August 2014 marked my 30th year at Sarasin & Partners. Looking back, it seems that some of the trends I saw then might be slowly re-emerging in global markets today.
When I joined in the summer of 1984, US interest rates were around 10 per cent. Today they are 0.1 per cent, the result of the great bull market in bonds which has pushed up rate-sensitive assets such as UK housing. Much wider differences in interest rates across countries were also the rule in the 1980s, and in a world where inflation and growth varied dramatically across regions, the near-zero rates across the developed world today would have been unthinkable. Such regional differences also contributed to greater moves in currency; in my first three years’ work for example, the sterling-dollar exchange rate soared from 1.05 to 1.85, while in my last three years the rate has remained almost unchanged.
Perhaps the biggest difference, though, lies in the emerging markets. Back in 1984, these were wild, politically unstable places, prone to Cold War manipulation. In short, quite unrecognisable from the near-safe-haven status EMs acquired in 2008 as an almighty credit crisis engulfed the West.
The extraordinary economic and market growth then experienced in EMs owed much to the geopolitical stability provided by US global leadership, the firmly mercantilist agenda adopted in Asia, and the advent of the internet, which empowered regional exporters and traders. Today, many of these trends seem to be reversing, meaning that EM growth will slow, national budgets will deteriorate and hard decisions will need to be taken to access capital and foreign investment flows abroad. Thirty years ago, political change and the end of the Cold War were the dividends at stake; today, the EM payoff could be better macroeconomic discipline and vastlyimproved governance.
So, what does this mean for world markets? Though the differences may be between small numbers, the gap between ten-year borrowing costs for the German government and for the US and UK governments is reaching multi-decade highs. Two-year government debt is showing similarly large divergences.
Yes, Germany is running a budget surplus while the US and UK are still running deficits, but the major influence is much simpler: while US and UK recoveries accelerate and markets bet that monetary policy will start to respond, in Germany rates are set for a European economy close to triple-dip recession, and on the brink of Japanese-style deflation. Such hugely different interest rate agendas have not gone unnoticed by markets, and much greater currency volatility is back on the agenda.
It’s rare for the start of a US rate-tightening cycle not to trigger at least some correction in the ‘risk assets’ of the day. This can take the form of increased volatility, tighter liquidity (especially for credit markets) or indeed a simple fall in market valuations. The average price-to-earnings multiple of the S&P 500 has typically dropped from a little over eighteen to just under sixteen in the year after the US Federal Reserve starts to lift rates. Today, though, we are talking of reversing perhaps the most determined easing cycle ever undertaken by central banks, with rates backing up from effectively below zero (when the impact of quantitative easing is included), at least in the US and UK. Simply put, it would be abnormal if some re-pricing of assets did not occur.
In recent years, financial markets have shrugged off the many instances of political conflict. With the US a more reluctant and often absent superpower, governance at the global level is increasingly being hollowed out by regionalism and ad hoc alliances. The geopolitical landscape is rapidly becoming unstable and fragmented and markets appear unconcerned. With a more unstable political backdrop, sovereign risk, and political risk in particular, will likely make a strong comeback, with markets increasingly starting to differentiate on the basis of political risk factors.
In summary, the ‘one-way bet’ for risk assets provided by cheap money over the past five years may now be entering its twilight period. Investors will have to work harder to find growth, and do so against a backdrop where valuations start to work against rather than for them. Asset allocation will need to be more active, currencies better analysed and higher interest rates gradually factored into asset returns. And, in the emerging world, while tougher times are ahead, they might yet unlock the themes of corporate governance and reform, in a surprisingly profitable way.
It all sounds just like 30 years ago.
Guy Monson is managing partner at Sarasin & Partners