“There are things known, and there are things unknown, and in between are the doors of perception.” Aldous Huxley
There are times when one has set out one’s stall, and it is right to wait and see what transpires. Readers will know that CheckRisk has warned of the change in short-term risk relative to long- term risk. With shorter term risk ameliorating while the long-term risk outlook is deteriorating.
The short-term risk perspective is more benign than most observers believe as a result of positive liquidity actions made by central banks. Increasing liquidity has become the single most important tool in the tool box for central bankers. It has been used so often in time of crisis that it has be- come an extremely predictable reaction to stress. The strategy can only work for so long, however, for the moment CheckRisk believes it will result in equity markets resuming an upward trajectory to year end. Naturally, there will be some hiccoughs along the way. The labour report in the USA released on Friday is one such blip.
This week, having set out the stall, CheckRisk is going to focus on two things. Bits and pieces that either confirm or deny our views and secondly, why the longer term outlook is such a critical period.
What could possibly go wrong?
Confirming or denying a view as time rolls on is one of the most significant risk functions imagi- nable. We often see Trustee Boards, and Investment Committees becoming wedded to a position that is clearly wrong. It is not that the original position was incorrect it is just the failure to adapt. If you are a member of an investment committee ask yourself honestly now, how often have you changed an original plan midterm? The answer, for most people, is very rarely indeed. In fact, plans only tend to get changed as the result of a greater crisis. In other words when we are forced. Reacting to short-term events is a suboptimal approach, and there is a better way to approach the changing risk environment.
The first step is to establish how long the investment plan that has been put together is meant to last. This can be as long or as short as desired. A pension fund may have a ten-year strategic goal, with bi-annual target markers that must be achieved for the plan to be considered to be on track. Other funds may only look out one to three years others still shorter.
The next step having established the plan is to create the target “marker” dates. These are mark- ers that formally verify if the performance target set by the strategic plan is being met or not. They should impede further progress if performance is behind goal and act as a call for a wider strategic review. Falling behind a strategic objective requires a challenge to change the approach or a justification for sticking to it.
In between the marker points, there should be a shorter term tactical asset allocation approach, even for longer-term funds. CheckRisk is convinced that the investment industry, for the most part, has put the cart before the horse. In this example, the cart being investment returns and the horse being the engine of returns that we define as risk. By placing risk in its rightful place, a different approach can be adopted, that of investing for risk. This approach recognizes that an asset or market can only provide a set amount of return for the risk taken at any particular point in time. Sometimes that return will be double-digit growth at others low single-digit or even negative returns. There is little point setting a long-term strategic return and then assuming that the performance profile to achieve that goal will be linear, it is simply unrealistic to expect such an approach to work.
Having a tactical approach has two big advantages and no discernible disadvantages. The first benefit is that a tactical approach forces a regular review of the strategic plan against the risk profile of the current risk environment. In other words, it overlays a pragmatic approach onto a longer term profile. The second benefit is it places risk as the driver of returns, allowing for both the derisking and taking on more risk when appropriate. There are no disadvantages because with a tactical risk approach it is perfectly allowable to make no changes if none is required.
Having set out the stall, it is important to consider the bits and pieces that may change one’s view. As far as CheckRisk’s stall is concerned there are two recent news items that we believe are necessary to consider. The US labour statistics and capital outflows from emerging markets, these two items are naturally inextricably linked.
Bits and Pieces
The US Labor Department said that 142,000 jobs were created last month following a revised increase of 136,000 a figure lower than the original release. Median estimates, according to a Bloomberg survey had been 201,000. The release makes it tough for the Fed to raise interest rates in 2015. CheckRisk has held the view that it was more likely to occur in Q1 of 2016. That being said it now looks like the best of the year in 2016 will be in the first half. The Fed will be acutely aware that the global economy is likely to slow then as the natural consequence of the global business cycle, inventory cycle and the need to raise interest rates collide. It is entirely possible, indeed CheckRisk has speculated, that the Fed will not be able to raise interest rates at all for the foreseeable future. Worse still if the Fed moves prematurely it will have to reverse the decision and re-embark on QE.
B.U.M.P. or the Breaking of Unconventional Monetary Policy remains the core risk for any investor. The when, the means of execution and the impact of the same are critical to the future outlook. In the short term, the most recent payroll data makes any increase in interest rates a big gamble and probably a policy mistake for the Fed. The Fed has been overly optimistic on their growth forecasts, and as we stated last week in the Global WRAP, it is likely that the Fed has already missed the boat. This is a major issue and is part of the reason a crisis is becoming increasingly likely in the 2017 to 2020 period.
To be clear the US economy is not, as far as our early warning indicators are concerned, heading for recession, it is growing at a rate that is not far below historical averages. Historical averages, however, are too small in the current situation given the increase in debt and the stage of the cycle. The averages are much lower than what we expected for the amount of liquidity that has been created. This is the perspective that drives our tactical approach. The US is at the latter stage of the credit cycle, by contrast Europe is at an earlier stage. The EMs are at risk of being held hostage by US rates.
The next six months or so are going to see a global pick up in economic growth. This is likely to be met with stronger oil prices, increased demand for commodities and a sense of relief that a hole in the road has been avoided. CheckRisk would caution on overconfidence at that time. The US Fed may use it as an excuse to get a rate rise in when, in fact, the recovery will be quite fragile and dependent on continued liquidity. The markets are likely to get through 2016, however, as the readjustment phase either commences or is put off. The big issue is what happens next. Or as we often say at CheckRisk, “What could possibly go wrong?” The answer to that question is unfortunately quite a lot. This is the main reason that the period between 2017 and 2020 is so fraught with risk. The ammunition has been used up, and there is still a major campaign ahead. Inflation remains too weak, and GDP growth too anaemic to deal with the mounting levels of global debt and at some point bond investors are going to start to realize that there is a mounting sovereign credit risk.
CheckRisk mentioned two concerns in this “bits and pieces” section. The second is the mounting issue of capital outflows from emerging markets (EMs). Again readers will have seen this in past issues of our Weekly Risk Analysis Profile (WRAP), and the impact a rising US dollar and interest rates has on EMs.
According to the Institution of International Finance EM’s will suffer a net outflow of capital this year the first time since the 1980’s this year. The IIF forecasts that foreign investor flows to EMs will fall to $548bn in 2015. This is lower than levels recorded in 2008 and 2009 at the height of the global financial crisis.
Also, the IIF estimates that private outflows from EMs are greater than $1tn this year, against a figure of $23.7tn of indebtedness a five-fold increase in the last decade. The rise in debt, combined with the EM currency depreciation is making the cost of servicing that debt even harder. Should the Fed decide to raise rates, the problem will be magnified not only by the interest rate cost but also the impact of a stronger dollar.
As we have said before the current short-term indicators are showing a significant increase in global money supply, and that should result in a better relative short term market environment. This does not, however, solve the problem of mounting debt in EMs, and the risks associated with their currencies or dependence on commodities. The risk is that the short term improvement masks a significant deterioration in the longer term outlook. In a nutshell, that is what CheckRisk is currently forecasting.
If inflation picks up, and/or we see a pick-up in global demand that leads to above average Global GDP growth then we will have to adjust our tactical approach again. We certainly hope that this is the case, but risk management is not about hope. A rising inflation outlook or an increase in Global GDP is very easy to pick up in the data and will be signaled well before it occurs. In other words, it is unlikely to be missed by a risk system such as ours, and there will be time to adjust. The inverse, a meltdown in EMs, or interest rate shock risk, or a loss of confidence in the strategy of central banks is more difficult to time. It is this risk that we at CheckRisk are focusing our attention upon and urging clients to do the same.
In between the known and the unknown are the doors of perception.
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