OPINION: Resurgent inflation in the US is just one threat on the horizon.
Investors face greater uncertainty as they head into 2016 and need to think carefully about their existing and future asset allocation. Most of all they need to think about risk. The days of easy market gains are possibly gone and downside risks are greater than any upside opportunity.
But to comprehend why great care and consideration is needed you first have to understand what has been driving markets these past few years.
The asset classes of equities, bonds and property have all been beneficiaries of quantitative easing (QE) and low interest rates, and both of those elements are in the process of being withdrawn.
In the US, the Federal Reserve's decision to raise rates for the first time since the Great Recession, eight years ago, is likely to create a volatile and an uncertain period for investors as markets adjust to a reduction in liquidity support, particularly in this low growth environment.
Europe is still weak, Japan’s economy has hit a soft patch, China’s growth is declining (although no longer alarmingly so), while the US continues to expand.
Add into the mix the full valuation of global equities and bonds and you have intriguingly unsettling market conditions.
In the US, in particular, equity markets are bereft of earnings growth and may struggle to move higher from here, while bonds everywhere are at risk from the lack of liquidity and potentially rising inflation.
This has pushed investors into places where once they would have feared to tread in the eternal search for income or yield. It has also created two significant risks.
First, by driving the valuations of these so-called yield assets, both stocks and debt, to breaking point and, second, by the illiquidity of many of these investments, such as corporate bonds.
With the benefit of hindsight, central bankers have aided and abetted the moral hazard that has emerged from investments in these asset classes.
At the first whiff of correction and the corresponding threat to market sentiment, central bankers have responded quickly to inject liquidity. This has led us to the predicament of overvalued markets unsupported by either profitability or growth.
Inflation threat remains
A few words on inflation: almost every market commentator seems to believe inflation is dead, yet in the US there are increasing signs that lurking below the surface of benign official statistics are indicators that reports of the old enemy’s demise have been greatly exaggerated.
Pay attention to the strong job numbers, unemployment rate and wage earnings growth, in particular. The latter is at its strongest level since 2009, while unemployment of 5% is often considered indicative of full employment.
If you add in a stabilising oil price (which prompted a recent uptick in markets) and rising rents, a picture emerges of inflation’s resurgence. It’s a matter of when, not if, and it will be a nasty surprise for both policy makers and markets. The action of the last week has seen oil fall again!
For the past few years, markets have rewarded the passive fully invested fund, backed as they were by central banks prepared to do whatever it takes.
The coming years will be different and once again we will live in interesting times, as the purported Chinese curse promises.
In this environment, it will be the active investor who profits as it will take great skill to navigate the shifting currents of tomorrow’s markets.
Alan McChesney is a principal at Auckland-based global fund manager NZAM
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