RATIONAL EXUBERANCE. Issue #12. January 2018

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1 RATIONAL EXUBERANCE Issue #12 January 2018 Multi asset views from RLAM Royal London Asset Management manages billion in life insurance, pensions and third party funds*. The Multi Asset team manages the Governed Range pension funds and Global Multi Asset Portfolios (GMAPs) available on a wide range of platforms. This month s contributors Trevor Greetham Head of Multi Asset Hiroki Hashimoto Senior Quantitative Analyst Nersen Pillay Investment Director *As at 31/12/2017 Nearly nine years into the recovery from the financial crisis and muted inflationary pressures are still keeping interest rates low. Meanwhile, America is implementing the largest corporate tax cut in history. It s not surprising that investors are bullish and valuations are getting expensive. We have been overweight equities in our multi asset funds since Stocks could dip if the US Federal Reserve hikes rates more aggressively than expected in 2018 or if the slowdown in China gathers momentum. Either way, we think this bull market has further to run. Goldilocks rides again The world is experiencing one of the longest economic expansions since records began and there s no end in sight with muted inflationary pressures keeping interest rates low. Stock markets like this not too hot, not too cold Goldilocks backdrop: growth strong enough to boost profits; inflation low enough to keep monetary policy loose. This was the configuration in the very long 1990s expansion that ended in the tech bubble. Valuations are getting expensive again today and sentiment is high (see chart) but we think the bull market has further to run. This porridge is too hot! The Investment Clock that guides our asset allocation has moved into Overheat again. America s late cycle tax cuts could super-charge their economy and trigger an unwelcome rise in core inflation. Stocks might correct on aggressive interest rate rises but it s too early to worry about recession risks and we would buy such a dip. This porridge is too cold! The downside growth risk the market isn t talking about comes from China where tighter policy is likely to cause a slowdown. Stocks didn t like Chinese weakness in 2015/16 but on the plus side, commodity price drops would take the steam out of inflation and elongate the business cycle still further. Again, we would buy the dip. Avoiding hidden dangers in retirement Our policy paper, Avoiding Hidden Dangers in Retirement, looks at investment strategies for people taking retirement income. We argue for a diversified multi asset approach rather than hunkering down in cash or chasing exotic high yield. Focus chart: Investor sentiment is bullish Our composite investor sentiment indicator is in bullish territory. We find this indicator useful to identify contrarian buying opportunities, the China panics of 2015/16 for example. It s less good at marking market tops as investors can sustain a bullish mood for months at a time when fundamentals are improving. Do strong growth, low inflation and tax cuts add up to make rational exuberance? Source: RLAM. Sentiment indicator based on market volatility measures, private investor sentiment and company director dealing. Please visit for our blog and information about our multi asset range. For product details, contact: multiassetsupport@rlam.co.uk 1

2 Number of instances 1960s 1990s Price-Earnings Ratio (CAPE, P/E10) A VERY LONG BUSINESS CYCLE Markets saw another strong year in 2017 with global stocks rising for the eighth year in nine and multi asset funds posting solid numbers once again. Commodities were a weak spot for sterling-based investors. The length of the current bull market in stocks is directly related to the length of the business cycle. The world is experiencing one of its longest ever expansions. We put this down to three factors keeping inflation and interest rates low: 1. Job losses and business failures in the Great Financial Crisis created a significant amount of spare capacity. 2. Governments in the UK and Europe cut spending in an attempt to reign in public debt, dampening the recovery. 3. Cost push inflation remains low as China rebalances away from commodity-intensive industries. Stock markets like this not too hot, not too cold Goldilocks backdrop: growth strong enough to boost profits; inflation low enough to keep central bank policy easy. This was the configuration in the very long 1990s expansion and we see a lot of parallels. Commodity prices also fell that decade, as Japan went ex-growth and supply came on from the former Soviet Union. Monetary policy was loose under Fed Chairman Alan Greenspan. It all ended with the irrational exuberance of the dot com bubble. Equity market valuations are getting expensive again today with Robert Shiller s cyclically adjusted P/E multiple ( CAPE ) for US equities heading back to late 1990s territory. The Bitcoin phenomenon is very reminiscent of dot com mania and symptomatic of the high degree of global liquidity. However, with interest rates low and growth solid, we think the bull market has further to run. Chart 1: The third longest economic expansion Chart 2: Stocks are getting expensive x Length of Expansion (Years) Source: RLAM, US National Bureau of Economic Research; data since Source: Robert Shiller, Yale University.. CAPE = stock price / 10 year average earnings. Table 1: Sterling-based returns by calendar year Source: RLAM, DataStream as at Figures show total returns in GBP terms ranked from highest to lowest each year. Multi Asset refers to the benchmark of the RLAM GMAP Balanced fund. 2

3 GROWTH MOVES ABOVE TREND GROWTH MOMENTUM RISING INVESTMENT CLOCK INTO OVERHEAT AGAIN The Investment Clock model links the performance of various investments to the stage of the global business cycle as determined by growth and inflation indicators. It is moving into the commodity-friendly Overheat phase. Global growth remains in a strong trend with lead indicators pointing upwards. Unemployment rates are falling in all of the major economies and business confidence is high. Inflation lead indicators have also perked up lately and the oil price is rising. You ll notice that our inflation lead indicators have been pointing downwards for most of the last decade as they did over the deflationary 1990s. Chart 3: Global growth picking up again Chart 4: Global inflation pressures also rising Source: RLAM, DataStream. Source: RLAM, DataStream. Chart 5: The Investment Clock diagram Chart 6: Latest reading back in Overheat INFLATION RISES RECOVERY Corporate Softs Government Industrial Metals STOCKS COMMODITIES BONDS CASH OVERHEAT High Yield Energy Inflation- Linked GROWTH MOVES BELOW TREND 100% 50% INFLATION MOMENTUM RISING RECOVERY OVERHEAT REFLATION STAGFLATION REFLATION Precious Metals INFLATION FALLS STAGFLATION 0% 0% 50% 100% Rolling 12 months Latest Source: RLAM, for illustrative purposes only. Source: RLAM, for illustrative purposes only. When plotted in two dimensions, our global growth and inflation indicators mark a position on the Investment Clock diagram that we use to guide our asset allocation strategy. We re back in Overheat. We ve seen several short-lived moves into Overheat in recent years. Each time, something has happened to release the steam, monetary policy has stayed loose and we ve moved back into equity-friendly Recovery. However, the longer the expansion goes on, the lower unemployment rates get and the more likely it becomes that wage inflation starts to rise on a sustained basis. 3

4 WILL TAX CUTS CREATE INFLATION IN THE US? Global stocks tend to beat bonds when the US unemployment rate is falling (shown inverted here) as this means the world economy is expanding. You can see the massive amount of spare capacity (high unemployment rate) created by the financial crisis. You can also see that there probably isn t a lot of spare capacity left today (low unemployment rate). Chart 7: Stocks vs bonds and US unemployment (inverted) Chart 8: US business confidence leads core inflation rate You wouldn t think an economy in its ninth year of expansion would need fiscal stimulus but that is exactly what is happening in America where the Trump administration has announced the largest ever corporation tax cut. Business confidence is surging and core consumer price inflation tends to rise with a roughly two year lag. America s late cycle tax cuts could super-charge their economy and trigger a sharp rise in inflation and wages. Chart 9: Real Fed Funds Rate vs 2% Recession Trigger Level A stepping up of Fed rate hikes would mean a sell off in US treasuries and could cause a correction in highly valued equity markets. However, the stock market tends to keep rising during a period of monetary tightening, rolling over only once growth itself actually peaks out. With the Fed Funds rate still below the rate of inflation and the second and third largest central banks in the world still printing money, we think it s too early to worry about recession risks. We would buy such a dip in stock markets. 4

5 WILL A CHINA SLOWDOWN RELEASE THE STEAM? The risk the market isn t talking about comes from China where tighter policy is likely to cause a slowdown. The downturn in the Chinese economy in 2015/16 scared policy makers into action. They devalued the renminbi, cut interest rates and increased credit availability. The economy picked up much more strongly, we think, than official GDP numbers suggest and now they are tightening policy once more. Chart 10: Chinese interest rates are rising Chart 11: Old economy and housing slowing Chinese bond yields are a good one year lead indicator for the economy. The rise in yields over the last year is likely to lead to slower activity in the old economy, as measured by the so-called Li Keqiang index. House prices are also set to drop. Chart 12: A commodity price drop would keep inflation low A slowdown in China would hurt global growth and cause stock markets to fall. However, commodity price drops would probably take the steam out of inflation, allowing interest rates to stay low and elongating the business cycle still further. Again, we would buy such a dip in equity markets. 5

6 Expected Value of Pot in today's money Probability of not runing out of money AVOIDING HIDDEN RISKS IN RETIREMENT Our new policy paper, Avoiding Hidden Dangers in Retirement, looks at investment strategies for people taking retirement income. With the average 65 year old likely to live for at least another 20 years, post-retirement is still long-term investment. We argue for a diversified multi asset approach rather than hunkering down in cash or chasing exotic high yield in assets like peer to peer lending and aircraft leasing that could cause nasty surprises as interest rates rise. Chart 13: Life expectancy for men and women aged 65 Chart 14: Sustainability of retirement income We ran 10,000 simulations for multi asset portfolios with different risk/return characteristics: 1) A Defensive fund with 25% of its assets in higher risk, growth-seeking investments like company shares, commercial property and commodities and 75% in less volatile sterling bonds and cash; and 2) A Growth fund with 75% in the growth-seeking assets and 25% in bonds and cash. Graphs are based on an assumed starting pot of 100,000 with an income requirement of 4,500 per year (a 4.5% withdrawal rate) consistent with the lower annuity rates available today. 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Taking out 4,500 (4.5%) income p.a. Defensive Portfolio Growth Portfolio Annuity Years into Retirement Chart 15: How much is left in the pension pot? The results showed that while the defensive portfolio gave slightly greater certainty of income in mid retirement, the growth portfolio was more likely to generate the investment returns required to sustain an income over longer time periods. An annuity guarantees you an income for life but is much less flexible than a drawdown pension arrangement and there is very little left in the pot for inheritance purposes once you start taking income. In contrast, both the defensive and growth portfolios in our modelling maintained their value long into retirement. 120, ,000 80,000 60,000 40,000 20,000 0 Taking out 4,500 (4.5%) income p.a. Defensive Portfolio Growth Portfolio Annuity Years into Retirement Source: RLAM: as at Simulated performance is not a guide to future performance. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Calculations consistent with mid-range growth rates and volatility assumptions required by the Financial Conduct Authority for pension illustrations and include no allowance for additional returns that could come from active management. See full report for details. 6

7 WHERE WE STAND We are moderately overweight stocks, tilted towards Japan and the emerging markets, and have an overweight position in high yield bonds. We are underweight UK stocks and underweight gilts = + ++ Multi Asset Stocks High Yield Property Commodities Cash -- - = + ++ Regional Equity UK US Europe Japan Pacific ex. Japan Emerging Market Multi asset: overweight equities and high yield; underweight bonds We are overweight stocks and underweight bonds, a position held in funds since We added to stocks during dips caused by increased political tension between the US and North Korea. We are overweight global high yield with recession risk low. We remain underweight government bonds and expect yields to rise as central banks tighten policy. We are neutral to slightly overweight UK property. A positive supply / demand backdrop and a rental yield cushion make UK property relatively resilient, despite Brexit risks to the City of London. We are broadly neutral commodities. Strong global growth is offset by a negative roll return in futures markets. Equity Regions: overweight emerging markets and Japan; underweight UK We are overweight Japan and the emerging markets. Both benefit from strong global growth. Japan tends to do better when the dollar is strong. We have been taking profits in the emerging markets on China slowdown concerns. We are primarily underweight UK equities, where earnings trends are less favourable and the economy is facing continued Brexit uncertainty. For professional clients only. Past performance is no guide to the future. The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. Issued by Royal London Asset Management January Information correct at that date unless otherwise stated. The views expressed are the author s own and do not constitute investment advice. Royal London Asset Management Limited, registered in England and Wales number ; Royal London Unit Trust Managers Limited, registered in England and Wales number RLUM Limited, registered in England and Wales number All of these companies are authorised and regulated by the Financial Conduct Authority. All of these companies are subsidiaries of The Royal London Mutual Insurance Society Limited, registered in England and Wales number Registered Office: 55 Gracechurch Street, London, EC3V 0RL. The marketing brand also includes Royal London Asset Management Bond Funds Plc, an umbrella company with segregated liability between sub-funds, authorised and regulated by the Central Bank of Ireland, registered in Ireland number Registered office: 70 Sir John Rogerson s Quay, Dublin 2, Ireland. Our ref: N RLAM PD