Peter Oppenheimer, Chief Global Equities Strategist, article in the Financial Times - Bear Necessities: Low inflation keeps risks of a bear market in check
Peter Oppenheimer, Chief Global Equities Strategist, published this article in the Financial Times, 5 OCT 2017
Bear Necessities: Low inflation keeps risks of a bear market in check
For several years after the start of the financial crisis of 2007, deflationary fears accompanied a persistently weak recovery in the global economy. Central banks responded, aggressively cutting interest rates and commencing Quantitative Easing (contributing to further yield compression). While global growth finally started to recover about a year ago, and has since broadened out, inflation has remained steadfastly low and in most cases below central bank target rates.
Structural factors, including the impact of technology, demographics and globalisation, are often put forward as explanations for the ongoing disinflationary pressures in the face of stronger growth. Whatever the reason, the lack of inflation has enabled central banks to keep interest rates at record lows. In the UK the official bank interest rate remains at 0.25% (the lowest rate since records began in 1694). The rate at which governments can borrow money is close to recent record lows and demand for ever longer dated debt continues to be strong. Austria recently issued a 100-year bond with a yield of a little above 2%.
In search of income, investors have been forced to buy riskier assets which, in turn, pushed their yields down and prices up. High yield European corporate bonds are now yielding on average less than the dividend yield on equities for the first time. But equities, too, have enjoyed the benefits of lower interest rates. The US S&P Composite index has increased a staggering 340% in total returns since its low in 2009 shortly after the start of QE. As with other asset classes, higher valuations have played an important role. The price/earnings ratio for the US equity market has driven nearly 40% of the return since the 2009 low. In Europe, where profits have been even weaker, valuation expansion has explained roughly 75% of the return in the benchmark (Stoxx600) index over the same period.
Should investors take cover and reduce risk now for fear of an imminent bear market? Probably not, according to our recent Global Paper, `Bear Necessities’ on lessons from history for identifying signals of the next downturn. Selling too early can be as costly as being late. An investor who sells the equity market just three months before its peak misses about the same amount (roughly 7% on average) as an investor would lose in the first three months of a bear market. Recognising the conditions that change the longer trend of returns is more important than trying to time the peak. Taking data back to the early 19th century in the US suggests there are different types of bear market that reflect the conditions that drive them. Bear markets may be classified as ‘Cyclical’ – generally triggered by higher interest rates and fears of an economic and profit downturn, ‘Event driven’ – triggered by a one-off shock (such as rising geopolitical tensions), and ‘Structural’ – a function of major economic imbalances and asset bubbles. Event driven bear markets can occur at any time but tend to be short and sharp. At the other extreme, Structural bear markets are long and deep, with average falls of around 50% and taking more than a decade to recover. Cyclical bear markets are somewhere in between, with average falls of around 30% and returning to their starting level after around five years.
Fortunately, many of the imbalances which preceded 2008 have since unwound or been shifted to the public sector, reducing the risks of a Structural bear market. Cyclical bears normally require a combination of conditions. Some of these, such as full employment, strong growth and high valuations, are currently in place in some countries. But rising inflation remains elusive. Market prices continue to reflect a low risk that interest rates will increase enough to trigger a recession in the near future.
This makes inflation expectations key to the prospects for financial assets from here. If prices in the real economy finally start to rise, interest rates would no longer be sustainable at current levels, causing a cascade effect. This could reverse the pattern of the past few years. Just as record low interest rates fuelled financial asset price inflation during a period of general disinflation, rising prices in the real economy could push down prices across all financial markets. In the more likely absence of any serious rise in inflationary expectations, we should still expect the returns across financial assets to be much more subdued moving forward as high valuations, coupled with the gradual withdrawal of QE, weigh on returns. Within equities, the gap between relative winners and losers is likely to become a more important driver than the rise in the broader index.