Planting a flag
Posted on 31 July 2014
"Equity investors are on the other side of the debate, and their views are diametrically opposed to those of the “New Neutralists"
Contemplation is a central feature of the summer season. Long, warm days and time away from the office are essential ingredients for introspection. For investors, summer represents the half-year mark wherein the inevitable taking stock of efforts during the period takes place. Judging from the returns across asset classes over the past six months, investors should be pleased.
In the service of summertime contemplation, a look at the great debate among investors is in order. This debate centres on the profoundly differing views of the world between fixed income and equity investors, and the attendant ‘who is right’ conclusion. Yields in the global fixed income complex have remained stubbornly low, and the periodic emissions from the Federal Reserve (Fed) suggest there is a lack of a coherent policy to judge economic growth and, therefore, a construct to determine the proper level of interest rates.
The European Central Bank (ECB) appears reluctantly to be giving in to the need for a more muscular approach to quantitative easing (QE) to prevent the currency bloc from sliding into the clutches of systemic deflation. (To be fair, the ECB has fewer degrees of freedom within which to operate than other central banks.) The Bank of Japan appears at the ready to provide another blast of QE to push the currency lower, and thereby sustain budding inflation. Beyond central bank manoeuvres, an implicit belief of those who think the bond market has it right is the idea, advanced by the bond management giant PIMCO that the “New Neutral” is essentially correct. This conviction holds that economies will generally grow more slowly, due to a deleveraging of historically high debt levels across the globe. Because fragile economies and consumers cannot handle normalised interest rates, central banks will be unable to raise them. Judging from the path of economic growth in the developed world since the end of the Great Recession, this idea has gained traction.
Equity investors are on the other side of the debate, and their views are diametrically opposed to those of the “New Neutralists”. They see rising global equity prices supported by higher sales and earnings, and perceive a different world emerging: one in which growth is gathering steam rather than dissipating. This group, call them the “Dynamists”, equates accelerating employment in the US, organic attempts at recovery in Europe, indications of success with the Abenomics program in Japan, and encouraging electoral developments in certain emerging markets as indications of a dynamic, rather than sclerotic, economic future. The Dynamists have their worries: will rising interest rates be a headwind for further gains? Will a changing regulatory landscape add costs (and impair profitability) to doing business? Are expanding valuations sustainable?
This debate is healthy for several reasons. Read in full in the latest summer edition of Compass as we explore and discuss.
Hans Olsen, CFA Chief Investment Officer, Americas