Beware of the risks you can’t see, not the ones you can

By Philip Smeaton, Chief Investment Officer

 
A news agenda dominated by Brexit, Trump and Trade Wars has understandably led to nervousness among our clients for several years now. This wasn’t helped by the market correction late last year, which reminded us that volatility can be just around the corner.
 
But last year’s market jitters had very little to do with Trump or Brexit. It was largely driven by investors reacting to the Federal Reserve (Fed) raising interest rates as they extrapolated what the rising cost of borrowing would mean for business. The conclusion wasn’t good, and it triggered a sell-off. The Fed quickly got the message and put a stop to the rate rises, even talking of a lowering them again to calm the markets. It seemed to work, and markets have recovered most of the losses of last year.
 
This underlines the importance of really understanding what drives volatility. It also reminds us that we must not be complacent. As Newton’s third law states: “For every action, there is an equal and opposite reaction”, and we have concerns that the Fed’s U-turn could ultimately have negative repercussions. Let me explain.
 

The threat of inflation


Today’s economy is showing remarkable similarities to those that preceded the inflation shock of the 1970s – low inflation, very low unemployment and persistently low interest rates. Back then, sudden wage growth caused inflation to soar from 3% to 10% in less than two years.
 
graphjuly19-(1).PNG
Expand chart.

Currently, investors don’t believe that inflation is an impending risk. Indeed, the majority view is that there will be a continuation of the current low-inflation, low-interest-rate environment. But we think there are good reasons to be concerned: 

  • Wage gains are inevitable as job creation continues and unemployment falls below 4%. As people earn more, this pushes up prices and inflation.

  • Businesses are still able to borrow money at competitive rates, which means there could be continued above-trend economic growth in the shorter-term, which again could lead to higher inflation.

  • The Federal Reserve has changed the framework it uses to set interest-rate policy. Historically, it would pre-empt rising inflation by slowly increasing interest rates. The new framework means the Fed will only increase interest rates after inflation visibly manifests itself, which increases the probability that it will rise above 2%, and possibly well beyond that. 

Inflation that starts to rise quickly would force interest rate hikes, and this combination of economic forces could have a devastating effect on market confidence.
 

A recession on the horizon?

 

In addition to the risk of inflation, we must accept that a recession could be possible. Several leading indicators are pointing towards an economic slowdown in countries such as the US, Germany, UK, Canada, South Korea, China and Japan. These indicators include: 

  • An inverted yield curve which means you currently get a better return on short-term debt than you will on long-term debt of the same credit quality. This is relatively unusual and has historically been a predictor of recession. 

  • Growth in the US looks set to slow from 4% to 1.5% over the next 12 months. The US has been riding high on tax and capex incentives, but these can only assist growth for so long, and soon these incentives will run their course.

  • Job creation is likely to slow now that the unemployment rate is so low, and corporate margins will be squeezed by wage growth as businesses compete for talent. 

Conclusion

 

Markets will always have their ups and downs, and it’s impossible to predict the timing and nature of volatility. But it’s our job as a company of investment and portfolio managers to analyse future risks and position our clients’ portfolios accordingly. While I wouldn’t advise you to stop reading the papers or watching the news, I would say that by the time news has hit the headlines, the markets will have reacted. It’s the hidden risks that matter, and it’s our job to worry about those on your behalf.

 

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