After an unbroken 11 month rise in the total returns on the S&P 500, how far can markets climb when they are trading at record levels? This bull run has brought earnings to their highest valuation since the tech bubble in 1999. However, we believe that the key factor is not an imminent recession based on normal trading patterns, but rather, the potential end of Quantitative Easing (QE) and the withdrawal of liquidity from capital markets.
Should QE reduction become the main threat, there is also the issue to consider of its introduction in the first place. The banking system was extremely fragile a decade ago and, while recovering, is not yet back to full strength, would it make sense to withdraw funds so quickly that another crisis arose?
Our current view is that policymakers, particularly in the US, will start to gently apply the monetary tools that take the heat out of speculative markets. It can’t be comfortable for the authorities in different areas to watch the rise of the ‘crypto’ currencies such as the Bitcoin, particularly as this weakens confidence in the major currencies, and is also a helpful currency for the black economy.
While employment levels are at a high, many new jobs created are either part time or of vulnerable status, and there does not yet seem to be significant wage pressure to immediately threaten current record corporate profit margins. Some early signs are evident but in the UK, Brexit and its consequences, is putting a lot of emphasis on job security.
There are signs that there might be a change of emphasis in the type of security that the market favours, particularly if a more cautious mindset starts to take hold. With cash deposits and Gilts offering miserable returns, the focus on income is as strong as it has been in recent times. We have mentioned what we call quasi bonds in the past. For investors who wish to have a more modest risk profile, a strategy that includes exposure to this asset class may offer a more predictable level of total return from the income portion itself.
Turning to capital returns, it has been noticeable in most bull markets that when risk free rates of return start to rise, it puts pressure on the multiple that investors are prepared to pay. That factor has not really come in to play yet but when, as managers, we feel that this could be the next trend in market cycles, it makes sense to start to anticipate a change in investor preference. With the valuations of growth stocks historically stretched against value stocks, we still like equities, but it might be time to start taking some risk off the table.
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