The effects of Brexit, Trump and the Italian referendum may have been short-lived but, argues Guy Stephens, market insensitivity and investor complacency should be a cause for concern
Market movements are usually influenced by four main factors - company fundamentals, macro and micro-economics, politics and investor psychology. At any one time, the first three of these can be more dominant or more recessive depending on developments and their magnitude.
This then defines the ‘mood' of the markets, which is where investor psychology comes in. At the moment, as we are all very much aware, politics is the primary influence. It has been for much of last year and is almost certainly going to remain so for most of this year.
This political noise initially generates unease with investor psychology and later complacency as it becomes the norm. As an example, markets now appear insensitive to certain risks that were considered unpalatable but very unlikely just a year ago.
We have all read about the short-lived ‘Brexit effect', the even shorter ‘Trump effect' and the barely noticeable ‘Italian Referendum effect'. This means markets are now potentially immune from any real existential threat as investors are in the mind-set of shrugging off any seemingly bearish development.
This has all the hallmarks of a bull market bubble. The recent past performance and resilience of the market when faced with impending doom is making investors assume the same going forwards. If markets can cope with Brexit, Trump and more EU turmoil, then they are seemingly invincible …
The last time we saw this psychological behaviour in the markets was during the credit bubble of 2007 when bullish and complacent investors ignored the early signs of strain in the sub-prime mortgage market of the US. It was seen as a $350bn problem confined to several overheated areas of the US residential property market.
How could investors have been so naïve and take so much risk in the belief the property market would rise forever? The UK mind-set was equally undisturbed - overlooking the problem because ‘at least we haven't got a problem like that over here'. Little did we know what lay ahead.
Bullish and complacent sentiment
Nevertheless, the early warning signs were there and the bullish and complacent sentiment was such that investors defaulted to a ‘glass half full' outlook and ignored it. The risk of being out of the market was seen as greater than the risk of being invested given the recent returns that were being enjoyed. No-one wants to bring a great party to an early close.
At Rowan Dartington, we adopt an approach of looking for what could go wrong by constantly kicking the tyres surrounding our assumptions. This is because a strategy of protecting against the downside, over the longer term, should deliver outperformance if you avoid the disasters - a simple mathematical certainty.
A bullish focus on the upside has a tendency to lead to complacency and inadequate analysis of what could go wrong. Many an entrepreneur has fallen on his sword by getting carried away with optimism for his business idea and failing to see the elephant in the room.
Instinctively, today's markets feel like this but writing this down in factual arguments is nigh on impossible since, again, this is all based on forecasts and assumptions from so-called experts, all of which missed the biggest credit crisis in living memory.
If we accept the forecasts are wrong, which they usually are, it is then a question of deciding what is most likely to surprise and what this will mean for market valuations, equities or bonds, alternatives or commercial property.
Last week saw a lot of fundamental data in the US, UK and Europe. We were treated to strong and robust US employment, Purchasing Managers Indices, economic sentiment, GDP and a tempering of the Fed's likely interest rate trajectory - all bullish indicators for fundamental support of the equity and bond markets.
The markets did not really move, however, because this news needed to be positive based on where the markets have travelled to, post the election of Trump. Valuations are suggesting that much of this is baked into the markets and so we will need something new to propel us forward from here.
I can remember all the theorists telling us back in the early noughties that with low inflation and low interest rates, we should get used to lower absolute returns. Historically, up until the end of the millennium, annualised growth in the equity market as measured by the MSCI World index in local currencies over the preceding 25 years was 13.6%.
Fast forward then to the bottom of the markets after the credit crisis- 3 March 2009, in the case of that index. The annualised return since then to last Friday is 15.1% - so much for lower returns. And I thought we were all disappointed with the level of global growth, economic productivity and the like?
Now some would say, ah yes but you have removed two of the biggest bear markets in history when the markets halved twice before arriving at this comparison. And that would be correct - and yet, when annualised rates of return are quoted, it does not assume we will have two bubbles building and bursting at any point in that period, so it is fair to exclude them.
Political musical chairs
So, what to do in this year of global political musical chairs involving our leaders who are going to influence the outlook so profoundly in 2017? We have moved from the Obama-Cameron era to the Trump-May era and both of the latter look far more nationalistic than their predecessors.
From a European perspective, the UK now looks every bit like an ill-tempered exile who no longer wants to play ball and is now best friends with the new thug on the block called Trump, who plays a different game.
Developments in the rest of Europe look like populism, which will only spread with further scandal such as that in France last week involving the political elite misusing taxpayers' money for self-interest. Furthermore, this will only embolden the view a different approach is required, globalisation has gone too far and looking after number one needs to be prioritised for a while.
Nationalism is normally bad for earnings as it flies in the face of free-market economics. There is a place for regulation to protect the consumer as we saw with the banking system following 2008, but trade tariffs and import taxes will only serve to undermine corporate profits as cost bases inevitably rise and prices increase.
This is being reflected in the bond markets, which are expecting inflation, but this inflation is not due to an increase in aggregate demand or wage growth. This is entirely down to an increase in costs, which will be passed onto the consumer, and that means a fall in consumers' spending power, standards of living, consumer confidence and profits.
Of course, Trump plans to offset this with corporation tax cuts and fiscal spending, which will create jobs and offset the negative profitability effects. Maybe he will be proved correct in time but it will take most of his first - and only? - term for this to be determined.
Meanwhile, the equity market appears to have taken it as a certainty. With the VIX volatility index not far from all-time lows and equity markets near peaks, we stand ahead of a tumultuous period in global politics. Be prepared for volatility and don't forget Newton's Universal Law of Gravity.
Playing chicken with this market could cost you dear.
Guy Stephens is technical investment director at Rowan Dartington
Retired in 2014
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