Among the current complex mix of global macroeconomic factors, some suggest opportunities while others appear to offer uncompensated risks. As wide and disparate as these may be, we must position portfolios for all of them if we are to avoid the “big mistakes” in our portfolios. That’s a daunting task, and one that requires an alertness to the altered state of the investment landscape and the risks that it brings.
Altered states and financial bubbles
We consider that the world’s financial markets have entered a new state of reality – one of globally managed market conditions. We say “managed” because the most important price of modern markets – the cost of short-term money – is being manipulated. Central bankers are even claiming that they can influence long-term interest rates. All in all, interest rates are being artificially repressed and have been for well over five years. The result is that financial markets today exist inside a fabricated reality. And as we’ve commented in previous articles, the third financial bubble in 15 years is underway.
We agree that this altered reality could last for quite some time. But we disagree that the bubble-ending catalysts can be accurately predicted. They never have been. And the majority of investors have never managed to escape the consequences. Therefore, what must investors do? Risks need to be understood and portfolios broadly diversified.
There have been some recent cautionary signals. For example, the U.S. Federal Reserve Board has committed to further tapering, recently cutting its open market purchases of Treasury and asset-backed bonds to $45 billion per month (as of September 2013, these purchases were as high as $85 billion per month). Some market volatility must be expected, but the Fed and other central banks stand ready to loosen the reins again if risk threatens stability.
Key risks to the outlook
We’ve identified the key factors that could impact the global outlook. The outcome of each is difficult to predict, but anticipating risks is possible. Some of these factor share common roots, but in sum they present quite a diversity of individual and independent risks. The net result? We continue to steer a course between all these risks, and that means we remain diversified with no extreme strategies. Here are the major factors we’re watching:
Emerging markets. Is it time to buy emerging market securities? Their relative valuations are low, and much bad news seems to be in the price. However, we still remain cautious over the shorter-term. Adjustments may still lie ahead. And because emerging markets have driven world economic growth in the past few years, the outlook for emerging markets is a key determinant for economic growth in the developed world.
Broken China? This is a crucial matter for the world as the odds for either near-term acceleration or a further credit unravelling are material. China is the poster child for the over-expansion of lesser-developed nations. It has relied heavily upon credit and debt expansion to drive its economic growth.
End of profit growth. It is accepted economic theory that the higher the share of corporate profits of national income, the lower the economic growth rate must be – eventually. As such, a shift of national income to corporate earnings is self-limiting over time and is a non-sustainable trend. Currently, the corporate share of national income in the U.S. is at an all-time high. This argues that corporate earnings growth will not prove to be the primary driver of equity market gains.
Relentless slow growth. Despite massive intervention and monetary experimentation over the past five years, the world remains mired in slow economic growth. Consequently, central banks will remain in the policymaking hot seat. Given that the implicit “global put” on financial markets has now run for more than five years, the accumulated speculative position build-up and malinvestment will be large.
Financial reforms. Above-average risks remain in global financial systems. Frankly, very little real financial reform has been achieved on any continent. In fact, banking institutions are larger and more concentrated than ever. Ratios of tangible capital to assets of the largest financial firms still average only 4% (according to the Bank for International Settlements). And, the largest banks carry a large volume of derivatives. Global bankruptcy laws have remained unaddressed. The giant U.S. government-sponsored mortgage lenders Fannie Mae and Freddie Mac are still under conservatorship. Europe is still only in the early stages of establishing a common banking regulator. The European Central Bank’s Asset Quality Review (AQR) is underway, and some observers predict a capital shortage of as much as $1 trillion.
Unstable geopolitical environment. The aftermath of the global financial crisis has resulted in the rise of anti-globalism and less multilateral cooperation. Slow economic growth and growing sovereign indebtedness have led to increasingly unilateral actions of individual nations. For example, China must continue its “high growth” strategy. And Russia’s annexation of Crimea was coldly timed to take advantage of global financial instability and weakness. All in all, the bottom line is that geopolitical instability must be anticipated to generate financial volatility and surprise from time to time.
Wilfred Hahn is Chairman and Co-CIO of HAHN Investment Stewards, engaged in top-down strategy, investment policy, and securities selection. He specializes in global investment strategy and ETF trends. This article is excerpted from the April 2014 HAHN Global Wealth Perspectives. You can reach Wilfred by phone at HAHN Investment Stewards, toll-free 1-888-419-6715, or by email at firstname.lastname@example.org.
Notes and Disclaimers
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The foregoing is for general information purposes only and is the opinion of the writer. No guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.