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How is this bull market going to end?
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How is this bull market going to end?

Moritz Sterzinger Private Equity November 2017

Back in October, I had the pleasure of commenting on the outcome of the German election and its wider implications for Europe and the euro in the subsequent European Market Briefing. I wrote that the most likely coalition – consisting of Merkel’s conservatives, the Liberals and the Greens – would be a less Europhile government then the outgoing grand coalition, which may have made much needed reform difficult should things get dicey in Europe again. Now it appears that there won’t be such a “Jamaica coalition” (as it is commonly known on account of the parties’ colour codes of black, yellow and green) and that instead we might see yet another grand coalition between conservatives and social democrats – albeit slightly less grand this time, with both parties having been decimated in the election.

While most Germans are unlikely to be happy with this, and while a repeat of the last government may very well cause the political climate to deteriorate further, Europhiles and globalists would surely welcome a continuation of the status quo (which, as Ronald Reagan put it, is “Latin for the mess we’re in”). Nothing’s certain, however, and we may as well head for another general election, which would… probably change nothing? Hard to tell. I can see the Liberals gaining from their gambit in declaring the coalition talks to have failed, but whether this is enough to get a conservative-liberal majority is anyone’s guess. In summary: grand coalition = “slightly bullish for the euro”; another election = “God knows, but probably less good for the common currency”.

Elsewhere, the UK and the EU seem to have agreed on a figure for their ‘divorce bill’. As a result, sterling rallied overnight against both the euro and the dollar. That is surely encouraging, but I am going to hold my breath until the ink on the Brexit deal is dry: both sides have plenty of ‘enthusiasts’ with a knack for jeopardising things just when you thought it was going well.

So much for politics. Much more fun is the current bull market in pretty much every asset class that you can think of (gold and some commodities notwithstanding), which tempts me to muse a little about how this will end.

One thing to put a sudden end to this party could be your classic ‘black swan’ or geopolitical event: large-scale armed conflict, for example. There are other risks lurking, though, and they may indeed materialise with the potential to derail the broadening global economic recovery. A trade war, for instance, set off by a protectionist America, would fall into this category. Equally, a sharp slowdown in China would hit the world economy hard – and is not beyond the realms of possibility given China’s extraordinary credit bubble.

But financial markets do not necessarily need real economic events to blow up – they are quite adept at managing to do so themselves. So what are the financial drivers of this sustained rally, and what would happen if they changed for the worse?

Some finger the rise of ETFs and index funds, which indiscriminately throw investors’ money at the market with total disregard for asset valuations and underlying fundamentals. I have no doubt that passive investing is fuelling this bull market, and that a sudden flight from these investment vehicles would make things pretty messy; but in the absence of any external factors, I don’t see why people would stop investing in ETFs let alone unwind their holdings on a grand scale, given the current lack of yield in other assets.

This continued hunt for yield at high equity valuations wouldn’t be so drastic had central banks not gobbled up so many investable assets. We keep talking about liquidity and policy rates, but the very fact that our monetary wizards sit on gazillions of government and corporate bonds as well as stocks (!) probably explains most of the “everything bubble’s” existence. While the ECB, the Bank of Japan, the BoE and the Swiss National Bank (which holds more Facebook shares than globally operating German insurer Allianz) do not seem inclined to reduce their massive balance sheets anytime soon, in the US it’s a different story. If you are looking for a reason why markets might sell off, a policy mistake by the Fed appears to be most probable.

The Fed left rates unchanged in September and November, but it is generally expected that it will hike come December. Its own (median) projections of its benchmark rate show c. 2.7% by 2019; unfortunately the market disagrees, with 1m Libor 2-year forward rates barely above 2% and 10 year treasury yields, two years forward, trading at c. 2.6%. Now consider that the Fed has started to unload its USD 4.5 trillion balance sheet and you can see a recipe for disaster. You might be forgiven for handing your money to the likes of Jeff Bezos, Travis Kalanick and Elon Musk without expecting to receive anything back for a decade or two whenshort term interest rates are close to 0%, but a current account yielding close to 3% in a couple of years’ time doesn’t look too bad compared with a company – albeit with a potentially bright future – that is burning through cash. It also looks quite attractive vis-à-vis a dividend yield of 1.92% plus some capital appreciation, which the S&P 500 currently offers. And one hopes the Fed isn’t serious about reducing its balance sheet, pushing up the long end of the curve. I can imagine quite a few people would find 10-year treasury yields of 4% quite attractive – certainly attractive enough to rethink their equity holdings and switch out of riskier assets into bonds.

So there you have your disconnect between the US central bank and this mysterious being called the market, and with it the recipe for a major repricing of all asset classes – unless corporate profits continue to rise (unlikely) or inflation at last starts to pick up. Maybe the Fed is right in assuming that there is some sort of Phillips Curve relationship between employment and inflation, but a global labour force and accelerating technological progress make a strong case for subdued inflation despite low unemployment and call into question pre-emptive tightening for inflationary pressures that never materialise.

On balance, I have my doubts that the Fed will follow through on its projected tightening agenda. For one, Janet Yellen and a few of her colleagues are on their way out and you could argue that they have started to tighten because they would prefer to be remembered as those who started ‘normalising’ rates rather than as the super doves that they have so often been. I am unsure what to think about Yellen’s successor, Jerome Powell, but I would be surprised if self-proclaimed “low rates guy” President Trump had nominated a hawk (had he wanted to, he could have picked Taylor). That said, I think the Fed will continue to blink as it has in the recent past, rather than lean against the wind. The question then becomes whether it can react in time and reverse course, should it turn out that it has tightened too aggressively. There is plenty of room for things to go wrong – watch this space!

All views expressed here are the author’s own and are based on information available at the time of writing.

 

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