argued that the existing discon-nection between the evolution of the economy and risky assets could not last long. For eight months we’ve been in a bear market coupled to high volatility, a situation we  were  not  used  to.  

Without  doubt,  few  investors  expected  a  correction  of  such magnitude at the beginning of this year.

The market corrections are a warning that the economic recovery driven by central banks’ lax monetary policy is not working. Furthermore, weak macroeconomic data published these last months undermines the credibility of central banks. The shifttowards lower growth is reflected in the GDP figurespublished recently.  In the US, gross domestic product has increased  a modest +0.7% (annualised) during the last quarter of 2015, bringing annual growth to +2.4%. In Europe, the deceleration during the last quarter is patent in the reported +0.4% (annualised), which brings the year’s increase to +1.5%. Other published indicators related to the European economy show that  the  deceleration  may  be  deepening.  The  manufacturing  index,  the  economic sentimentindicator andthe German IFO Survey do not bade well for a recovery in the first quarter of 2016.

In  my  opinion,  stock  market  investors  have  not  totally  discounted  this  economic slowdown. In the 12 months before the demise of Lehman Brothers, equity markets, bond markets, and interest rates were expecting an economic slowdown but not the Lehman  effect.  In  September  2008  the  US  stock market  had  accumulated  a  20% correction, spreads of high yield corporate bonds had stretched to 600 basis points, and the 10 year US interest rate had lost 75 basis points down to 2.75%. Today, the US stock market correction is not significant. From last year maxima, reached on May 29th, the S&P500 correction adds up to-7% as per end February, high yield corporate bonds have corrected 300 basis points, and Treasury Bills have lost 45 basis points to reach  the  current  1.84%.  Usually,  the  evolution  of  the  stock  market  is  a lagging indicator of interest rates in order to discount higher or lower financial risks. If we refer to the economic crisis of 2008, it looks likethe stock market has not discounted the current economic slowdownenough. In other words, if the slowdown intensifies the  stock  market  should  fall  further  as  a  result  of  the  revision  of  future  corporate results.

In  my  opinion,  stock  market  investors  have  not  totally  discounted  this  economic slowdown.

We  still  think  a  lax  monetary  policy  is  not  the  right  solution  to  induce  a  more vigorous and consistent economic recovery. In the recent G-20 meeting inShanghai there were talks of a coordinated action to compel it, but again the responsibility has been  passed  to  central  banks. The  world  economy needs,  among  other  actions, structural reforms and demand and offer policies fostering prosperous growth.

By now, all portfolio managers are asking themselves whether they should take the buyingopportunity offered  by  the  correction,  maintain  their  equity  exposure,  or rather limit losses. Since the great crisis of 2008, strong market corrections have been contained  thanks  tothe  intervention  of the European Central  Bank or the Federal Reserve whichinjectedliquidity by means of asset buying. As we havementioned, the current correction is not important enough to justify a new reaction from central banks. Furthermore, in  view  of  their  diminished  credibility, the  risk exists that markets do not deem them capable of stopping a panic. In this case, the assets that havebenefited from their intervention are those likely to be more affected.

As we do not believe in the effectiveness of monetary policy to generate the sought-after  economic  recovery,  we  are  not  inclined  to  increment  our  exposure  to  equity notably. Although the economic cycle does not seem to have bottomed out so as to justify the start of a new expansion phase, we continue to analyse assets in order to incorporate them into our portfolios, as long as they sport attractive valuations and fulfil the conditions of our investing philosophy. We are still very much conservative, but  during  February  we  have  slightly  increased  our  equity  and  corporate  debt exposure, taking advantage of the attractive valuation of old acquaintances.

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Guillem Bienert

Chief of Portfolio Management
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