As the equity bull market extends well into its eighth year the investment environment appears ever more risky to us. Company fundamentals are deteriorating, with profit margins and earnings under pressure, while balance sheets are more leveraged than most people think. At the same time valuations have risen to levels historically associated with market peaks.
A key support to the markets over the last few years have been the ever more extraordinary monetary policies adopted by central banks. However, with around US$13.5trn of negatively-yielding sovereign debt globally already1 – and talk of ‘helicopter money’ ramping up, we believe we are fast approaching the point at which central bank intervention does more harm than good – a point at which central banks are no longer masters of economic destiny.
And that’s before we touch upon the potential one-off risks – those so called ‘black swans’. While the noise surrounding June’s Brexit vote has quietened, the uncertainty that it will inevitably bring looms large for the medium term. The autumn brings an Italian referendum on constitutional reform – a vote that could conceivably trigger an Italian in/out EU vote in turn – while November will see the US Presidential elections and all the unknowns that come with the rise of ‘The Donald’. Elsewhere in Europe, concerns over a resumption of the migrant crisis, along with fears over Russia’s intentions towards Ukraine continue to cast a long shadow.
We, like many, have been surprised at the strength of the market rally post the EU vote. Indeed, we think that this continued show of strength should be viewed as a warning sign, not a reason for optimism. There is a dangerous narrative pervading markets right now (there always is near market tops) that claims equities are the only option for investors in an increasingly negative interest- rate world. Such a narrative, which ignores absolute valuation to focus solely on relative value against bonds, is likely to end in tears as, and when, capital values fall.
Meanwhile, the great white hope of substantial fiscal stimulus remains exactly that. It has the potential to be very positive but in all likelihood remains a long way off. In reality, it will probably require a significant deterioration in markets and economies to prompt a response big enough to make a difference.
So where does that leave us? One of the advantages of being a long/short investor is that volatility is not necessarily a bad thing. At the moment, on the short side we are concentrating on domestically- focused areas of the UK market, areas such as retail and property. And on the long side, we are focusing on larger cap, more internationally-diverse businesses in industries such as pharmaceuticals, oil and gas and business services. For investors like us, there remain plenty of opportunities in the current market environment.