Strategy for an un-presidented reflation fade

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15/09/2017

OPINION | As hopes of US President Donald Trump sparking a boost to global growth fall away, an active, absolute-return approach with an emphasis on capital preservation is more important than ever.

June 2017 marked the eighth anniversary of the current economic cycle, making it the third-longest expansion in the post-war period. Looking back, it certainly hasn’t been a normal recovery. The story of the period has broadly been one of a constant tug-of-war between the deflationary forces that have been the natural post-crisis tendency and the reflationary response provided by central banks’ increasingly interventionist and experimental monetary policies.

At Newton Investment Management, we employ a thematic approach to help identify the long-term trends across the investment landscape. We use a theme we call ‘state intervention’ to highlight unorthodox policies’ unintended negative consequences; namely volatility, inflated asset prices and poor capital allocation.

While ‘emergency’ monetary policy has been in place almost throughout the last eight years (although the participants have changed), nominal growth has remained subdued, and corporate profits on a global basis have barely grown since 2011. Most striking is that financial-asset prices of almost all types have rocketed, sustained by persistent stimulus and the promise that a more normal recovery is just around the corner.

Given that we see central-bank stimulus as the primary support for most asset prices, if and how a tightening in policy proceeds is important for investors. Given the scale of the stimulus in this cycle, the exit may be as experimental as the policy itself.

The reflation impetus subsides

With this in mind, the sight of world sharemarkets continuing their relentless upward march seems yet another example of ‘situation normal’ for today’s financially charged world. Although geopolitical and economic uncertainty remain elevated, some of the risks previously jangling investors’ nerves seem to have subsided somewhat.

The post-Brexit wave of nationalist/populist feeling, which our ‘divergence’ theme brings to our attention, has failed as yet to get traction at the electoral level. Indeed, the recent election in France of President Emmanuel Macron and the improved electoral prospects of Chancellor Angela Merkel’s CDU party in Germany appear to have shifted the pendulum back in a direction more favourable to the European Union.

In the context of this benign environment for taking risk, the underlying trend over recent months has been market participants appearing to become progressively more sceptical about the reflation trade. Growth sectors, such as health care and technology, not cyclicals, have driven sharemarkets until very recently, while industrial indicators such as US auto sales have fallen in every month this year.

Predictably, too, one might say, market participants seem to have come to the realisation that Trump may not be able to transform growth in the US economy after all. Although investors do still seem to be clinging to hopes of some tax reforms before the mid-term elections in 2018.

Wishful thinking?

Nonetheless, once again, it seems, we are being steered towards the idea that policy has finally created some kind of synchronous global recovery. Key to the official narrative is that the experiment with monetary policy has been a success, in that it has shepherded us all through this difficult period and saved us from a much worse fate.

The problem with this version of history is that the global financial crisis was not an unforeseeable exogenous shock that came from outside the system, but a direct result of policies and models that led mainstream economists to fail to see the crisis. The application of exactly the same policies and models today does not exactly inspire confidence.

In this environment of political uncertainty, and with signs of heightened volatility to come in financial markets, we believe an actively managed, absolute-return investment approach, with a focus on capital preservation, may be more important than ever in helping investors achieve their goals.

 Aron Pataki is a portfolio manager with the real return team at Newton Investment Management, a subsidiary of BNY Mellon. This column covers some of the issues he discussed at the 11th annual Investment Magazine Absolute Returns Conference in Sydney on September 14, 2017.