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Robin McDonald: Worry lines

Fund managers are paid to worry. So at a time when our fellow investors appear buoyant and almost universally optimistic, what is there to worry about?

Today, it is clear that investor enthusiasm for equities is largely based on the idea that the recent recession is over and that the economy will form a V-shaped recovery similar to standard post-war recoveries.

This is evident from a market that has rallied by 60 per cent from its lows, a charitable price/earnings multiple for this stage of the cycle, and
It stands to reason therefore that in the short term, we worry about the complacency of investors towards an overvalued market which is losing upside momentum. It has been much easier this year for governments to stimulate speculative markets than the economy but liquidity can only take you so far. Bull markets cannot be sustained without a durable economic expansion and this rally has already far exceeded the macro fundamentals. This brings us to our medium-term worry – the nature of any recovery.

Recall, this was not a recession brought on by excessive inventories, or by inflationary pressures for that matter. It was a recession that was triggered by excessive debt accumulation and a government’s willingness to tolerate years of excessive risk-taking in the private sector.

Historically, economic recoveries have always been paced by rapid expansion in debt-financed classes of expenditure such as housing, capital spending, and sustained (not just cash for clunkers) demand for automobiles. But these drivers of economic growth that existed in typical recoveries – debt origination and consumption growth – are very much compromised at present. Hence, central banks are following a doctrine of massive government-led monetary reflation and debt creation as the answer to this secular consumer deleveraging cycle.

We may well be in for a quarter or two of positive gross domestic product growth, courtesy of such unprecedented intervention into the real economy and capital markets. However, to assume that because investors have managed to take the stockmarket up 60 per cent from the March lows, the economy is about to embark on a sustainable growth phase is to ignore the history of what really happens in a post- credit-bubble environment.

During this private sector delever- aging process that began two years ago, governments have taken it upon themselves to not only stem the reversal in the unprecedented rise in the level of national debt relative to GDP but actually to push the ratio further into the stratosphere to new all-time highs.

The degree of their largesse has been so massive, that in the longer term, it will inevitably have profound negative implications for the holders of most risky assets – together with government bonds – when this debt has to be repaid. These risks remain outside of investors’ timeframes at present. They will not remain so indefinitely.

Robin McDonald is a fund manager at Cazenove Capital

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