Many central banks and investors are basing policy and investment decisions on a partial appraisal of asset pricing conditions. The post-crisis recovery phase has been characterised by a confounding mix of familiar and unfamiliar factors.
In too many cases, we believe that analysis has fixated on the more recognisable aspects of the environment. These can lead to an overly traditional or biased view of the economic cycle. The result is an unhelpful emphasis on cyclical developments in seeking to determine when major economies will achieve self-sustainable growth and monetary policy normalisation.
These are important factors but our analysis should focus on the ongoing structural repercussions of the global financial crisis. Foremost among these are a wide range of imbalances that imperil long-term financial stability. Debt, demand and trade imbalances are interlinked and have already contributed to equity market volatility over recent months.
The most obvious example is that developed markets are demand deficient as they endure ongoing deleveraging and austerity, while emerging markets have excess supply. This sows the seeds of a disinflationary environment and helps explain the motivations for competitive currency devaluations and recent weakness in global trade and manufacturing data.
The main problem with a traditional cyclical analysis of the macroeconomic environment is that there is little reason to expect a sudden resolution of the long-term global issues. In China, the authorities have yet to prove their willingness to act decisively to address the country’s economic slowdown, despite significant industrial over-capacity.
In developed markets, debt levels remain high and deleveraging will remain a constant feature of the landscape for a considerable period of time. This is unsurprising in the light of evidence from previous financial crises that the recovery period can take eight to 10 years.
Without any imminent change in the key structural conditions that have contributed to the current low-growth, low-inflation environment, it is difficult to envisage a step-change in these variables. Our base case is for continued ‘mini-cycles’ in economic growth as the interaction between debt levels and monetary policy expectations makes pre-crisis levels of growth unsustainable.
More constructive expectations of a sustainable upturn in economic growth in key countries, led by the US, are likely to be flawed. This is currently important because assets continue to discount a positive fundamental outlook for economic activity. We are concerned that high expectations for growth and earnings make many markets vulnerable to a significant downturn if our more prosaic global outlook is correct.
We believe the short-term risks are exacerbated by a cyclical outlook that is skewed to the downside. The Federal Reserve has put itself in a position where it must make a clear decision on interest rates by the end of 2015. However, US monetary policy may well bring many of the global imbalances to the fore, not least through its transmission in currency markets. This leaves equity markets very vulnerable at a time when global manufacturing has clearly already entered a weaker patch that is likely to contribute to a downturn in US growth momentum.
If the August and September equity weakness was simply a mid-cycle correction then the worst is probably behind us. However, for as long as authorities and investors gloss over the challenging structural backdrop, there is significant downside risk that is not reflected by high asset prices.
We believe it is a time to be careful and to emphasise capital preservation. However, our conservative stance is based mostly upon our belief that expectations are too high for the mediocre economic environment. If and when these expectations moderate, we envisage participating in emerging opportunities across a range of asset classes.
Mark Harris is head of multi asset at City Financial.