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Impact Investing

IPE special report May 2018

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Is history quietly repeating itself?

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With the system already as heavily leveraged as it was in 2007, markets are hanging on every word from Ben Bernanke. Dan James thinks this only adds to the feeling of déjà vu

Those who forget the lessons of the past are often condemned to repeat the same errors. Today, economic hope exceeds business reality. We assume that things will rebound simply because they always seemed to before. This, of course, wasn’t true in the 1930s and has now not been true for almost three decades in Japan. Looking ahead, a Japan-like outlook with sideways, volatile markets in risk assets, punctuated by sharp sell-offs and short-lived relief rallies may become the ‘norm’. With this in mind, even at today’s skinny yields, bonds look attractive.

Markets now hang so disconcertingly on Ben Bernanke’s every word that, last month, the clumsily handled news that the Fed committee could decide to reduce its monthly QE bill at the “next few meetings” if the economy looked strong enough, was sufficient to send markets into brief apoplexy. But there’s a world of difference between what the Fed will sensibly do, if and when the US economy is robust enough to stand on its own two feet, and what the current prognosis requires. Indeed, Bernanke is only too aware of the “significant headwinds” led by government austerity and disappointing news on unemployment.

There’s also the clear (and familiar) risk that cheap money leads to asset-price bubbles – the recent strength of the US property market has disquieted many – but after Bernanke’s warning that a “premature tightening of monetary policy could lead interest rates to rise temporarily” and that this could subsequently derail any recovery, the risk of the US curtailing QE this year looks remote.

For now, this is just as well, as our research clearly shows that the economic fundamentals stopped being the primary driver of global markets back in 2008. Since then, the central banks have carried the show.

We can show this by demonstrating the effect that the balance sheet extension by the major central banks has had on major risk assets. Thanks to the global hunt for yield set in motion by central banks, we’ve already seen a compression wave sweep right across investment grade and into the high-yield and emerging debt space.

Fundamentals haven’t supported risk assets for almost five years and there’s little to justify the recent record highs in the S&P, the FTSE or the Topix, except for the good intentions of central bankers. Chinese PMI looks worryingly weak and loud concerns are being voiced about an overheating property market and bad loans in the banking system. Although the dust has settled since a bailout was agreed for Cyprus and the European Central Bank (ECB) cut rates again, the euro-zone remains one sovereign crisis away from meltdown – and there’s no shortage of likely candidates.

Meanwhile, although Japan’s stock market may have benefited from ‘Abenomics’, the offensive against deflation rests on a $1.4trn capital injection – sufficient to double Japan’s monetary base and a similar commitment to that of the Fed for an economy barely a third of the size of the US.

The big question is how much longer the QE super-theme can run. With only three central banks large enough to drive global markets in a meaningful way and the US and Japan already ‘all in’, the ECB holds the last silver bullet. Unlike its counterparts, it still has the means to open the floodgates.

Perversely, this means that two of the biggest investment risks facing pension scheme investors right now are the threat of a sustained global downturn which comes once central banks are finally tapped out, or the threat of a concerted global recovery, which results in central banks cutting off the supply of cheap money and raising interest rates.
The withdrawal symptoms that result from the latter are likely to be so great they overshadow any benefits from more robust growth.

We expect to see circumstances requiring the ECB to empty its last chamber, so we may well see markets making one more volatile lurch forward. This is likely to be the point that risk investors start to get off the bus and why we’ve been immunising our portfolios by buying market volatility and hedging further upside in our equity and bond portfolios.

We think the time has come to trade in some of the future upside in exchange for protection from whatever version of events eventually unfolds. With volatility remaining subdued for so long, the price of such umbrellas is currently quite low. Of course, by the time risk investors decide that the QE sunshine has come to an end the price of umbrellas will have risen well beyond the means of most investors.

Dan James is head of global markets at Aviva Investors

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