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#Market Strategy — 17.09.2017

A TALE OF TWO MARKETS

Prashant BHAYANI

“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity….“ You might be wondering why I am quoting The Tale of Two Cities by Charles Dickens, but it reminds me of the dichotomy of the strong market returns experienced across asset classes year-to-date vis-a-vis the sentiment of many investors who cannot quite accept this reality.

This year has been another solid year for both bonds and equities as broadening global growth has boosted shares and central bank accommodation combined with lower than expected inflation have kept bond yields low. In short, global synchronized growth and Goldilocks have ruled! In addition, European political risk and protectionism fears have receded, improving risk appetite, fueled by cautious positioning at the start of the year.

Give credit to Mr. Market who has relentlessly, efficiently, and objectively priced in these fundamentals like a steam roller with utter disdain for political chatter, geopolitical flare-ups, and alarmist newsflow. Good global economics trump perceived political uncertainty. Impressive!

However, some near term risks do loom on the horizon.

Firstly, and clearly the most intriguing, what happens when central bank balance sheets stop expanding? The central banks of the US, Europe, and Japan collectively own more than $14 trillion in assets or 37% of GDP. (Figure 1) Our forecast is the Federal Reserve balance sheet reduction in Autumn and the ECB will announce tapering in October with implementation in January. They are itching to start reducing this debt mountain while global growth remains resilient and economic volatility low. However, as in mountain climbing will the trek down, be more treacherous than the way up?

Global Central Banks Have Kept Rates Low Boosting Asset Markets

Source: Bloomberg, BNP Paribas Wealth Management, 5 September 2017 

Secondly, given disappointments in inflation year-to-date and nearly and another estimated $2 trillion of bond purchases by central banks, the bond markets have started to price in low rates forever again, despite synchronized global growth! Strange times indeed, what do they know the equity markets do not? As I write this piece, the US 10-year Treasury almost broke the 2% level, last week before bouncing back. The market is presently pricing in just one interest rate rise over the next two years. While the interest rate cycle and inflation won’t be like the last due to demographics, the impact of technology driving disinflation, and lower productivity, it’s clear the market has likely priced in much of these factors. With the US and UK already at unemployment levels in the low 4%, the bigger surprise for bond and stock markets will be if inflation surprises finally picks up. Remember what everyone else already knows about is usually not worth knowing.

Thirdly, the US stock market is presently an aging bull, at 8.5 years old, by the way that's old for a stock market bull! It is already the third longest in history. However, this bull has legs, as the longer we are in a Goldilocks environment, the longer the cycle. That is why valuation has been a lousy catalyst for predicting bear markets as true bear markets are caused by an unexpected financial event, recession, central bank policy error, or gross overvaluation.  However, while, valuation is not at 2000 levels, it could become a headwind in the short-term for further gains in the market given the S&P P/E expansion to 18x and earnings revisions have largely been priced in. The catalyst for further positive earnings revisions seems unlikely given we expect global growth to slow somewhat for rest of the year but remain healthy above 3%.

Fourthly, the S&P 500 presently has gone for the fourth longest period without a 5% correction in history and the longest in 27 years. Frankly, it is getting kind of boring.  The “buy the dip” and “take profit” camps have found this grind higher the most painful. Volatility has remained low but recently I have observed that volatility is picking up from very low levels DESPITE the markets hitting new highs for the year. That illustrates narrowing market breadth, negative divergences, and a more fragile technical position. Will we finally get that elusive healthy correction? The odds are going up.

S&P 500 has Largerly Priced in the Robust Domestic and Global Earning Environment

Time-2

Source: Bloomberg, BNP Paribas Wealth Management, 5 September 2017 

Finally, geopolitical risks can flare up, of course, North Korea being one. Trade protectionism could reignite, central bank policy error is possible, and greater than expected slowdown in China growth after the NPC meetings in October. However, none are in our base case.

However, what does an investor do now?  Our belief is that markets need some time to consolidate their gains but we are still in the latter stages of an equity bull market, not the beginning of a bear market. Government bond markets look richly priced but there is some return left in corporate bonds. However, don’t forget the chart on the correlation of bonds and equities in this bull market. Lower yields combined with higher equity prices. Therefore, in any potential market correction both asset classes could sell-off simultaneously. The diversifying impact of a traditional bond-equity portfolio cannot necessarily be relied upon. Where can you still earn safe income or generate more than single digit returns? Investors need to broaden their tool-set and increase allocations to alternative asset classes such as private equity, selected hedge funds for low correlated returns, and unconstrained bond strategies to search for yield. Furthermore, buffered solutions to take advantage of any sell-off could prove attractive. Cash will likely remain a drag on portfolios. When investors begin to focus on the 2018 outlook we will reassess to gauge the return of positive momentum in equity markets as well as we could have higher yields allowing better levels for bond reinvestment. Going forward let it be the best of times!