Global equities
19 Aug 2016 | By Ian Heslop

Off to the beach

Is it just me? Or are any of my fellow peers from the Square Mile looking forward to downing their financial tools and heading off to the beach for a period of quiet contemplation?

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Is it just me? Or are any of my fellow peers from the Square Mile looking forward to downing their financial tools and heading off to the beach for a period of quiet contemplation?

There have been some nasty undercurrents in global equity markets of late, centred mainly on geopolitical events. Nationalism, driven by a disaffected cross-section of the population, suffering from the effects of real wage erosion, is starting to rear its ugly head once more.

The manifestation of such a trend, and a more general rejection of ‘globalisation’, is everywhere. In Brexit, in the rise of the far right in France, in increasing tensions in the South China seas, and most obviously in the perturbing rhetoric of Republican presidential nominee, Donald Trump. Am I the only one deeply concerned by his simple, but unnerving phrase, ‘Americanism, not globalism?’

How should governments respond to the rising tide of nationalism?

So, exactly how should governments respond to the rising tide of nationalism? And, just as importantly for investors, what are we to make of the direction of equity markets?

To government responses first. A new study by the McKinsey Global Institute concludes that, far from cutting back on investment spending, the world needs to ramp up its spending on infrastructure to keep pace with economic growth. There’s little excuse not to. Low, or even negative bond yields mean governments have a ready supply of cheap, available finance.

While countries such as China and Japan, the report concludes, could afford to pare back infrastructure spending, a notable laggard is the US, where construction spending has fallen from 4.2% in 2009 to 3.2% in 2014.

While both Clinton and Trump have embraced calls for more infrastructure spend on their respective campaign trails, these have been largely overshadowed by the heated debates over tax policy and scepticism on trade.

How should equity markets react?

And how should equity markets react to the rising tide of populism, protectionism and platforms deeply rooted in anti-elitism and a growing distrust of institutions?

Trying to factor in the effect of geopolitical events on equity markets is an unenviable task. Fortunately, our style of investing dictates that we don’t have to. As part of a team that studies how investors react to macroeconomic events, instead of trying to forecast the outcome of such events, we aim to assess, rather than predict, investor behaviour.

What is investor behaviour telling us at the moment? According to our market environment indicator below we see that sentiment on a global scale – in North America, Europe, Japan and the Asia Pacific region – remains firmly in pessimistic territory.

Market environment change over 12 months – Sentiment/risk spectrum

Regional market environments June 2015 to 2016

Source: OMGI, produced by the investment desk, as at 30 June 2016.

And yet, the trends we see in market sentiment currently don’t accord with the overall direction of equity markets. Why, for example, is the S&P 500 index hitting new highs when earnings momentum has fallen for eight successive quarters? Why has the FTSE 100 index rallied sharply, just as investors become mired in uncertainty following the Brexit vote?

Policy responses from central bankers have much to answer for. ‘Bad’ economic news is often seen as ‘good’, being met with increased bouts of quantitative easing. Central bankers flood the market with increasing liquidity through bond purchases, compressing bond yields in the process, and sending equity markets higher.

The premise is dangerous because it encourages misallocation of capital. It also means that bank margins, the life-blood of any economy, struggle to be anything other than hugely depressed, given banks follow the trend in global bond yields.

So, in the all-pervasive hunt for yield, equity markets are driven by bond yields, which in turn, are bid ever lower by the aforementioned central bank buying.

Until stock markets reflect fundamentals once more, this is how the world of investing has been shaping up. But central banks are running out of policy options fast. And, as the governor of the Bank of Japan has already proved, negative interest rates aren’t always the answer when it comes to stimulating an economy.

Could fiscal stimulus really be on the cards? Plenty to think about then… and plenty to occupy investors come the autumn.

Now, back to the matter in hand and holiday packing. Where did I put that sunscreen?

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