Climbing the “wall of worry”
We’re currently facing a confluence of potentially negative factors in the global economy and financial markets. Yet equity markets, particularly developed markets, keep going up. This is known as climbing the wall of worry. Let’s have a look at the main worries.
Delta, and other, Covid variants
One of the biggest concerns facing markets continues to be Covid. As we have discussed before, whilst things are returning to normal, we are most certainly not out of the woods just yet. The variant on most people’s minds continues to the be Delta variant, which originated in India and has spread rapidly around the world, causing concern for governments, central banks and financial markets.
From our point of view, the biggest risk posed by the Delta variant is in the US, where vaccination rates have slowed due to the politicisation of vaccinations and mask wearing. The following charts show that the third wave (largely caused by Delta) of the pandemic is cresting. Although, notably, not in the US as yet:
Clearly, this rapid spread raised the risk of renewed restrictions of movement and the severe knock on effects on the global economy that these have been proven to have. However, the political appetite for renewed lockdowns in the US, UK and Europe appears to be minimal and so we view this as a small but not insignificant risk to markets.
Nonetheless, the potential for highly virulent mutations of the virus is a risk that we should not take lightly. Afterall, with each new variant comes greater uncertainty over the efficacy of vaccines. According to the European Centre for Disease Prevention and Control (ECDC) there are currently three variants of concern. These are Delta, Beta and Gamma. To clarify, variants of concern are those where there is clear evidence indicating a significant impact on transmissibility, severity and/or immunity that is likely to have an impact on the EU/EEA. There are also other variants of interest, one of which (Mu) has now been recorded in the UK.
Now, I would like to reassure readers that I am not raising this to worry you. Global deaths from any variant of Covid are a fraction of those suffered in the first wave and all evidence thus far shows that vaccinations do offer substantial protection against becoming seriously ill. I simply raise the issue as it is something that we, and investors around the word, are watching very closely indeed.
Monetary policy and inflation
We’ve discussed inflation at length and our view has not changed materially. We continue to believe that the current bout of inflation will be transitory although it may not fall as quickly as the market expects.
Now, the key here is that the US Federal Reserve (Fed) is doing it’s very best to telegraph any changes to its policies loud and clear, so as not to spook financial markets. All indications are that the Fed is getting ready to start reducing its Quantitative Easing (QE) programme earlier than originally thought. As a brief reminder, QE is a process whereby central banks buy their own debt, or bonds, in order to increase the supply of cash in the financial system and stimulate economic growth. Should this reduction, or tapering, of QE come to fruition it has the effect of tightening monetary policy at the margin.
It is debatable whether QE programmes around the world have achieved their goal of stimulating economic growth or have simply increased inequality by proposing up asset prices and “blowing bubbles” in financial markets. That is a deep a complex subject, but the fact is markets have enjoyed an abundant supply of money for over a decade and the taps are going to be closing at some point.
So far markets have taken the possibility of tapering in their stride. Is this because the Fed has done such a good job of communicating it’s thinking and intentions, or is there a degree of complacency? Time will tell.
Reaction to tapering of QE together with the timing and pace of interest rate rises have the potential to impact both bond and equity markets. Given the outlook, our view is that, the path of least resistance for bond yields is up, meaning potential capital losses for bond holders. Nonetheless, bonds warrant their place in portfolios, but flexibility and selectivity are key when choosing fund managers in this asset class.
Fiscal cliff in the US
One concern here is the debt ceiling. In the US, Congress needs to approve increasing the amount of accumulated government debt over and above the debt ceiling. In 2019 the debt ceiling was raised to $22 trillion (no that’s not a typo) before being suspended until the 31st July this year, during which time it was adjusted to the current level of debt, now $28.5 trillion. The US treasury is using clever accounting so as not to breach the debt ceiling but these “extraordinary measures” can’t hold off a breach for long and most estimates expect only until October or November.
So, a deal had to be done in congress. Due to the highly polarised nature of US politics, the Democrats are having to include a debt ceiling raise into their budget legislation, which also includes $3.5 trillion of social security and infrastructure spending. Republicans are largely opposed to increasing spending and debt and so negotiations are likely to be protracted.
Why does this matter? Well, if a deal is not done in time then it could result in a shutdown of the US Federal Government. This sounds far-fetched but this happened, for 35 days in 2018-19. Should this happen again, hundreds of thousands of Federal workers would not get paid and benefits cheques would be delayed. Whilst painful for those affected, the wider economic impact will be relatively small.
The bigger impact comes from loss of market confidence in the US administration and the ability of the US to pay its debts. Back in 2011, this led to ratings agencies downgrading the credit worthiness of the US. If this were to happen again, the impact of global markets could be significant.
We discussed the regulatory crackdown in China last time so I will not repeat myself. Developed markets have taken this in their stride so far and there have been no noticeable spill over effects. However, the potential impact on long term Chinese growth cannot be ignored.
TINA here to stay?
Now that we have discussed a few of the key risks facing markets, it’s important to think about why developed market equities continue to climb this wall of worry. Well, market mantra appears to be “there is no other alternative” (TINA).
Financial conditions are highly accommodative and policy support for markets is huge, even if the Fed starts to taper QE. Corporate earnings are strong, analysts are, abnormally, rather pessimistic and corporates are buying back their stock in droves. All of these factors underpin the strong equity markets.
The risks discussed, and others, all have the potential to derail the bull market in equities. However, we see no risk of recession in the short to medium term and, providing the Fed doesn’t shock markets by raising rates too quickly, we think that equities should continue to deliver reasonable returns. Nonetheless, the risks to our view are numerous and, in addition to those already discussed, we see de-globalisation and geopolitical instability as the ones to watch.
Diversification, diversification, diversification
Here comes my broken record again. We’re living through times of extreme uncertainty. Equity and bond valuations in most regions are at extreme levels and investing at these levels can feel uncomfortable. As the renowned economist John Maynard Keynes once said “markets can remain irrational longer than you can stay insolvent” and so it is vital to have a plan and stick to it. A well balanced and properly diversified portfolio is essential and should help to see you through the difficult times ahead.