For years now, slow economic growth, the spectre of deflation, political upheaval and high levels of debt have concerned global financial markets. As bond yields have become negligible, or indeed negative, the pursuit of income has become all-consuming. This is particularly so as the western population has aged and regulatory pressure has forced savings into presumed safe assets such as government and triple A debt, the current pricing of which has become extreme.
So much so that it could be argued that these assets are now among some of the most high-risk assets that investors could own. If a bubble is an almost complete consensus that certain assets are must haves at any price, then that is where we have arrived in the market of highly rated bonds, government debt and dividend yielding, so called defensive equities.
Recent debt issuance by some European countries for 100 years at rates of around 2 per cent interest, a rate that the US cannot borrow at for even just 10 years, shows how much appetite exists for these assets with seemingly no price sensitivity. This is either a complete belief that inflation over the next 100 years will not hit 2 per cent, or otherwise a commitment to lose money in real terms which can only be driven by regulatory requirements and a bottomless demand for any income product from an ageing investor base.
Currently over $10trn is invested in negative yielding government bonds and corporate debt, despite inflation rates that are now, on the whole, gently rising. Even corporations such as Sanofi and Henkel have been able to issue debt at negative rates, a price where the holders are paying the company for the pleasure of funding their business.
Defensive equity sectors that are less cyclically sensitive, such as food and personal good sectors, have been driven to some of their highest historic PE levels, despite some pretty lacklustre organic growth prospects. The common defence of these positions and valuations has always been that an ageing population and highly indebted nations will drive deflation and negative economic growth, much like we have seen in Japan for the last couple of decades. If zero interest rates can still deliver real returns for Japanese government debt holders then surely that is the investment model for the rest of the world.
Sounds plausible but looks like a flawed argument. The world is recovering, albeit slowly but there are real signs that for the first time for a decade or more growth is accelerating across the world at the same time. It is doing so in a far more anaemic manner than any prior recession in our memories, but this is to be expected given the nature of the financial crash that began in the US and engulfed sovereign debt markets.
A cataclysmic scenario of a complete collapse of the global financial system and nation states defaulting was quite terrifying. But it has passed and financial markets will need to reflect this reality at some point. The US began the healing process years ago with an aggressive recapitalisation of their banking system. Europe sadly dragged its feet and is still yet to fully deal with the balance sheets of some of their weaker banks, but the global economy seems to have come in to some kind of balance after years of excess supply and limited demand.
Indeed, China, the source of so much of the deflationary pressure experienced across the globe over the past decade, seems to have finally embraced the destruction of its loss making, environmentally poisonous industries and shut much of its excess capacity down. Coupled with slow, yet steady demand growth, the key economic balance of supply and demand seems to have come somewhat better aligned.
There are plenty of signs of encouragement. Chinese growth accelerated for the first time since 2009, rising a more than healthy 6.9 per cent so far this year. Industrial production globally has been strengthening all year according to the PMI surveys, with industrial production in the likes of France achieving growth rates not seen for years. Unemployment is at record lows in places like the US, UK and Germany, with even the overall Eurozone rate falling to the lowest since 2009. The economies that have really struggled since the crisis such as Italy and France are without doubt experiencing better demand growth than at any point since.
However, at the same time, many financial markets persist in pricing in a crisis environment despite the far more robust economic backdrop. Whilst a slide into deflation and recession is theoretically possible, nothing in the data suggests this is the most likely scenario for now. The valuation gap between quality and value stocks in equity markets remains extreme by historic standards: also a sign of impending economic stress. But if economies continue to strengthen and strong labour markets finally lead to some wage growth and inflation, then this valuation gap could rapidly reverse.
Remember that the period from 2000 to 2007, when value investing returned many times the returns achieved by other styles, was the last time we were in the current scenario of accelerating global growth. Positioning for some rotation should at the very least be worth some consideration at this point.
Jake Robbins is manager of the Premier Global Alpha Growth fund