Direction of Change

 (Photo : NN investment partners)

(Photo : NN investment partners)

A lot of things have been improving in recent years and as a result the global economy is now in its best state in more than a decade. And markets have noticed, and adapted. Asset prices currently reflect a much healthier outlook for global growth and corporate profitability than a few years ago. Until the February turbulence, markets also kept on indicating that things continued to improve. As a result, risky assets and especially equities continued to rise.

Over the last couple of weeks, the question has emerged whether we have reached a level in prices that embeds most of the good news. And whether there remains enough additional momentum in the positive news flow to stimulate a renewed rise in global risk assets.

To make an assessment on this critically important point from an asset allocation perspective, one first has to appreciate how a market organism develops over time. It is my strong belief that markets are not necessarily rational all the time, but that they are nevertheless very smart. The collective intelligence of the crowd of investors that compile a market knows very well that both the underlying economy and the market ecology itself are complex systems. The complex nature of an ecology full of mutually influential “agents” (as economists call them) and feedback loops creates inherent uncertainty about the future shape of that system. Actual uncertainty makes it impossible to exactly measure or “know” probabilities about possible future states of the world.

The combination of this uncertainty about the future and the continuous flow of new information forces the market system to continuously adapt. It means that investors have to stay “open” in their thinking about the future. The likelihood of an assumed future is hard to trust and new information might push the system into another self-enforcing direction. As a result, the future of complex systems is very path-dependent and not determined by an equilibrium that can be mechanically determined. Therefore, it is much more the direction of change rather than the level in both fundamentals and investor convictions and behaviour that drives asset prices and sets the tone for the evolution of markets.

And, as said, many of these market drivers have been changing for the better in recent years. Macroeconomic data, earnings reports, the stance of monetary and fiscal policy, political risks, investor sentiment and capital flows all have been remarkably well-aligned over the last 12 months. And despite the fact that nothing was perfect over this period, the fact that all those metrics were basically moving in the right direction caused markets to keep on moving up.

This is exactly what might have started to change somewhat. Not to the extent that it will really undermine the global synchronized recovery, but maybe enough to alter the risk-return balance for risky assets. The announcement on steel and aluminium import tariffs by the US government has shifted the risks around global trade policy downwards. At the same time, little additional support from policy seems likely to come around. Central bank support is gradually peaking out, with the Fed getting more confident on its rate hiking path and the ECB getting closer to the end of its QE program. Furthermore, additional fiscal support is hard to find now that the US tax cuts are behind us. Moreover, one has to wonder how effective fiscal policy can still be at this stage of the cycle as “crowding out” risks are (finally) more realistic again.

Maybe even more important is that leading indicators of the global business cycle (like PMIs or business and household sentiment surveys) are showing a first serious sign of rolling over since the middle of 2016. Also, economic data releases have started to struggle to beat ever-optimistic expectations and corporate analysts have stopped upgrading their expectations for future earnings growth in most regions.

None of this takes away the fact that the global economy is doing so much better than we have seen in many years. For markets, however, that is now becoming old news and the power of this observation to lift markets further has probably weakened a bit. In a complex and uncertain world, it is also difficult to extrapolate too strongly on the back of the recent and limited information on the policy, macro and earnings front.


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