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Robin McDonald: Building up cash in the calm before the storm

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Nobody ever lost money by taking a profit. At the very least, we believe that conditions are today in place for equity markets to endure a period of significant turbulence.

That is not to say that weak markets are inevitable, but rather we believe the environment is becoming increasingly tenuous and asymmetric to the downside.

In other words, value has all but disappeared, investor expectations are high, positioning appears crowded and evidence of risk aversion is scarce.

Of course we could be misreading things. Certainly we’re in the minority and time will tell. But one can only marvel at how successful central banks have been at sedating investor anxieties. 

Fighting the Fed has just not been possible so far this cycle. Slowly but surely, even the staunchest of bears have relented.  

To be clear, we are not forecasting a material slowdown in economic growth – although that may follow if markets fall substantially. For the time being we are fairly untroubled by the consensus view that with fiscal headwinds subsiding, real US growth next year could accelerate to 3 per cent real.   

But it is the default optimistic read-through to risk markets that doesn’t sit quite right with us. Let’s say the US is poised to grow at around 5 per cent nominal next year, which is 3 per cent real growth plus 2 per cent inflation. Under that scenario, 10-year bond yields – the global risk-free rate – still look indefensibly low at 2.6 per cent.

Ben Inker’s latest quarterly letter for GMO titled, ‘What the *&%! Just Happened?’ does a handy job of summarising these concerns: “Since 2009 it has been difficult to avoid making money in the financial markets. Nominal bonds, inflation linked bonds, commodities, credit, equities, real estate – everything – has been bid up as a consequence of very low expected returns on cash.  And this gives today’s markets a vulnerability that has not existed through most of history. Today’s valuations only make sense in light of low expected cash rates. Remove that expectation (i.e taper) and pretty much every asset across the board is vulnerable to a fall in price, as the rising real discount rate plays no favourites.” 

Essentially, in spite of this economic recovery being the weakest on record, equity and other risk markets have seen one of the most rewarding advances in history. Colossal fiscal deficits combined with abnormally loose monetary policy – ffinancial repression, predominantly via quantitative easing – have made it so. 

And yet, with the US ostensibly on the brink of escape velocity, we now encounter this stealth valuation risk. How ironic.  

In Inker’s words: ”There is no asset class you can hold that would be expected to do well if the real discount rate rises from here… May’s shock to the real discount rate came not because inflation was unexpectedly high or because growth will be so strong as to lift earnings expectations for equities  and other owners of real assets, but because the Fed signalled that there was likely to be an end to financial repression in the next few years. And because financial repression has pushed up the prices of assets across the board and around the world, there is unlikely to be a safe harbour from the fallout, other than cash itself.” 

Conventional measures of risk aversion indicate a widespread expectation of calm waters ahead. The Vix, for instance, is once again back at the subdued levels of summer 2007.  In response, we have built sizable cash exposure in anticipation of an environment less serene. For once, however, we’ll be very happy to be wrong on this one. 

Robin McDonald is a fund manager at Schroders

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