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Cazenove multi-manager view: Too far, too fast?

Equity markets have been on a power surge since their March lows. The S&P 500 has now rebounded a full 50% over the last five months. Only in 1930 did we witness a stock market rally of this magnitude over such a short time frame. Then, like now, the market was propelled higher by super-charged policy stimulus and tentative signs of economic improvement. Unfortunately, in the absence of an upturn in final demand, the market soon ran out of steam and eventually bottomed more than 80% lower in 1932! Should we be concerned? Probably.

To date, this “one of a kind recovery” – as it has recently been described – has been “jobless, revenue-less, income-less, profit-less and consumer-less”. Indeed, whereas in previous cycles, a 50% bounce from the lows would correspond to material expansions in GDP, employment, corporate profits and bank lending, all of these indicators are yet to make their cycle lows this time around.

Increasingly, investors are looking to the equity markets as evidence that an economic recovery is imminent. This was also a mistake made in the 1930s. A lot of hope and expectation has now been priced in over recent months. Against that backdrop, risk has increased markedly.

Real, durable bull markets need the support of real, sustainable economic growth, and that never occurs without a revival in final demand. To date, in spite of the biggest fiscal boost ever recorded, consumers remain moribund – an indication of their debt hangover from the previous cycle.

This is the difference between your standard economic downturn, and that which is defined by asset deflation and credit contraction. Genuine recoveries take longer to materialise and the risks of multi-dips in the meantime are considerable.

Stock market cycles tend to coincide, more or less, with broad trends in the credit cycle. When people borrow and spend it causes business profits to grow. The businesses then expand; they hire more people and build more capacity. This had been true of the cycle pre-2007.

Then, when the credit cycle turns, everything goes in the other direction. People stop borrowing and begin paying back. Sales decline. Unemployment grows. Profits fall.

We are now in the early stages of a credit contraction. This is not a pause in a credit expansion; it is a change of direction.

The key to understanding the downswing of the credit cycle is that demand contracts. Real demand will increase only when debt has been reduced to more manageable proportions and real wages increase.

In the meantime, governments are trying to fix a debt-saturated economy by piling on more debt. While this has seemingly had the desired effect in the short-term, the question now is whether it is sustainable. Our fear is that it will prove not.

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