Financial Market Outlook

by George Hatjoullis

Financial markets have become a little disconnected in the last month or so. As a rule financial and economic variables exhibit stable relationships. These relationships can change but then they exhibit stability for sustained periods once again. This stable relationship is sometimes referred to as the macro regime. Changes in macro regime are typically preceded by periods of disconnection with prices and interest rates moving seemingly independently. My friends at Quant Insight can confirm that this breakdown of macro economic regime is now quite general. Such periods can be quite unsettling and quite dangerous.

The trigger for this breakdown in macro regime has, in my view, been the central banks. I have hinted at this in earlier blogs. The financial crisis is evidently over and the emergency policy rates and actions taken to restore financial stability are no longer required. Central banks are looking to raise rates not because of an imminent inflation risk rather despite the lack of one. Such low rates and aggressive QE are simply no longer necessary. The relatively well contained inflation environment means there is no rush to raise rates but the bias has now shifted to higher. The markets are adjusting to this and it is never a smooth process hence the disconnection. The only exception to this situation is Japan but regular readers of my blog will know Japan is a special basket case.

Although there is no imminent inflation threat the conditions for higher inflation are in place so the CB bias is sensibly forward-looking. Bank balance sheets are restored and more prudent practices are in place. The banks and regulators have fumbled their way to more confidence and this will enable bank credit to grow faster going forward. A rise in interest rates will generally benefit bank profits so this will act to increase credit capacity. The logic is that higher rates will also reduce demand but this does not necessarily follow (oddly enough) immediately. The immediate impact of higher rates may thus boost economic activity though if rates rise far enough and for long enough there will eventually be a negative impact. A gentle rise in rates is thus no immediate threat but the markets are never quite this subtle in their responses.They will either assume a rise is ill-conceived and will quickly be reversed or extrapolate way too many increases. Moreover the prevailing mood may shoot from one view to the other on a weekly basis until a new macro regime is settled on.

The disconnection is not solely down to the CB shift however. There are other issues for markets to digest. Trump is proving to be a problem for US policy with a state of paralysis setting. There are very visible geo-political changes taking place globally. Erdogan’s Turkey is not a good Nato ally and is breaking away from traditional loyalties and behaviours. Relations between the EU and Turkey are breaking down. Relations between the EU and US are breaking down. Russia seems to be influencing geo-politics despite efforts to isolate and contain via sanctions. Meanwhile China is quietly growing and asserting its presence everywhere but especially in the China seas. Middle-east states are turning on each other. North Korea is behaving like a naughty child seeking attention. Sooner or later someone is going to give way to the urge to reprimand it.

The markets themselves have reached levels that are making many nervous. Call it financial vertigo. No one quite believes the valuations but no one is yet willing to go against them. Everyone would be a little happier with a corrective test and is quietly adjusting positions to allay nervousness. The resulting price action adds to the sense of disconnection. Generally markets do not fail when there is this much nervousness but the next step is complacency. Markets always fail when they get complacent. It is hard to tell from where I sit when complacency has set in. It is evident in some quarters but seems not yet general.

If you have a sensible investment strategy the best thing to do in this situation is nothing. You might want to skew your portfolio towards stocks that benefit from rising rates (like banks) and reduce utilities exposure. You might want to reduce bonds in favour of cash. But your basic low risk/high risk asset allocation should not change. If you have chosen correctly then it is designed to ride precisely this environment. How do you choose the right allocation for you?

Let us simplify by talking in terms of cash and equity as the low risk/high risk asset classes. Ask yourself how you would feel if equities fall by 50% (can happen). If your response is to rub your hands with glee and mumble ‘opportunity’, then maybe a 40/60 cash/equity allocation works for you. If your response is heart palpitations then maybe 60/40 or even 70/30 is best. Of course you never know your true response until the 50% fall occurs but you have to try. In my experience most people are either in managed funds and have much higher equity allocations or in cash and have no equity. In other words they have never given the matter any thought. I suggest you do and soon.