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Economic expansions don't die of old age, they're murdered

Glenn Freeman  |  13 Sep 2017Text size  Decrease  Increase  |  
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The role of policy missteps in economic fortunes and balancing risk and inflation; are global equity markets overvalued, and why, and where can you find opportunities?


Noting the implicit role policy missteps play in boosting or harming nations' economic fortunes, Peter Warnes' latest Your Money Weekly newsletter discusses the dangers of misallocating capital.

"In an historically low interest rate environment, risk assets, firstly equities and then property, appear to be the only game in town for many. New investment fads, like exchanged-traded funds, gather great momentum. This is when capital can and does become misallocated, pushing risk asset valuations further into higher ground," Warnes says.

He refers to a well-known financial market circular, The Absolute Return Letter--from UK-based Absolute Return Partners founder, Niels Clemen Jensen--and draws links with Australia's domestic economic situation.

Jawboning house prices

In the cat-and-mouse game of balancing market risk and inflation targets, Warnes says "the Reserve Bank of Australia is jawboning housing prices lower" while "APRA is doing the heavy lifting by introducing macroprudential regulation".

He explains why the various stakeholders--the RBA, APRA, and the Future Fund--are behaving the way they do, and how they should adjust their tactics. "Central banks should be focused on taking measures in correcting the misallocation of capital and ensuring its redirection," Warnes says.

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As the Absolute Return Letter's Jensen opines, from a whole-of-world perspective: "Global economic growth is accelerating; yet inflation is modest--in many countries almost non-existing. Inflation-less economic growth, they call it."

"On the other side of the table you'll find a sizeable camp of bears. It is all going to end in tears, they argue. No wonder the average investor is slightly puzzled. What on earth is going on?" it says.

Outlining the arguments from both the bull and bear sides of the floor, the letter says: "In defence of the bull case, one has to admit that the current level of investor optimism is more than just wishful thinking. Consumer confidence is growing, and so is business confidence, both of which are powerful drivers of equity returns."

From the bulls, it notes an underpinning "belief that there is absolutely no reason to worry about inflationary pressures coming from anywhere. Even if economic growth were to gain further momentum, inflation won't come back to life anytime soon".

It also refers to the argument that the longer the current global economic recovery runs--now into the eighth year since the first tentative steps out of the GFC. "How much longer before we hit the wall?"

This matters little, Jensen says: "The fact that the average economic recovery has lasted 5.7 years contains little information of value. The numbers are not statistically significant."

In terms of equity market valuations, while noting it is "very much a US-based argument", Jensen says "they are not outright cheap anywhere in the developed world"--particularly prescient, given many ASX-listed companies have recently delivered their FY17 results.

Ignore the tossers

Jensen notes some market bulls argue the overvalued US equity market isn't the be-all-end-all, with other indicators painting much less bleak pictures: "Don't believe what those tossers tell you."

"Regardless of which valuation indicator you zoom in on, the story is the same--the US equity market is grotesquely overvalued."

Jensen also picks apart a favourite bear argument of excessive indebtedness, with total non-financial debt-to-GDP now higher than at any point in the past 50 years.

From this, he draws the conclusion "there is likely to be plenty of blood in the streets, should one of the following two scenarios unfold: if interest rates were to rise meaningfully; or if US GDP growth were to turn negative".

"Whereas I wouldn't assign a high probability to the former, the latter could easily happen, and will most likely happen in the not so distant future as policy makers are indeed making a policy mistake right now."

A case for EMs

Adding another perspective, Aron Pataki, portfolio manager in the real return team, Newton Investment Management--part of the BNY Mellon group--sees an opportunity in some of the above factors.

He believes continuing weakening of the US dollar should benefit other global markets, particularly emerging countries "like Mexico, India, Indonesia: we think the fundamentals in these countries are good, coupled with a weak dollar environment, which sets up the theme and investment case for picking some bonds and stocks in these countries".

Within Newton's own absolute return strategy, Pataki says it had also factored in a trend toward "de-globalisation"--which may have affected some of these emerging countries, but especially China, through altered terms of trade driven by more insular, US-centric policies.

"One of the emerging themes of 2016 was de-globalisation ... we actually dismissed that theme at the end of the year because we didn't actually see that playing out ... the Trump administration has actually not been able to push through all these changes. In fact, all of the election promises have failed so far," Pataki says.

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Glenn Freeman is a Morningstar senior editor.

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