Man FRM Early View

February 2019

Originally published in the February | March 2019 issue


Those of us in the UK, as the stereotype goes, enjoy nothing more than talking about the weather. February has proved a fertile environment in this regard – shifting from snow at the start of the month to record temperatures of over 20 degrees Centigrade as the month draws to a close. Financial markets seem similarly disjointed. Government bonds have continued to rise through 2019 in much the same way as they did in the fourth quarter of last year. By mid-February there was a record USD7.9 trillion of government bonds trading on negative yields, much more than at any time during QE. Looking at the bond market since the start of the year you’d be forgiven for thinking that we were in a ‘flight-to-quality’ regime – but not many of those come with an 11.5% return to the S&P 500 Index. 

So what’s going on, and what has changed since Q4? There’s not much of an answer in the fundamentals. Global growth (as shown in PMIs) has been fairly weak, and the corporate landscape is generally one of falling earnings expectations (though, in our experience, this tends to lag the market rather than lead). We have pressure on both sides of the price to earnings multiple, and the CAPE Shiller PE Ratio for US equities is now back above 30x.

Perhaps the biggest change has been the substantially softer rhetoric from central banks, which twinned with the significant step down in breakeven inflation through the fourth quarter of last year goes someway to explaining the level of bond yields. When you factor in the softening of the trade war tensions, and an active management industry that had significantly deleveraged through November and December, things start to click into place. Is it surprising that investors are now willing to pay a high multiple for stocks that might either be a source of growth (that scarcest of commodities these days) or that pay a dividend in excess of the carry available elsewhere in the investment landscape? Credit spreads have also tightened materially since the start of the year, and behavior across markets points to a hunt for carry in various formats (indeed, intra-equity moves saw higher-yielding companies outperforming).

Against this backdrop, the gyrations (rather than the level) of the equity market also start to make sense – market valuation in a low rates world is an inherently unstable business. One can build a narrative that sees inflation continue to surprise on the downside, lower but still positive global growth, and an ever-tighter hunt for yields that sees equity markets continue from here without any real improvement in corporate fundamentals. Why not have valuations at 40x earnings when there is nothing else to do with the vast swathes of money generated by the central banks over the last decade? Why not buy equities when you can make as much in capital appreciation over two months as you would receive in carry over the next 25 years holding 30yr German government bonds?

The instability, of course, comes from the necessary conditions of this narrative. We saw in February and October that at high valuation multiples it is easy for the market to get spooked by the first whiff of inflation (we’d encourage readers to dust off a copy of the September 2018 Early View which outlined these thoughts in detail). And while US 10yr breakeven inflation fell from around 2.1% to around 1.7% during the fourth quarter, this has now crept back to 1.9%. The oil price has followed a similar path. Powell has made it quite clear in recent comments that he is more concerned by asset prices than by inflation – so maybe the world can tolerate higher inflation without higher rates (at either the short or the long end of the curve). After all – most of the developed world has accepted negative real rates on their long bonds for some time now, would it be that much of a surprise if the US followed suit? It’s possible, but as we’ve seen from the difficulty of European and Japanese indices to regain their pre-2008 highs, such a path may only add to the longer term instability of US equities. 

It has become something of a cliché in these letters to dance around the recent market behavior (whatever that may be) and then conclude that the answer is to buy hedge funds. In a break from tradition, this month we will be more nuanced. While we aren’t forecasters, the expected volatility from all asset classes is, in our view, higher. Finding the correct relative valuations of different asset classes in a low growth and low rate world is really difficult and unstable at that. We think that sharp moves of +/-20% in an asset class will be both more likely and harder to forecast. In such an environment, diversification is king. One doesn’t need to say that the return to skill based investing (that elusive ‘alpha’) will be better or worse than in other periods, but we would encourage readers to focus more closely on two things: 1) the correlation of their risk asset betas; and 2) the correlation of their ‘alphas’ to their risk asset betas. Where they can find truly diversified alpha sources, we believe these will have an important role to play in their portfolios over the next few years.

This article is only available to subscribers.

Having problems?

If you have any questions regarding subscriptions or restricted content, please contact us on +44 (0)207 278 3385 or