Markets are no longer pricing effectively for risk
Global growth is strengthening. Jobs markets are strong. Reflation is taking place. And there is a view that low interest rates may be counter-productive. The factors that have contributed to recent Fed tightening are also justified reasons to think interest rates may rise sooner than thought in the UK and eurozone, but not in Japan. The challenge is that over recent years, monetary policy in the UK and other Western economies has: fed asset price inflation by making markets more attractive; led to housing and government bonds being seen as ‘safe investments’, but also resulted in markets no longer pricing properly for risk. Given this, the worry is that economies and markets may now be vulnerable to higher rates.
Also, volatility is low. This is seen best in the VIX index, which while a measure of US volatility is seen as a generic guide to global market volatility. At times of stress and uncertainty volatility rises; when conditions are seen as stable or predictable, volatility falls. Over the last month the VIX index has averaged 11.82. To put this in perspective, the high it reached during the financial crisis was 80.86 in November 2008. It reached 25.8 on 24th June last year, the day of the Referendum result, and 22.5 at the time of November's US election. This would suggest that markets now, led by the US, expect no nasty surprises.
Gilt yields are lower
That certainly appears to be the case in the UK, where government bond yields are also low. 10 year gilt yields are now 1.22%, similar to the average yield over the last year of 1.16%. The bond bull market has now lasted over 25 years, from the beginning of the 1990s. In April 1990 10 year yields were 12.8%. Since then the trend has been down, albeit with a few temporary setbacks. An improved inflation outlook, and with it lower interest rates, has been the main driver.
Since the financial crisis, genuine concerns about the sustainability of economic growth and the health of the financial system helped push yields lower. Over the last year, the move into negative yields in some bond markets - such as Switzerland and Germany - has shown that for some investors preserving their capital, rather than seeking a return on it, has been an over-riding concern.
While UK yields have not moved into negative territory they are nonetheless low. At the time when yields started to fall in the early 1990s, there was a healthy debate that the inflationary 1970s and 1980s were the aberration and a return to low yields was a return to the norm. That, indeed, was my argument at the time. The challenge to it throughout has been the high level of government debt, and its implications.
The risks for UK gilts
Currently, the negative for UK gilts would be if the present inflation pick-up proves to be a bigger problem, forcing the Bank of England to hike rates sooner and more aggressively. While that is possible, yields remain low as such concerns are offset by the belief that UK growth may lose momentum, keeping inflation at bay. Indeed, while the latest UK jobs data shows a robust labour market, the pace of employment growth may be slowing, while wage growth remains subdued. Nonetheless the longer-term post-Brexit fundamentals for the UK still look good.
Data just released showed UK inflation rising to 2.3% in the UK, above the 2% inflation target. Since last June, headline inflation rates have risen across a host of countries: from 1.0% to 2.7% in the US, from 0.1% to 2.2% in the EU, using the harmonised measure, from 0.3% to 2.2% in Germany and from 0.5% to 2.3% in the UK. Higher food and firm energy prices are the main reason, but in the UK, the weakness of sterling has clearly added to this and inflation looks set to rise further here in coming months. This in turn will squeeze the growth in consumer spending. Most of these inflation surges mask weak underlying price pressures. Core inflation in many countries remains subdued. This rise in inflation will add to pressure on the Bank of England to raise interest rates. Despite this, it is likely to keep focused on domestic price pressures, as that will help determine how much of the present pick-up in UK inflation proves to be temporary or sustained.
Could a correction be on the way?
In contrast, the UK stock market has not performed well this century. Bear in mind too that the make-up of the FTSE 100 changes over time, also the poorest performing stocks are replaced, giving an upward bias to the Index. This equity market, the FTSE 100, halved in value at the beginning of this century, until its low in March 2003, largely during to the bursting of the tech bubble. There was then a steady recovery, back to previous highs, only for the 2007-08 financial crisis to see it halve again.
Since reaching its pre-crisis low at the beginning of 2009 the market has rallied, but it has been a case of spurts - the latest being since the Referendum, helped by a weaker pound, robust domestic growth and global reflation. The lesson of the last 17 years, however, is that UK equities can be subject to abrupt setbacks, particularly if the global environment changes. The question is whether that could happen again, or indeed whether domestic factors could provide the shock?
Of course, one must view assets not only in the context of their longer-term trend, but also relative to other assets and to the economic cycle. For instance, sterling's fall, which looked long overdue based on the UK current account deficit, has provided the economy with a huge competitive boost. It has also provided a one-off gain from overseas investments. But how do such investments look now? Emerging market equities have performed poorly in recent years, but now may look more attractive given the economic cycle. Meanwhile, the challenge for eurozone and US equities may prove similar to that here: contrasting the benefit of stronger growth versus the challenge of higher rates. US equities also look fully valued versus European equities.
Here at home there are a number of factors. One is the likelihood is that the next two years will see a lot of Brexit negotiations ‘noise’. There may be briefings and updates from the two sides but, with 28 countries, the European Commission Council, plus other groups lobbying, there may be much speculation and misleading information, whether intentional or not. This may add to volatility.
Another is the Bank of England's policy. Its corporate bond-buying scheme - which we disagreed with - should halt soon, with the Bank having bought about £8 billion of the £10 billion planned. The impact may be limited. Although the Bank of England looks unlikely to change policy anytime soon, market interest rates may start to rise, based on the expectation of possible tightening in 2019.
Much will depend upon the macro-economic environment. The government's fiscal numbers are improving, helped by the rise in nominal GDP - with higher inflation and solid domestic growth - plus still low interest rates. Inflation is rising this year, as we previously highlighted. Growth, while solid, may slow as the year progresses. While for now, the global reflation story driving the world economy may be the main focus for international markets, the challenges attached to valuation, and to future central bank policy need to taken fully into account.
The improving global economic environment and the still resilient domestic economy suggest that UK equities can remain supported in the near-term. But, as this note has outlined, financial markets are not factoring in any risks and there are, potentially, a few of these on the horizon. If these materialise then it would not be a surprise to see markets correct at some stage. In coming months there will be many conflicting economic, financial and political pressures on markets.