Where next for the investment cycle?
Many retail investors take a risk assessment survey before investing. Typical questions include: what is their tolerance for risk? What capital losses are acceptable? It is time for many managers of pension funds to consider their answers to similar questions: what is their ability to trade, are they prepared for a period of very low returns?
We are not alone amongst fund managers in suggesting that the investment markets and the global economy are currently mid-to-late cycle. Such a statement belies the fact that there is a range, of course, between the USA at one extreme and, say, Brazil and Russia at the other. Nevertheless, we must pay close attention to the vulnerabilities appearing in the two largest economies, the United States and China. In the former profit margins have peaked, making the corporate sector more vulnerable to internal or external shocks. A quote from the IMF’s Financial Stability Report summarises the problems facing the latter: ‘17% of Chinese corporates owe more in debt payments every year than their yearly earnings. Writing these loans off would be equivalent to 7% of Chinese GDP’. A manageable risk but still a material one.
Time to price in a recession? Not at all. The markets certainly worried about this possibility back in early February, but the policy makers quickly responded: the FOMC, ECB and PBOC have all changed tack remarkably quickly. Indeed, turning to China again, on some estimates the expansion of total credit was equivalent to 5% of GDP, in just the first quarter of this year! No surprise that certain equity indices are trying to re-test their recent highs.
Another over-looked report, from the Office for Budget Responsibility, is also rather important. There is growing evidence of a step change down in UK labour productivity growth, starting before the global financial crisis but exacerbated by its effects and the subsequent policy responses. As a result, the OBR now thinks the UK will only manage to expand at 2.1% a year, a sharp contrast to the figure of 2.75% when Gordon Brown was Chancellor. The net result is that at best we are talking about a lost decade in terms of the implications for real incomes, profits, or taxes, potentially a rather longer time period if the government cannot push through all the structural reforms which the IMF and OECD are promulgating.
The UK example is by no means unique, but mirrored in all the major economies – the situation is better in a few, worse in many others – reflecting a series of structural and cyclical factors. However, the outcome is clear: we are living in a world of low numbers (growth, inflation, profits, real incomes, interest rates, bond yields). This would be manageable if it was not for volatility, or put another way the trades across borders as a wave of investors look for any growth opportunities. Subsequent spells of weak or indeed negative asset price returns need not spook investors if the research process is robust enough, if funds can move quickly to take advantage of brief valuation opportunities, or if the fund is happy to diversify into higher yielding but less liquid assets to boost long term returns.
Of course this phase of the investment cycle will evolve. We are drawing up the triggers to assess whether the next major shift is indeed into recession – borrowing costs remain a good lead indicator - or conversely whether to expect a typical end cycle period of buoyant sentiment. This could be driven by much greater confidence in a shift from monetary to fiscal policy as the next major tool. Meanwhile, markets are trading in a world of low numbers.
Andrew Milligan, Head of Global Strategy, Standard Life Investments
First published in Professional Pensions 22nd April 2016