16 Jan 2018


“The stock market will fluctuate” - J. P. Morgan

First, our usual caveat.  We aim to achieve solid returns by investing in great or obviously cheap (preferably both) companies and the holding them for however long it takes for their long term intrinsic values to be realised.  We do not invest on macro themes, rather we consider them when constructing our portfolios to mitigate any potential risks that they might contain. 

This is what our crystal ball is showing us.

There is a good chance of a market correction in the near term.  Markets generally fluctuate.  As discussed earlier, the S&P 500 and the S&P/NZ50 both posted positive total returns in every month of the calendar year in 2017.  In November 2017, Deutsche Bank noted that the duration of this equity rally, without a typical 3-5% pullback, is on track to become the longest since WWII. This benign environment is most unusual and will come to an end at some point.  History suggests that point is close.

However, it might not be the end of the bull market.  While the Fed has started reducing the pile of the bonds it acquired after the financial crisis, the net level of central bank bond buying is still positive when you include Europe and Japan.  Consensus expectation is a move to net bond selling by these central banks by some time in 2018 but a deep correction might change that.  The QE taps might again be opened, keeping liquidity high and real interest rates low.

Perhaps one more buy-the-dip success might just create an orthodox, euphoric end to this bull market.  That could mean that markets have further to rise before they fall.  Moderate inflation, strengthening global GDP numbers, falling bond prices (as nominal yields rise) and equity perma-bear capitulation might create the final euphoric bull market rally that has so far been missing.

In our opinion, only inflation will permanently close the QE taps.  And, initially at least, some inflation is likely to be viewed as positive.  It will only be when investors fear that it is getting out of hand that it will be considered negative.  We continue to believe that inflation expectation is a key metric to watch.

This would be, in our opinion, a nirvana financial outcome.  Provided inflation doesn’t get totally out of hand debt will be steadily sunk by the rising tide of prices and incomes.  It will still be unpleasant, and it will probably result in a bear market, but it won’t be as unpleasant as a deep recession.

New Zealand has participated fully in this global bull run and there is no reason to believe it might decouple soon.  The new Governor of the Reserve Bank, Adrian Orr, is unlikely to disappoint and the economy is in good shape.  Currency strength may surprise if the world continues with quantitative easing. Key metrics to watch for New Zealand are net migration and global inflation.

While this is our base case scenario, investors must keep in mind the fragility of financial markets due to elevated debt levels and the imbalances created from the very low interest rate environment.  This means that even a small financial shock might create a financial avalanche.  And there are plenty candidates for shocks; trade wars, central bank tightening, Brexit carnage, North Korea, China turmoil … take your pick.

About the only thing we can truly be certain of is that markets will fluctuate.