No one likes a harsh winter. Lack of daylight hours and inclement weather, particularly freezing fog, can make conditions hazardous, leaving drivers with reduced visibility. It’s enough to send, even the most patient of us, slightly mad.
For stock market investors, the last eight years have witnessed both traits. ‘Reduced visibility’ has been in evidence because central bankers have created a wholly artificial financial environment, by crushing bond yields through the use of their persistent and counterproductive quantitative easing. This has resulted in bond prices grinding ever higher and distorting company valuations in the process as investors looked for yield.
This endless search for yield has resulted in ‘bond proxies’ (companies which offer investors a semi-decent yield, akin to a bond-like coupon) reigning supreme, with little care for valuation levels and comparative risks. The prevailing low interest rate environment has denied banks a decent interest rate spread, so crucial for the maintenance of their profitability, while savers have been robbed of any sort of reward on hard-earned savings.
How did this form of madness ever come about? I still question how multinational companies have been able to issue debt at negative yields to willing buyers. Why would bondholders be willing to lose money on their investments? Fortunately, the Bank of Japan, in recognition of its previous folly, was instrumental in capping the yield curve at zero in September of last year, effectively drawing a line under the era of negative yields. Not before time, it appears that the world has changed.
We have moved from a deflationary environment to the start of an inflationary one. But beware discrepancies in global monetary cycles. Whereas it appears the US is on the path to interest rate normalisation, and higher inflation, the uncertainties of Brexit on the UK economy means that Governor Mark Carney is unlikely to follow Janet Yellen, chair of the US Federal Reserve, anytime soon.
In theory, the rise in inflation expectations, the green shoots of spring, is not unwelcome, as long as it is controlled inflation. Presently, there is enough spare capacity within the system to ensure that the global economy does not overheat. Fiscal stimulus, in the form of building bridges, mending railroads, laying down new highways, will stir up much needed ‘animal spirits’ and encourage investment. Beware getting too carried away. Trump’s infrastructure plans are unlikely to become law until 2018.
So, to the here and now in stock markets. The onset of inflation is already translating into rising bond yields (and falling bond prices), restoring bank profitability, and creating an environment in which economically sensitive or cyclical stocks can thrive.
Value stocks are replacing growth stocks in investor popularity; the inexorable rise of bond proxies is giving way to an upturn in the prices of cyclical stocks. It’s a trend which, to my mind, is only now beginning to manifest itself. Just as the bond market took 35 years before its multi-year run finally came to an end, the change in stock leadership is likely to be embedded for many years to come.
But beware obstacles…
While the world watches and waits for President Trump to decide which policies most deserve to be turned into US law, we now have some pointers on the administration’s current thinking.
Already the strength of the dollar is causing the president concern. No one, least of all corporate America, wants a strong dollar. And we’ll only realise fully the extent of that impact once the forthcoming results season gets underway.
Protectionism under the Trump administration seems certain. He will likely focus his attention on those countries with which America has the biggest trade deficit, namely Mexico and China. By talking the dollar down the president could put pressure on these economies which he deems to have artificially weak currencies and big trade surpluses. The recent Mexican stand-off suggests a difficult road ahead.
Irrespective of these worries, the stock market euphoria continues. I use the word ‘euphoria’ in the loosest possible sense. I feel it has been a most depressing bull market; no one has believed the equity market rally, nor trusted it. That’s clear from the phenomenal amounts of investor cash which have been sitting on the sidelines in recent years.
Will 2017 finally be the year in which it is better to travel than arrive? What if Trump’s pro-growth policies disappoint? What if we end up with a year of lower global growth but higher inflation? We all know how the fear of stagflation impacts stock markets. After eight years of uninterrupted stock market gains, I firmly believe it would be a good thing to take stock of where we are. As an investor I would welcome a healthy correction, a year where equities end around 5-10% down instead of riding on the endless crest of the central bank wave.
The fog is lifting. Let’s end the madness and return to normality.