The performance of equity markets since mid-February has been simply stunning. Against a backdrop of dramatically weaker corporate earnings, weak economic growth and simmering macro concerns, risk assets have barely missed a beat in their march higher. Markets have been in a Goldilocks period, whereby the important drivers of the day are neither too hot nor too cold. For markets, the broad level and volatility (mostly lack of) of oil prices, interest rates, inflation, economic data and the US Dollar have been just right, with a great big dollop of central bank support obviously helping. When we consider the macro fundamentals and the most likely outcomes, we do not see the Goldilocks period continuing for that much longer. Something will change and probably soon.

We often read research that we wish we had written. This week, the blog “NorthmanTrader” wrote a commentary called “Feeding the Monster” which uses a great analogy which we wish we had thought of (see link at the end). In their note, the monster is Cerberus, which they describe as “the hound of Hades, a monstrous multi-headed dog who guarded the gates of the underworld, preventing the dead from leaving.”

The situation with Cerberus is described as, “Today central banks have taken on the role of feeding our own modern version of Cerberus to keep all the troubles away. Ever since the 2008/2009 financial crisis Cerberus has been chained to a wall, but he’s pulling and he’s growling and he’s demanding ever more attention. But in the process of feeding Cerberus with ever lower rates and stimulus central banks keep making him stronger and fiercer and ever more aggressive. But worse, central bankers are running out of food to feed the monster.” Regular readers will understand we have a lot of sympathy with the Cerberus analogy.

In our opinion, there is a significant battle brewing in markets. On the one hand, central bankers continue to do and say whatever it takes to keep markets from falling over. However, they are beginning to lose control. Global economic growth continues to struggle against serious headwinds that we have written about often. NorthmanTrader talks about Debt, Deflation and Demographics to which we would add poor productivity and record inequality (see our notes on demographics here and productivity here from late last year).

Thinking about the looming battle, we would actually say that this is part of a war that has been ongoing for nearly two years now. Financial markets bottomed in early 2009 and started a very impressive recovery bolstered by near zero interest rates and QE in the US and UK. Whenever cracks appeared, notably in 2011 and 2012, the Fed simply cranked up the printing press and hey presto, markets went roaring higher.

However, as the Fed began to unwind QE in 2014 and equity valuations reached obscene valuations, broad measures of equity markets, such as the New York Stock Exchange Composite and the MSCI World Index made an initial peak in the middle of 2014. With continual stimulus from Europe and Japan and verbal support from the US, markets made a secondary peak in the Summer of 2015. However, no net progress has been on these equity measure for two years.

The opposing forces have broadly offset each other for two years now, and it feels like we have reached a point in time when the status quo will change. At some point, Cerberus will become unshackled and will devour poor little Goldilocks.

Chart 1 – The MSCI World Index and the New York Stock Exchange Composite

So what could possibly upset the temperature in Goldilocks’ perfect world? There are some major structural issues to overcome. Demographics, debt and deflation along with poor productivity and income inequality are absolutely leading to what many refer to as secular stagnation. In the shorter term, the list of worries also includes:

• Can the US economy grow fast enough to allow companies to grow their profits but not too fast so that the Fed will have to raise interest rates
• Can companies continue to leverage their balance sheets to engage in unprecedented financial engineering
• Can wages grow fast enough to support growing consumption but not too fast so as to hurt corporate profit margins
• Can the oil price rise enough to avert crises in Russia and Saudi in the next few years without causing too much inflation
• Can the US Dollar remain stable enough so as not to cause trouble for Emerging Markets in particular, whilst Europe and Japan maintain stable to slightly weaker currencies
• Can China maintain a stable exchange rate and not devalue which would cause a deflationary wave to cascade around the world
• Can Europe maintain control in the face of angrier voters, weak banks and the risk from Brexit
• Will the UK vote to leave Europe
• Will investors continue to buy into central bank policies of ZIRP/NIRP and QE
• Can Japan turn around the failing Abenomics experiment

You’ll be pleased to hear that we don’t have time to cover all of the above issues this week. All of the above are important in their own right and I am sure we will discuss most of them in the next few months.

The thing that we would most like to be able to predict is the exact time that Cerberus becomes unshackled. Unfortunately, although we feel confident in our view that there really is no asset class out there that offers good value, we do not know what will be seen in hindsight as the trigger for falling prices. What we do think will happen is that as prices will fall, investors will begin to sell first and ask questions afterwards. We continue to believe that the selloffs seen in late 2014, Summer 2015 and early this year are simply a foretaste of what lies ahead. In coming weeks, we will refocus on events that we believe are important and could easily trip up markets. For the here and now, we can only wonder how long Goldilocks has left before Cerberus breaks free.

Link to the NorthmanTrader post.
https://northmantrader.com/2016/04/12/feeding-the-monster/

Stewart Richardson
Chief Investment Officer