Financial markets are undergoing a paradigm shift: André Huwler, Chief Investment Officier at Andbank, explains why in this week’s „Monday Analysis“ and how to react to it.
Why are market commentators, seers and investors so terribly slow adapting to new regimes?
All truth being told, this is mainly down to something known as „career risk“. We explain. We all are inclined to take the consensus, least risky view, i.e. we prefer to err on the safe side. For example, should we today go against the consensus and recommend buying the Mexican Peso, now that it is so obviously undervalued? Well, maybe that’s a darn good idea. Should we be right, we may get a good old clap on our shoulder from our clients and probably no specific recognition from our employer. However, should it go wrong, our clients will not hesitate to point out how we could have recommended something that obviously could only go wrong. After all, the outcome was written all over the WALL (pun absolutely intended)! One or more accounts will close, bonus is cut, warnings are given, etc. This explains in very large parts, why we (actually them, not us) are so slow in adapting our views. It is better to follow the herd, even though the waterhole may be in the opposite direction.
Ok, so what is our point?
Our point is that it took investors nearly 35 years to discover the tremendous bull market in bonds. For example, since beginning of this millennia, boring, boring bonds have outperformed stocks by a wide margin with much lower volatility. It is in our vivid memory, that investors in the aftermath of the Global Financial Crisis (2007-2008), did not recognise that the massive debt overhang would lead to ever lower rates and that central bank activity around the globe would only even more pronounce that process. Only in the past few years, did the consensus suddenly come to believe in „lower for longer“, which refers to the recognition that interest rates are not going to move up in the medium- to maybe even the long-term. Though as real yields (yield minus inflation) dropped into negative territories for many major economies (e.g. USA, UK, Japan, most of Europe, etc.) investors continued accumulating fixed income assets and started looking for second tier substitutes. The acronym TINA („There Is No Alternative“) gave investors the perfect excuse to pile into high yielding stocks, smart beta and minimum variance strategies and, worst of all, hope for further capital gains on their negative yielding bonds.
So where are we now?
We at Andbank Luxembourg believe that we are in the early stages of a reflation/inflation period, which will push interest rates higher than widely expected by the market today. The quantitative easing program introduced by the US Federal Reserve bank has finally caught traction, and US yields have started moving higher, putting pressure on the US Federal Reserve Bank to increase rates, in order not to fall further behind the curve.
But what if the real growth (inflation) surprise lies in Europe?
We Europeans, with a natural hang to see the glass half empty, could be in for a big growth surprise. The ECB is five lightyears behind the curve and may be faced to wind down their quantitative easing program and start raising interest rates sooner than expected.
Where should this growth come from?
We do not know for sure, though what experience tells us is that a small snowball starting to roll down the mountain can turn into an avalanche of massive dimensions. The signs of growth we are currently seeing are arrogantly wiped of the table by the consensus with the argument that the base effect (oil, an important component in inflation calculation, was roughly $30 a year ago and is now trading above $50, so year-on-year comparison shows strong pick-up in inflation) will fade away in a few months. Perhaps. We do not think so.
Hence, what allocations do we recommend?
Start underweighting bonds, keep durations short. In the equity space, give preference to European equities. Don’t be short the EUR versus the USD.