Investors will be well aware of the reflationary narrative in markets, with growth and inflation having picked up over the past few months. Yet recognition of this change has not been universal.
While fund managers have been going long oil, hoovering up cyclical stocks and increasing active exposure, asset owners have shown little inclination to do so. They remain uninterested in commodities and equities, still favour fixed income and prefer bond proxies
This is an interesting divergence of opinion, especially as asset owners have had the best of it over the last few years. Fund managers who positioned themselves for an environment of higher yields and rising inflation in 2013 and again in 2015 were stung badly as a slowing global economy prompted renewed policy intervention. Reflation hopes quickly faded and bond yields fell sharply; so much so that by mid-2016 more than $13trn-worth of government bonds traded with a negative yield. They were then rightly lampooned for misreading the market.
Against this backdrop, it is tempting to recall the proverb “fool me once, shame on you; fool me twice, shame on me”. Asset owners’ ever tighter embrace of passive strategies suggests they may be thinking just that.
Yet history also offers examples of fund managers eventually being proven right. The so-called “nifty 50” stocks drove US indices during the early 1970s. Many active managers shunned these quality growth stocks, underperforming the wider market for several years. But when the 1973 oil shock kicked in, the proportion of active managers who beat their benchmarks jumped from 10 per cent to well over 90 per cent.
There are some reasons to believe a more reflationary environment may once again lead to sustained outperformance by active funds. The global economy picked up speed over 2016, with indices of economic surprises running at multi-year highs. Tighter labour markets, cuts to oil production and US tariffs could all drive inflation higher, which has already picked up some speed after several years in the doldrums.
This is not confined to just one region; it is everywhere. With output gaps closing even in laggard economies like the eurozone, conditions are ripe for more sustained price pressures. Interestingly, as these developments have unfolded, the proportion of active managers beating their benchmarks is picking up.
Bond bulls will argue that even if this is all true, central banks will eventually step in and tighten policy and, in any case, structural forces like ageing populations and high indebtedness will outweigh transitory cyclical developments. But will central banks tighten?
Haunted by the 1930s, they have spent years coming up with reasons to loosen policy, rather than tighten it.
The most recent culprit was the Bank of England, which lowered its estimate of the level of unemployment consistent with stable prices, giving it room to ease policy after Article 50 is triggered.
This institutional laxity may be about to go a step further in the US. President Trump will shortly announce several new appointments to the board of the Federal Reserve and will appoint a new chair and vice-chair next year. The Fed is famously exempt from the checks and balances that Trump will have found so frustrating during his first few weeks in office. Might he take the opportunity to appoint someone more attuned to his growth-led agenda to head one of the most powerful bodies in the country?
The Fed has been led by a professional economist for most of the last 50 years but that was the exception rather than the rule prior to 1970. Could he break with recent practice and appoint a businessman to run it? What that might do to inflation expectations is anyone’s guess.
Changes in market narratives are always difficult to navigate, with turning points only obvious in retrospect. Yet while the low growth/low inflation story has strong foundations, investors should remain open to the possibility that change may be around the corner. If it is, then better times may lie ahead for active managers.
We live in an age where a central bank retired almost the entire stock of banknotes overnight (India), citizens overpay their taxes to avoid negative interest rates (Sweden and Switzerland) and central banks everywhere follow policies that would have been unthinkable 10 years ago.
We know from history that major changes in inflation expectations can come out of nowhere. If ever there were a time when we should be prepared for surprises, surely this is it?
The “no inflation for as far as the eye can see” narrative may still be the right one but the risks are rising. Active fund managers should hope they continue to build.
Bill McQuaker is portfolio manager on Fidelity’s Multi Asset range