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Richard Buxton: Goldilocks, two bears and a bull

The global economy currently appears “just right” but how long can that continue?

Buxton Richard Old MutualFor much of 2017, the stockmarket could have been likened to the character of Goldilocks; the little girl who, after some difficulty, eventually found her perfect pot of porridge. One that was neither too hot, nor too cold.

A combination of gently rising economic growth, buoyant
labour markets and (to the surprise of many) low inflation has, thus far, translated into a global economy that appears “just right”.

China’s growth ticks along nicely, Europe is no longer the sick man of the world economy (Brexit induced uncertainties aside) and US data points to gently rising economic growth.

But the question for many is this: for how long can the Goldilocks era continue?

Investors know market-moving events can alter the temperature of the porridge at any given moment. How will markets react to a shrinking of the US Federal Reserve’s balance sheet? Is the stimulus instigated by the Chinese authorities finally coming to an end? Is the Phillips curve (the chart that plots the relationship between rates of unemployment and corresponding rates of inflation) dead or temporarily buried? Inflation, after all, is a key driver of bond markets, which in turn drive equity markets. While these unknowns hang in the balance for now, let us return to the storyline.

Enter bear the first

The pronounced performance of growth stocks at the expense of value stocks has been a recurrent theme ever since value stocks reached their peak in 2007, and a particular hallmark of 2017.

In the UK market, it is typically expressed as the gap between consumer staples (the likes of Unilever, Reckitt Benkiser) and growth stocks (Sage, SSP) on the one hand, and value stocks (Barclays, BT and utilities and unloved domestic retailers) on the other.

Those with long memories will know that the last time there was a material unwind of this growth/value skew was the bursting of the tech bubble in 2000-2003, where the rotation from growth to value was particularly vicious in nature and short in duration.

Of course, the conundrum for today’s investors is for how long can the current dispersion continue? And what form will it take? It might be that the dispersion unwinds slowly over time.

It might also be that there is no incremental buyer for value stocks. The clue is in the name. Cheap stocks often remain cheap for a reason. But that does not mean it will not happen…

Enter bear the second

So to the second bear, the keeper of the yield curve. With more US interest rate rises on the horizon, short-dated bond yields, unsurprisingly, continue to rise (although my second bear, being more of a procrastinator than the first, is unsure if UK interest rates should rise further anytime soon).

Meanwhile, longer-dated yields – those with maturities of 10 years or more – refuse to budge. The yield curve looks decidedly flat.

So, what is the presence of this bear telling us? Traditionally, flattish yield curves have, though not always, presaged a slowdown in growth. This time round it could, of course, be different.

We know incremental rises in interest rates are a function of a return to more normal economic conditions, hence short-dated yields should be rising.

But we also know that once central banks taper their bond purchases, supply will become more readily available and yields should, in theory, start to rise. So why is this not happening?

Timing is everything. Just as it has taken years of central bank largesse to kick start the global economy, similarly it could take years for this stimulus to unwind. Do not expect bonds to yield nominal GDP (real GDP growth plus inflation) any time soon.

Of course, the counter argument to that is that bond yields could rise more sharply if we get a rogue inflation figure. Europe’s largest trade union, IG Metall, has just asked for a 6 per cent pay rise in recognition of “excellent economic conditions”. And, referencing growth in technology, not since the 1930s have we had such slack
in the economy. But that gap could soon start to narrow and inflationary spirits be rekindled. The Phillips curve could be alive and well, after all.

Enter the bull

As an investor, it is all too easy to obsess over short-term problems: Trump, Brexit, monetary tightening and so on. The longer-term perspective becomes completely obscured. So to end on, above is a chart of why my story contains only two bears and one rather large bull.

It is an 80-year logarithmic chart of the S&P 500 index. The years 1936-1950 and 1968-1982, which mark the periods between a bull market peak and the next time the index exceeded that peak, were followed by 18-year bull markets in 1950-1968 and 1982-2000.

During those periods, the S&P 500 index ratcheted up gains of 400 per cent and 1400 per cent respectively. The last time such an event occurred was in 2013, when the S&P broke through the previous peak of 1550.

The dotted blue arrow in the top right corner is a copy of the solid orange arrow which marks the 1950-1968 bull market. It takes us to 2031 and an index level of 8200. It seems my story has a happy ending after all.

Richard Buxton is head of UK equities at Old Mutual Global Investors

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