Don t let confirmation bias distort your view of the markets

Transcription

1 September 2018 Investment market update Facts vs. fears? Don t let confirmation bias distort your view of the markets One of the fascinating aspects of the current financial markets is that investors can find a plethora of information to support either a positive or negative view of the world, depending on their disposition. The aim of any analysis, however, should be to put preconceptions to one side and allow the data to speak for itself and inform your opinion, rather than the other way around. A well-known concept in the fields of psychology and behavioural economics is that of confirmation bias where we only embrace information which confirms a particular view, while discounting, ignoring or rejecting information which doesn t. There are many reasons why investors might view the future with trepidation - and these issues very often dominate the headlines and have been covered in many of our recent articles, including President Trump, trade tariffs, emerging market turmoil, Brexit, political populism, Italy, flattening yield curves, the possibility of a Federal Reserve (Fed) policy mistake, US midterm elections, peak earnings and Iran tensions. Sadly, it is not often that the evening news broadcasts are filled with stories of good cheer and messages of hope. While acknowledging that some of the doom and gloom highlighted above has merit, what other more positive data should we also consider when deciding on an appropriate investment strategy? Facts vs. fears? The aim of any analysis should be to put preconceptions to one side and allow the data to speak for itself. Most of the perceived negatives seem to centre on fear: fear of the unknown, fear of the unexpected, fear of what might happen. Sometimes it is right to be fearful and some fears have substance. However, sometimes fear can make us overly cautious and the possibility of a negative outcome is given too much credence. Putting these fears to one side, real data continues to suggest that a pro-growth investment stance is warranted. The facts to focus on One inescapable lesson of financial history is that equity bear markets typically precede economic recessions - stock markets may be seen as a forecasting tool - and recessions, in turn, are generally caused by policymakers (typically in the US) pushing interest rates to the point where they stifle economic activity. Or, to put this another way, expansions don t die of old age; they die because the Fed murders them. Investment Market Update September

2 Therefore, as investors, the crucial facts to monitor are the health of the global economy and interest rate policy. The facts: the economy The global economy remains in reasonable shape; maybe not in quite as fine a fettle as 2017, but supportive nonetheless. The US economic expansion remains vigorous and has been turbo-charged by President Trump s attempts to make America great again. Against this, growth in China, Europe and Japan has underwhelmed the investment community. However, this is in the context of expectations which were simply too high at the turn of the year. The subsequent data wasn t bad, it just wasn t as good as some expected. On balance, the global economy is in reasonable shape. The facts: the yield curve The crucial factors to monitor are the health of the global economy and interest rate policy. Economic recessions are typically signposted by an inversion of the yield curve where longer-term interest rates fall below shorter-term rates, creating a linear ski-slope of borrowing costs. Every economic recession in the US has been led by an inversion of the yield curve. Since 1968, there have been seven recessions in the US and, on average, the yield curve inverted just under 12 months beforehand. On only one occasion (1998) was an inversion of the yield curve not followed by a recession and provided a false signal. This time round there are those who suggest that the yield curve s predictive powers may have been undermined by central bank purchases of government bonds, which has manipulated the yield curve and therefore made its predictive prowess less conclusive. While there is some justification for this view, on balance we suggest steering away from the this time it s different mentality. If it looks like a duck, swims like a duck and quacks like a duck... So, while the shape of the US yield curve has been flattening (becoming less of a hill) and this might reasonably be judged as an amber warning, we believe it s still some way away from full inversion. There is little indication of any stress within the financial system and while interest rates have been on an upward trajectory, there is still some way to go before they can be feasibly judged as being in restrictive territory. In fact, real interest rates (which account for inflation) are still zero and will likely need to reach at least 2% before they begin to have a dampening effect on activity. The facts: corporate earnings In the absence of a recession, it s the corporate earnings picture which is the most important determinant of stock market fundamentals - and again the evidence supports a constructive stance when we consider the bellwether US stock market. US corporate earnings rose 24.6% year-on-year in the second quarter and while these results were boosted significantly by the Trump administration s tax cuts, profit margins stand at a near record 11.8% and top-line sales growth has been strong. 72% of companies have surpassed revenue forecasts. Meanwhile, the equity market is being offered additional support by companies actively buying-back their own stock. Goldman Sachs estimates that US companies will repurchase US$1trn of their own shares in 2018; the figure could be as high as US$1.2trn according to some estimates. If so, this will lift the total stock purchases from the corporate sector to over US$5trn since This is larger than the Fed s quantitative easing programme of US$4trn. Companies have been the biggest buyers of stock since the financial crisis. The fears: Trump, trade and tariffs As well as the perceived risk of a policy mistake from the Fed, the other primary fear for markets is the highly visible trade war between the US and the rest of the world. Much has already been written on this topic, and while the outcome remains uncertain and it s possible that any escalation in the tit-for-tat tariff moves could have a negative impact on the global economy, these measures would need to grow in magnitude and implemented for a sustained period before the effects became severe. President Trump s objective may truly be a world which benefits from lower trade tariffs and it is possible that he may yet secure this outcome, even if his tactics are questionable. So too, the US trade deal with Mexico, as part of the renegotiation of NAFTA, has shown that progress can be made, even if that progress is hard won and the effects relatively symbolic. Investment Market Update September

3 Ultimately, while there is much from a macro perspective which might be a concern, there is still little hard evidence that this will change the underlying fundamental picture, which remains positive. Overcoming confirmation bias Based on the facts, the cycle both economic and financial has further to run, although the evidence would suggest that we may be in the final innings; the beginning of the end. This final phase can both last longer than is commonly perceived and, historically, has been an extremely rewarding period for investors. Bull markets tend to end with a bang, not a whimper. There are significant gains yet to be realised and, given the probability that longer-term returns may be below average, it is incumbent upon us to try and capture as much of the current upside as possible. We are not oblivious of the investment risks. We simply believe that the evidence for a change in investment strategy has yet to be presented. As such, our overweight position to equity markets remains intact as we believe there are still attractive returns to be had, even if the headlines sometimes suggest otherwise. We believe there are still attractive returns to be had, even if the headlines sometimes suggest otherwise. This article was written for you by Justin Oliver, our Deputy Chief Investment Officer, Offshore. Investment Market Update September

4 Our investment views as at September 2018 The view in this table refers to our balanced, risk profile 5 model portfolio. This risk profile has a benchmark with 61.5% in equities, 22.5% in bonds, 13% in alternatives and 3% in cash. Indicative positioning of balanced portfolio. Asset class positioning -- - = + ++ Outlook Alternatives Bonds (Govt) Bonds (Other) Commodities Equities Viewed as a way of moderating portfolio risk at a time of high volatility in equity markets and rising bond yields. Yields have risen and may become interesting at some point, but overall returns are not attractive compared to other asset classes. Greater returns appear to be available for strategic bond managers, but we should be aware of the additional risks taken to achieve them. Bears watching due to weaker US dollar and reduced supply. Most industrial metals are in contango (future prices below spot prices). Equity markets should continue to be supported by solid economic fundamentals, despite rising interest rates. Property (direct) Yield, rather than capital growth, should be viewed as the primary reason for investment. Cash Cash levels have been reduced. Equity allocation -- - = + ++ Outlook Emerging markets Europe Far East Japan North America Sector specific Emerging markets have struggled, but offer value. Fundamentals generally sound, although pockets of weakness exist. Growth moderated in first half of the year, and political and trade risks have risen. Some stock specific opportunities remain. Valuations appear cheap; China and global trade are key to the region's outlook. Chinese debt levels and housing bubble are a concern. Stock market offers value and some sectors of corporate Japan are in good shape. Macro data slowly improving. Leveraged to world growth. Economic and earnings momentum has justified an increase in exposure, augmented by US exposure in healthcare and technology themes. Healthcare and technology remain long-term themes. May consider further thematic opportunities. UK Economic fundamentals are not compelling and Brexit concerns are pronounced. Currency allocation -- - = + ++ Outlook US dollar Euro Sterling Growth and interest rate differentials will likely continue to support the US dollar; President Trump will increasingly rail against strength. Upside could be capped by any further extension of QE programme, or escalation of Italian debt concerns. Sterling's prospects remain heavily dependent upon the Brexit outcome and hence the outlook is binary. = Weighting within 1% of benchmark. + / - Weighting between 1% to 5% away from benchmark. - - / + + Weighting in excess of 5% away from benchmark. Investment Market Update September

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