Are surreal gains heading for reality rabbit hole?

Markets are partying, but our five-strong panel of experts explain why its more akin to Alice in Wonderland finance, and outline their consequent strategies.

The Great Monetary Experiment continues. In 2009, central bankers introduced us all to the weird alchemy of quantitative easing to get us out of the financial crash. To everyone’s surprise, they are still at it 10 years later, even though there are growing doubts about its effectiveness with interest rates already at rock-bottom.

In an effort to rekindle fading global growth prospects, the US Federal Reserve has now slammed interest rate policy into reverse. At the beginning of the year, the market had been factoring in more rate rises. Now it expects cuts this year and maybe more in 2020. Elsewhere, heavy hints from the European Central Bank suggest more monetary easing is on the way for the eurozone too.

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All this has been great for government bonds. In the US, the UK and continental Europe it has shoved bond prices up to record levels. UK 10-year gilts now yield less than 1%, while German and Japanese bond returns are negative.

“We have quite an unusual situation,” Rob Burdett at BMO Global Asset Management points out. “Negative yields on government bonds means we lend money on the basis that we are guaranteed to get back less than we lend out.” It sounds like Alice in Wonderland finance – a view held by Agustin Carstens, general manger at the Bank of International Settlements, the world’s leading financial watchdog.

Exceptionally low returns on bonds – non-existent in real terms – continue to encourage the search for yield and growth in global equities as well as reigniting the attractions of gold, as we explain below.

Equity optimism

On the equities front, the first half of 2019 saw across-the-board gains of 10-20% in US, European and UK markets, as well as healthy gains in some emerging markets. Only Japan has been a relatively sluggish performer.

“With interest rate cuts pending, it no longer seems plausible to expect a recession in the US within the next 12 months,” says Connor Broadley’s Chris Wyllie. “That is the basic building block of this rally.”

But Wyllie wonders whether the building block is made of stone or sand. “You have to believe the rate cuts will be effective, but the market’s bears have been arguing that monetary policy has now lost its power because we have had low interest rates for so long.”

He is far from being alone in his cynicism. The June Global Fund Manager Survey from Bank of America, which covers about 180 fund managers with around $600 billion ($470 billion) in their tender care, was the most bearish since the financial crisis. It showed cash levels rising and the relative allocation of equities over bonds at its lowest for 10 years.

That, paradoxically, is positive for Coutts’ Monique Wong: “It clearly shows investors are certainly not in a euphoric mood, so I don’t want to get too negative,” she says.

Euphoria is not something we have come to associate with Richard Dunbar at Aberdeen Standard Investments. He rarely takes his equity sector scores above 6.

“I am not changing our scores much,” he says. “The past few months have taught us to be fully invested, but with reasonably balanced portfolios, and this makes more sense than betting the farm on any one idea.”

Best-performing funds and markets in first half of 2019

Case for some bond exposure

Dunbar admits that government bonds hardly represent great value at present, but he insists: “They do have a place in a portfolio. The lesson of the past few months has been to be exposed in both bonds and equities.”

Schroders’ Keith Wade also joins that cautious consensus: “We expect an imminent rate cut from the US Federal Reserve and another one in September, but our experience is that it takes much longer [than expected] for those interest rate cuts to percolate through.”

Burdett stresses how difficult it has become to judge prospects during this period of monetary experiment. “The fund managers survey from Bank of America shows everyone is more gloomy, but markets are still going up,” he says. “We live in unusual times, and a lack of wage pressure is still a feature in key economies such as those in the US, the UK, Germany and Japan.”

He believes equities remain relatively attractive but that there may be much more volatility in markets in coming months. “While interest rates are now expected to be lower for longer, we think dividend expectations are for further continued growth both this year and next,” he says.

Dunbar agrees: “There remains a powerful attraction in the return offered on equities in this very low-interest rate environment.”

As usual, US equities remain the key debating point among panel members. There are no changes in scores this time around, with numbers reflecting a cautious mood. Indeed, panel average scores for all equity sectors range narrowly between 4.8 and 5.8 since the previous review in the May 2019 issue of Money Observer.

Even though Wyllie’s US score is only 4, he acknowledges that “at least in the US I have growth, despite valuations looking toppy. I have to find growth because returns offered by bonds and cash are so low.”

However, he remains nervous about prospects. He says: “There is a fin de siècle feel about the world right now: a feeling that we are trying to squeeze the last drops of juice from the growth lemon. Our growth indicators for the US have rolled over in recent weeks.”

Burdett argues that one of the attractions of the US market is “a unity of political opinion, even among Democrats, about most aspects of the capitalist system”. He adds: “It is not the case in other parts of the world and it underpins the US market.”

That’s why he is keeping his score at 4, while sticking with a score of 9 for cash. “We are not expecting an economic calamity, and if there is a correction in equities, we will probably be buying.”

Gloomy on US growth

Wade scores a 6 for the US, but he fears the US economy will grow at barely 1.5% next year as the effects of Donald Trump’s past tax cuts fade. He is one of those who doubts the effectiveness of interest rate cuts. “It is difficult to see how global growth is going to come from monetary stimulus. It will have to come from fiscal expansion,” he says.

Dunbar keeps his score for the US at 6, but he is looking to take some profits soon. He stresses the importance of the settling of the US-China trade dispute. He thinks any revival in global growth will have to be Chinese-led. However, he says: “Recent moves in China to stimulate growth have not had as much impact as some had hoped.”

UK equities remain as shrouded as ever in the uncertainty created by the great Brexit disruption. A feeling that almost anything could happen has prompted both Wade and Burdett to take profits and lower their scores.

Wong has not lost faith yet. Her score of 8 for UK equities is like a beacon of light amid the Stygian gloom. “I like UK equities because Brexit produced the opportunity to buy. But, silly me, I thought Brexit would be settled by the end of March. Now I fear it will become even more protracted.” She feels that uncertainty also creates opportunities for those prepared to buy the UK for the longer term.

She has support from Wyllie, who says: “We are more positive on the UK than we have been for a while.” He sticks with a score of 6, but points out that if Brexit is bad in the market’s eyes, the pound will reflect that. He adds: “If it is not so bad, there is ample room for a market re-rating.”

Keith Wade has cut his score from 6 to 4. “The risk of a hard Brexit or a general election and a more left-wing government has increased,” he says.

Currency concerns

UK equities remain out of favour with foreign investors, as much because of sterling’s weakness as anything. The average panel score for the UK is now down from 6.4 to 5.6.

Some emerging markets have fared well so far this year and there are hopes that a weaker dollar - prompted by lower US interest rates – might boost the performance of this part of the world further. The only score change has come from Rob Burdett, down from 8 to 7. “We think there will be more volatility in equities in the coming weeks, and that usually means a stronger dollar as investors seek safer havens,” he says.

European equities have performed well this year, with average gains around 15% in the first six months. Yet the panel remains unenthusiastic. Only Burdett has raised his score, from 4 to 5, while Wyllie has taken some profits.

There were no changes in the scores for Japan. The country underperformed other leading equity markets in the first half of 2019. Burdett is still the most bullish on Japan. “It remains fundamentally cheap,” he insists. Dunbar fully supports his view.

Elsewhere,Wong is taking some profits in government bonds and Burdett has trimmed his score for UK bonds. But Wade has raised his global bonds score from 5 to 6, because his fear of recession has not entirely gone away.

“Schroders is quite cautious about the global growth outlook,” he says. “We think financial markets will need a few rate cuts before they are convinced about a revival.” Meanwhile, his cautious stance includes emphasis on large companies offering basic products and services. He adds: “We like companies that make things you have to buy even though you think the world is coming to an end.”

Perhaps recession is what the markets now need, as the US-led bull market in equities is now 10 years old. Warren Buffett, the legendary Berkshire Hathaway investor, admitted recently he had a mixed view on that prospect. “I have seen many recessions,” he said. “And I hope to see another one.”

Wong points to the attractions of a recession for investors. She says: “A lot of investors fear a recession because the last one was the global financial crisis. But I don’t believe there are enough imbalances in the system to warrant a recession of that magnitude next time.”

She adds: “Recessions can be healthy: they re-set the cycle, they re-set the game and they re-set valuations.” That presumably is why wise old Warren Buffett likes them.

- Gold price hits five-year high: the pros and cons of the ‘Marmite’ investment

Why our panel is going for gold

One notable effect of the complete change of tack on interest rates has been a revival of interest in gold.

Wyllie says his portfolios now have just under 10% exposure to gold on average. He believes that it is negative real interest rates on government bonds that have been driving the gold price to new highs, rather than trade wars or fears of war in the Middle East.

Coupled with this, there are signs that the recent downward trend in the price of oil may have come to an end and be about to turn upwards again. “There has been very little capital spending on the search for new resources lately, and I can foresee a possible supply crunch for oil within the next three years,” Wyllie says. Richard Dunbar agrees: “The oil price has fallen by nearly 20% this year and pressure on the price is now on the upside.”

Together these influences have prompted three of the panel to raise their scores for the commodities sector, driven by these two key components of the commodities mix. The average score is now up from 5 to 5.8. This is the only average score to have risen in the latest survey.

Monique Wong says: “When real yields fall, you can expect the gold price to rise, and of course to non-dollar investors, gold has become more attractive, because it is priced in dollars.”

Gold has also become a significant part of the more defensive investment strategy mix at Schroders. Wade says: “We have taken some profits on our government bond positions and increased our exposure to gold.”

Monique Wong points out that one reason for the recent strength of the Russian stockmarket – which has risen by 30% this year – is the benefits Russian oil companies get from oil being priced in dollars. “Their cost base is in roubles and their revenues are in dollars,” she says.

Scorecard: worse all round

The asset allocation scorecard for the quarterly update by five experts August 2019 issue

Notes: The scorecard is a snapshot of views for the third quarter of 2019. How the panellists’ views have changed since the second quarter of 2019: red circle = less positive, black circle = no change, green circle = more positive. Key to scorecard: EM equities = emerging market equities. 1 = poor, 5 = neutral and 9 = excellent.

Panellist profiles

Rob Burdett is co-head of multi-manager at BMO Global AM and a research team leader. BMO has £187 billion under management.

Chris Wyllie is chief investment officer at Connor Broadley, a financial planning and investment management firm with £400 million under management.

Richard Dunbar is deputy head of global strategy at Aberdeen Standard Investments, which has some £610 billion under management.

Keith Wade is chief economist and strategist at Schroders. The asset management company has £400 billion under management.

Monique Wong is a multi-asset investment manager at Coutts, the private arm of RBS, which has some £17 billion of assets under management.

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