‘Return of the Mack’– Mark Morrison

11 October 2018

After a historically benign 2017, this year was always likely to see a return of volatility and over the past few days we have seen some pretty broad weakness across equity markets. So what is going on and how should we react? A cursory read of the business section of any newspaper or a quick look at financial media will tell you that investors are worried about rising bond yields and trade.

Tackling the rise in bond yields first, we should be thankful not morose! Rising bond yields suggest that all that talk of ‘secular stagnation’ a few years ago was ‘off the mark’, bond yields are going up because economically the world is a better place. Some commentators are starting to offer stark warnings about rising wage pressures and inflation, to which I respond what splendid bubble do they live in? 
 
Sure higher wages might impact corporate margins in the short term and this may provide a challenge in certain markets but one of the great challenges of the current era has been the rise in inequality and isn’t in better than more people participate in the growth of the economy and won’t this support revenue growth? Don’t we want more inclusive growth? 

Now I am not ignorant to the fact that higher bond yields and inflation are characteristics of a maturing cycle and some will point to the fact that we are getting closer to next recession. Well, we are by definition closer to the next recession, in the same way that I am closer to my end. Like myself this economic cycle is not immortal and we will have another recession but the indicators we look at are not flashing red. Of course the future is unknowable, so we can’t be definitive but the balance of probabilities suggest both this cycle and I have some time left. We are, therefore, not particularly concerned by the rise in bond yields but recognize that after a period of historically low rates some market ‘digestion’ is quite understandable. 
 
Turning to trade, this is more difficult to assess. However, it is interesting to see the US reach agreement with Canada and Mexico recently. Indeed, the relatively quick resolution of this negotiation lends further weight to the argument that the dispute with China is about much more that the trade deficit. This is a battle for economic supremacy, with the incumbent power seeking to check the ambitions of the new pretender. 
 
This suggests that US/China tension is not going away any time soon and it is something we will have to get used to. In the short term the negatives are obvious, as supply chains are potentially disrupted, but we believe it would be foolish to offer a definitive view on how the relationship will evolve. For example, maybe heightened tensions will lead to competitive investment between the nations. 
 
So where does this leave us? Well firstly the bigger declines in equities tend to be set against a backdrop of recession and falling earnings, we don’t see this today and don’t believe it is likely. Secondly bond yields are going up for good reasons and on balance monetary policy is still supportive, suggesting the market is simply adjusting to a better economic environment, causing volatility in the bond market and temporary losses in the equity market. Thirdly, many markets have already experienced notable falls, with emerging markets down over 20% since their 2018 high, so the US/China trade dispute is at least partially priced in, with emerging market valuations looking attractive on pretty much all long term valuation analysis. 
 
Turning to how we should react. Well to state the obvious market drawdowns should be viewed as a gift for long term investors and history tells us that investing in a sensible way during periods of stress will be rewarded. We will never attempt to predict the short term but I can certainly say that we are looking for opportunities right now. 
 
As ever, please do not hesitate to contact us to discuss our views further.