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Will the Fed generate a tipping point?

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Following the election of Thatcher, Reagan and Kohl in the late 70’s, early 80’s three main interrelated trends have created a very benign environment for investment markets for more than 30 years. These trends were globalisation, disinflation and developments in monetary policy.

Together they have created a long bull market (rising prices) in bonds, as inflation fell, so did bond yields, which are inversely correlated with prices. Globalisation allowed much faster corporate earnings growth than GDP growth as more plentiful and cheaper labour boosted margins whilst consumer markets expanded. Lower inflation, interest rates and bond yields allowed a higher multiple to be applied to those earnings by the global stock markets. This in turn has generated a multi decade rise in equities, fixed interest and other asset prices, albeit with considerable volatility along the way. Most asset prices around the world are currently expensive relative to their own history, some such as US equities are arguably excessively so, some emerging market equities less so.

A new political order is emerging (or you could argue has emerged) with different policy priorities. Thus, globalisation may be replaced with nationalism and protectionism. Monetary policy (central bankers determining the price and availability of credit) may be replaced by fiscal policy (politicians deciding how much to tax and spend). Global trade and hence corporate earnings may suffer, whilst disinflation may be replaced with inflation.

This combination may result in a reversal of the benign trends enjoyed over the last 30 odd years and result in an inflection point that will reverse the bull market in bonds, reduce the multiple applied by the stock market to corporate earnings and occasion a rotation from growth companies to value companies.

Since the election of President Trump some of this rotation has already happened. Value companies have reversed their long underperformance of growth companies. Bond yields have backed up (prices fallen) and inflation has started to pick up- although this was in train prior to and not because of the recent political changes.

But so far, equity markets have taken what for many was a surprisingly positive view of prospective policy changes- with global equity markets up substantially since November last year. The promised fiscal stimulus has been taken very positively and clearly outweighed the negative impact of the rise in inflation and bond yields.

What might reverse the rise in equity markets?

Throughout my 40-odd year career in the investment management business equity bear markets (declines in prices) have been in anticipation of, or because of, economic recessions. Economic recessions have come along because of rising interest rates as central bankers decide economic growth and employment levels are sufficiently strong to be a danger to steady inflation and they raise interest rates, just as the US Fed started to do in December 2015, did more of in 2016 and is warning it will continue to do this year.

They hope to do just enough to curb inflation but not significantly detract from growth. Sadly, it rarely turns out this way. More often than not, too little too late means bigger rate increases eventually generate a tipping point and recession ensues.

Each cycle has its own characteristics that allow commentators to argue it will be different this time.
This cycle has been characterised by a heavy carry over of debt from the 2008 financial crisis that has kept short rates much lower for much longer than anyone ever imagined. This in turn has allowed a further build-up of global debt which is estimated to be 50% higher now than in 2008.

All of this highlights the difficulty of the task facing US policy makers. Hopefully, they will be able to set interest rates at a level which allows continued economic growth without too much inflation.

The dilemma facing professional investors is where to go if traditional asset classes are all expensive and at risk from rising US rates. Their response has been to raise the weighting of ’alternative assets’, formerly the preserve of institutional and high net worth investors but now readily available to retail investors through funds on the big investment platforms.

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Welcome to my website. I'm Gregor Logan, an independent management professional with over 35 years of experience in all asset classes, including equities, bonds, property, private equity, alternative assets and bonds. I previously held senior-level roles at MGM Assurance, Pavilion Asset Management and New Star Asset Management.

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