Entering the roller-coaster

The period following the big financial crisis of 2008, has been characterized by an extreme, almost abnormal level of stability for a long period of eight years. Markets have risen steadily and most of the major global economies were able to avoid significant downturns. Central banks made this possible through their determination to support markets in every possible way including the use of new and radical means such as negative interest rates and the quasi endless quantitative easing.

Geopolitically too this period has stood out through its stability in terms of relations between nations. While there have been serious local conflicts such as in Syria there have been no major international wars, neither militarily nor economically.

This stability has been achieved through the decision-makers’ determination to avoid anything susceptible to threaten economic or political stability following the trauma of the financial crisis. One can argue that this stability has to an extent been achieved by failing to address key issues, conveniently ignoring them instead of addressing them which means that they are likely to get back with a vengeance in the future.

2016 clearly marked a turning point in terms of political stability following the Brexit vote last June. The election of Donald Trump clearly also represented a significant turn in terms of American policies and economics. Tensions between countries are increasing significantly both in terms of military and economic tensions. The French presidential election further illustrates the decrease in predictability even though it is not necessarily always in a negative way (if Macron indeed wins the presidency he could speed-up much needed reforms in France).

So far the increase in political instability has not hurt the economic and financial stability and markets have continued on their bull run to new record levels. This is where the risk of complacency increases. After almost a decade of raising markets the temptation to assume that the current momentum will continue can be strong. What should be of particular concern is that there are many signs that suggest that caution is required. Paul Tudor Jones, an American investor and hedge fund manager stated it forcefully as recently quoted in a Bloomberg article1:

The legendary macro trader says that years of low interest rates have bloated stock valuations to a level not seen since 2000, right before the Nasdaq tumbled 75 percent over two-plus years. That measure -- the value of the stock market relative to the size of the economy -- should be “terrifying” to a central banker, Jones said earlier this month at a closed-door Goldman Sachs Asset Management conference, according to people who heard him.

Tudor-Jones also emphasized how the size of major funds such as Bridgewater which follow risk-parity strategies could amplify the impact of any correction. The article summarizes a number of further indicators which suggest caution. Company insiders were significant net sellers of shares. Margin debt (debt that people borrow to buy shares) reached a record high. Other successful investors and not particularly pessimistic investors such as Seth Klarman, Larry Fink and Leon Cooperman are guarded in terms of their market expectations.

A recent important development is the Trump administration stated a willingness to finance its proposed tax reductions and fiscal stimulus through an increase in deficit “in the short term”. The reform aims to copy the Reagan playbook in the hope that the higher economic growth it will create will eventually generate additional tax revenues. Only the future will tell but caution is warranted. The initial Reagan tax cuts were eventually reduced as the deficit ballooned and the starting point today is also different as the debt level is much higher.

The obvious risk of an increase in US deficit is the increase in interest rates and inflation it could induce. In the quite likely event that the Trump administration will try to prevent an increase in interest rates a realistic scenario is an increase in inflation leading later to a strong rise in interest rates when inflation reaches a point that would be considered unacceptably high. Another possible scenario is an increase in inflation over the longer term as it could be an alternative way to inflate the public debt away. In both instances long-term credit with fixed rates would be most affected.

Does all this mean that a market downturn is imminent? Not necessarily. The current momentum can potentially go on for a while and continuing to enjoy the party can be tempting. As Citigroup’s then chief executive Chuck Prince famously said in 2007, “as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” We all know how this ended and the problem is that such parties often end in a sudden and brutal way. While we do not know when the current party will end we are certain of one thing: when in 2025 we will look back at the previous eight years they will not look like the long, quiet river since the financial crisis. Markets and politics are slowly getting back to their roller-coaster nature.

In terms of investment implications we strongly recommend staying away from credit investments with fixed rates and long durations. The allocation to equity markets should be guarded although we believe that the European markets could do well this year considering that much of the political uncertainty is being removed and that Europe is at an earlier stage of the recovery cycle than America with encouraging growth and inflation data despite the negative perception. Alternative finance which steps in to provide financing in areas where the main banks are not active remains very attractive in our view as it can combine good returns with limited risk and moderate duration. Hedge funds following strategies that benefit from volatility are attractive albeit this is an area that requires particularly sharp skills.

Good direct investments in niche areas can be very appealing. We currently see an interesting opportunity in a very specific real estate niche in Panama which we are pursuing with a highly experienced local partner. Panama has become a highly successful economy with impressive growth rates and excellent governance. To make matters even better the local currency is effectively the US dollar. With a 3-5 years view, these are investments that will in our opinion do well independently of global market developments.


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