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Three market scenarios, including a 30% fall

We are cautious about global equity markets at present and running a defensive portfolio. This is because we face an extraordinary cocktail of circumstances that skews risks to the downside, including:

  • Asset prices are at, or near, record levels

Prices for sovereign, corporate and high-yield bonds and equities are at, or near, record levels thanks to the ultra-low policy interest rates and the massive quantitative-easing programs of the G3 central banks (the US Federal Reserve, the European Central Bank and the Bank of Japan) over the past decade.

  • Central banks have commenced quantitative tightening

In response to the strengthening economic environment, the Federal Reserve is raising the cash rate and has commenced a pre-set programme to shrink its balance sheet while the European Central Bank has announced that it will cease its asset buying program by 31 December 2018. The combined impact of announced balance sheet activities of the Federal Reserve and the European Central Bank will remove liquidity from global markets, resulting in a reduction in demand for bonds and other assets by these central banks of about US$1.5 trillion on an annualised basis from October 2017 to the end of December this year. We believe that a change in demand by the central banks of this magnitude is likely to have a meaningful impact on longer-term bond yields by early 2019.

  • Late-cycle US fiscal stimulus

In our view, the Federal Reserve’s strategy to tighten monetary policy in a smooth and well-foreshadowed manner has been complicated by the large fiscal stimulus being implemented by the Trump administration at the tail end of an extended economic expansion. The tax cuts and additional spending will make a fiscal injection into the US economy of nearly 2% of GDP per annum for the next two years. The US unemployment rate at 4% is near an 18-year low and the US economy has added jobs over the past 93 months, which is the longest such consecutive stretch on record. While there appear to be powerful longer-term secular forces at work that are likely to result in low inflation over the longer term, there is a significant risk that the size and timing of the US fiscal stimulus could trigger a jump in US inflation, in particular from stronger wages growth, over the next year or two. This could be highly problematic for the Federal Reserve and complicate its efforts to engineer a gradual tightening with a soft landing. We cannot think of a similar combination of circumstances in modern history. The cocktail of circumstances could be explosive. The best hope for investors is that either the US tax cuts and extra spending have limited effects on growth and inflation in coming years or the secular forces that have kept inflation low accelerate to offset any inflationary pressures from the fiscal stimulus.

The possibilities of three scenarios

We assess that there are three possible scenarios for markets over the next 12 to 18 months:

  • The first scenario is a continued US economic expansion without triggering a material increase in US wages growth or inflation. In these circumstances, we would expect the Federal Reserve to increase short-term interest rates and to shrink its balance sheet broadly in line with current expectations. In these circumstances, it would be reasonable to expect that over the next, say, 18 months the US cash rate would rise to 3% to 3.5% and the 10-year Treasury yield would increase to about 4%. In this scenario, defensive equity assets, longer-term bonds and emerging-market equities are likely to underperform growth assets and economically cyclical assets, and some commodities are likely to outperform driven by the economic expansion. We would place slightly less than a 50% probability on this scenario.

  • The second scenario is where the Federal Reserve is forced to act more swiftly and forcefully than expected to counter inflationary forces. It would be reasonable to assume that US longer-term bond yields could jump suddenly and meaningfully (above 4% compared with 2.86% for the US 10-year Treasury bond at the end of June), which could trigger the biggest slump on world share markets since the global financial crisis. In our view, a 20% to 30% global stock market correction in the next 12 to 18 months is conceivable. In these circumstances all equities are likely to be affected. We would put a similar probability on this scenario to the first or, in other words, we don’t know which of these two scenarios is more likely.

  • The third scenario is where an external event occurs that causes the Federal Reserve and the European Central Bank to reverse course and put on hold any further tightening of monetary policy. We believe that this is most likely to occur in circumstances of a significant event and, therefore, this scenario is likely to be negative for share markets. There is a remote possibility of a ‘Goldilocks moment’ where the central banks stop their plans to tighten money policy, longer-term bond yields fall and equity markets don’t fall or even rise.

While global stocks have set record highs over the past 12 months, we are cautious on the outlook for equity markets and consider that risks are asymmetrical to the downside. Our caution is reflected in the defensive positioning of the Magellan Global Trust with cash at 30 June 2018 representing 21% of the portfolio.

Conservative investors sleep well

Some people might consider that having such a large cash holding exposes investors to underperformance if equity markets rise. We have no fear of missing the tail end of an extended bull market. Renowned investor Sir John Templeton was perhaps best known for saying:

“Bull markets are born on pessimism, grown on scepticism, mature on optimism and die on euphoria. The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.”

In our view, only conservative investors sleep well. Implicit in conservative investing is the focus on the conservation of capital. As Warren Buffett has said, there are two rules in investing: 1. Don’t lose money. 2. Don’t forget the first rule.

 

Hamish Douglass is Chief Executive Officer and Chief Investment Officer at Magellan Asset Management, a sponsor of Cuffelinks. This article is general information and does not consider the circumstances of any investor.

For more articles and papers from Magellan, please click here.

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