Cycle is on brink of liquidity phase

Investors should not heed the macro picture too much – the investment cycle is affected less by the global economy, including imbalances in America and China, and more by sentiment.

Many investors are concerned about the global economy and various threats such as inflation in America or China’s imbalances. In my view economics is becoming less important, while investors should pay more attention to capital flows and valuations. Markets are entering a dangerous environment, with some wonderful opportunities but one where ultimately investors need to consider how to protect their wealth.

In our recent quarterly asset allocation meeting, we asked a key question: “at what stage is the investment cycle?”. Different factors affect stockmarket performance in different ways at different times. Some are fundamental, such as interest rates or earnings, some relate to valuations, while others are technical, such as investor positions. The importance of each of these factors varies over time – this can be seen easily enough from newspaper commentary during each phase. We read about investors being demoralised and scared at the trough of the cycle, then bargains surprisingly start to be seen, before the sweet spot arrives where profits grow with few clouds on the horizon.

Our analysis suggests that markets are moving out of an “earnings” phase into a “liquidity” phase, out of a period when investors mainly react to company earnings and into a phase where investors decide to pay a lot more for an asset. If so, the net result should be a re-rating of the markets, a higher price/earnings ratio.

In the current “earnings” phase stockmarkets have simply risen in line with corporate profits; if anything there has been a modest de-rating in most regions since the bear market ended in 2003. In a classic “liquidity” phase, sufficiently large flows of capital cause a distortion in the pricing of financial instruments.

One candidate could be the build-up of foreign exchange reserves. Via the sovereign wealth funds of several emerging market economies, these are starting to flow away from government bonds into a wider range of riskier assets. A second example would be the mergers and acquisitions (M&A) and private equity booms. The sums involved are already large, but despite the recent backing up of bond yields there seems little reason to see an end to this upturn before 2008.

Traditionally, what ends the investment cycle? Answer – a slump in growth or an inflation shock. In terms of the headline consumer prices index, the next risks for central banks lie with an upturn in food prices. The risks of drought affecting grain producers like Australia or Ukraine have been much discussed, but other foodstuffs face problems as well. Examples would be the surge in the cost of milk in America earlier this year, or the impact of poor weather in Britain on vegetable prices.

The problems in the subprime mortgage market in America have been so well discussed that perhaps investors have become too blasé about the risks of an American recession in 2008 – even if it cannot yet be a central case forecast. Otherwise, we would warn investors to pay more attention to policy tightening taking place outside America, as this will determine whether countries accelerate or decelerate into 2008. Europe would be a prime example.

There is a strong relationship over time between changes in European bond yields and changes in European industrial production, with a 12-18-month lag. At present the models suggest a moderate deceleration in European activity into 2008, but more aggressive European Central Bank (ECB) moves would mean a sharper response.

A third concern must be credit markets, less so corporate bonds and more the derivatives markets. There have been warnings from several regulators and credit

Shows S&P 500 Composite Price index (LH scale) and the 12-month forward earnings for the S&P 500 (RH scale) to July 1.Source: Thomson Datastreamrating agencies. An example would be the ECB’s latest Financial Stability Review: “we are concerned that the growing presence of credit portfolio investors, hedge funds and private equity in the derivatives markets has led to greater and possibly excessive leverage. In particular, there are concerns that this could have led to some slippage in credit risk assessment standards and pricing”. The recent Bear Stearns debacle highlights two problems. First, in the absence of a transparent market, pricing is difficult. Second, in a world of securitised debt, reaching agreement on debt re-negotiations is more difficult.

We are professional investors who are paid to take a balance of risks and opportunities. To sum up, do not pay much attention to macroeconomic news, as long as inflation remains broadly under control. We think it will.

Start to pay more attention to valuation issues, to the imbalances within markets, and to measures of investor sentiment. The next phase of the investment cycle could see a noticeable re-rating of riskier assets, before problems start to appear.

This is a summary of a talk given by Andrew Milligan at an investment conference in Monaco.