Stock markets, in general, have continued their upward trajectory. Share prices, benefiting from the extraordinary monetary policy that Central Banks have implemented via Quantitative Easing, have now been on a bull run since March 2009, the second longest in history. There has been relatively little volatility in markets. Furthermore bond markets have been in a bull market for the last 3 decades, benefitting from falling interest rates, which are now effectively 0%. Cash is still yielding nothing. So where to from here? I think we are at the start of a new stage in the economic cycle, one in which there is more risk to the downside than of upside potential, and I would suggest that investment portfolios at this point in time should therefore be defensively tilted.

Historical Background

The first response to the Global Financial Crisis and resultant recession was for big central banks such as the Federal Reserve in US, the Bank of England, and the Bank of Japan to slash their over-night rates to encourage main street banks to provide additional credit to the economy to boost economic activity. When this failed to have the desired effect, they introduced Quantitative Easing programs. This involved Central banks creating electronic money in order to buy government bonds to increase money supply to further reduce interest rates, thereby encouraging businesses and people to borrow more money, so as to spend more money and create jobs to boost the economy.  This reaction was a deliberate and appropriate response in the face of global recession and it has been moderately successful. Recession has been staved off. Unemployment has fallen in the US, UK and much of Europe.

What Now?

Central banks want a ‘Goldilocks Economy’ - Governments and central banks like there to be "just enough" growth in an economy - not too much that could lead to inflation getting out of control, but not so little that there is stagnation. Growth figures out of the US, UK and Europe have not been as strong as would be liked in the first quarter of 2017. US Gross Domestic Product grew by just 0.2%, and UK by 0.3%. Growth in Europe has naturally varied from country to country, France grew by just 0.3% while Germany grew by 0.6%. (Data from OECD.org) Economic growth of less than 1.5% -2% per annum could be considered stagnation.

The problem now faced by central banks is when and how to taper down the financial assistance that economies have been in receipt of. Obviously the QE exercise has to come to an end sooner or later, the questions are how and when to do this. Central bank’s balance sheets have ballooned as a result of the QE program and this cannot go on ad infinitum.  

To date only the US Fed has started to nudge interest rates higher, with a view to controlling wage inflation. This will be a difficult process and something that the Fed has a history of getting wrong. In time the European Central Bank, Bank of Japan and the Bank of England will have to follow suit.

Winners & Losers from QE (so far..)

It is often forgotten that there has (already) been a cost to personal savers of these actions by central banks and governments. The losers (so far…) have been the savers who have left their money on deposit. They have been penalised with pathetic interest rates. It is unsurprising that in the face of paltry interest rates, investors have been forced up the risk curve in order to seek returns which they view as acceptable, and indeed required, in order to meet their financial goals,… after all who is going to leave their hard earned money on deposit when the return is negative after charges? So savers, in pursuit of returns, have been forced to become investors and pour money into stock markets, and the resultant effect is that equity markets are at all-time highs.

I am not sure that the dizzy heights of the stock market indices reflect the economic reality as it currently stands, given the anaemic economic growth achieved in recent times.  Furthermore as mentioned previously there must be corrective action by central banks to withdraw the stimulus from the economy in the near future,..what effect will such action have on equity markets who have become addicted to an environment of low interest rates and ready money?

Cyclically Adjusted Price/Earnings Ratio for S&P 500

The above graph depicts the Price Earnings ratio based on average inflation-adjusted earnings from the previous 10 years, known as the Cyclically Adjusted PE Ratio (CAPE Ratio), Shiller PE Ratio, or PE 10. The mean ratio is 16.76, with a max of 44.19 and minimum of 4.78. As depicted it stands at 29.85, considerably above the mean.

The graph in itself does not indicate or predict an imminent crash, and neither do I….I do not have a crystal ball, and there are valid criticisms of using the CAPE ratio as a measure of equity value. It does not integrate the level of bond yields, which are traditionally viewed as a key determinant of proper equity values. Of course, yields remain historically low, which could mean that stock prices deserve to be a bit higher as compared to earnings than would normally be appropriate. But overall I do think that perhaps equity valuations have gotten ahead of themselves and think that there is more risk to the downside than potential upside in equity markets currently.

I would recommend all clients to review their investment strategy and ensure it accurately reflects both their ability to take risk, their investment time horizon as well as their appetite for risk. I would urge that investment strategies are diversified across asset classes. I am happy to assist in this regard so please call me. 

Kind Regards,

Gavin Gilmore                                                            t: 01 444 7620
QFA, FLIA, CFP, AITI Chartered Tax Adviser (CTA)         m: 086 383 5894