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The Worried Well

Tuesday, May 01, 2018

The ‘worried well’ constitutes an established medical phenomena of patients who present to medical professionals with symptoms which – upon investigation – yield no underlying morbidity. This medical analogy is useful for assessing the current state of investment markets because, while it is easy to point to a laundry list of risks facing investors, it is much harder to conclude that the fundamentals which underpin the markets in the medium- to-long term are under dire threat.

Rising US wages, inflation, trade deficits and tariffs, higher interest rates and European political uncertainty have all been cited as headwinds for the market. However, none of these can in themselves justify a substantial and sustained sell-off. For investors, this presents the intriguing and contrarian possibility of buying stocks at favourable levels.

Perception and reality

But first, it is important to be confident that the perceived risks are indeed just that – perceived. A cursory analysis of the breakdown of the January US CPI print shows that apparel, hospital services and auto insurance drove inflation that month. What unites them? Nothing! This in itself is reassuring since it suggests that inflation is not broad based, but random and esoteric. The ‘wage rage’ episode had its origins in January’s 2.8% year on year US hourly earnings growth report, but there is no evidence that this is part of a pattern and it has since been followed up with softer data for February.

In the US, a wide trade deficit indicates for the most part that the economy is healthy and growing, since increased consumption naturally sucks in proportionately more imports like cars, toys and other goods from overseas. Moreover, while steel tariffs have been threatened as a policy response to the deficit, exemptions have already been applied to the largest importers into the US. China represents a very small proportion of total US steel imports and around 0.03% of total Chinese export share. So the global impact of a Chinese steel tariff war should be negligible and the world will carry on, like it did after the Bush presidency imposed similar tariffs in 2002. Indeed, the last thing the Trump administration wants is a truly damaging trade war which will affect the healthy stock market and macro picture that it has been so keen to claim credit for.

Meanwhile, despite talk of a faster normalisation, real interest rates across the US, UK, Japan and eurozone all remain negative and there appears to be no rush to reduce central bank balance sheets. Furthermore, US equities have delivered positive returns when the equity risk premium (the gap between the equity earnings yields and the 10-year US Treasury yield) has been far lower than it is today.

The final risk to address is political uncertainty. The recent Italian elections provided an unhappy stalemate but markets were - quite sensibly - unruffled. If anything, Italian growth has been enjoying a new lease of life on the back of better French and German economic performance and, as long as Italy remains unlikely to crash out of the eurozone, there is little reason to believe that politics will derail this momentum.

ERP* intact: equities can still accommodate much higher yields than today:

ERP intact: equities can still accommodate much higher yields than today - Graph

Source: Bloomberg. Period analysed 31.03.1998 to 31.01.2018. *Equity risk premium defined as S&P 500 forward earnings yield minus 10-year US Treasury yield.

Past performance is not an indicator of future performance and current or future trends.


Fundamentals are in good shape

Beyond the unfounded symptoms, the market ‘patient’ is in fact showing signs of underlying vigour. In the US, the economy could well achieve the 3% growth target set out by the administration given the steep ascent of the ISM Manufacturing PMI gauge. Similarly, the recent responsiveness of US oil production to higher oil prices means that the latter will be effectively capped - good news for both US and global consumers who should be able to enjoy better real growth in 2018. The eurozone’s GDP growth of nearly 3% also boasts a healthy underlying composition – notably both consumption and investment enjoy a high and broadly equal share of the credit for the better growth figures, with government expenditure barely figuring. In the so-called emerging markets the outlook is even brighter. Growth is strong and the IMF predicts simultaneously lower inflation for these economies going forward, setting them up for a true ‘goldilocks’ scenario of high growth without the usual price pressures that go with it.

Focusing on what matters: sell-offs amid good fundamentals are mercifully rare:

Focusing on what matters: sell-offs amid good fundamentals are mercifully rare - Chart 2

Source: Bloomberg, RIMES Period analysed 31.12.1987 to 31.01.2018.

Past performance is not an indicator of future performance and current or future trends.


The implications for equities are clear and are perhaps best articulated by the following observation: over the last thirty years, the S&P 500 has posted negative returns of six months or more just three times against the backdrop of a rising Conference Board Leading Economic Indicator (LEI). In other words, equities rarely sell-off for long when the fundamentals are in good shape. For investors therefore, today’s distractions should represent an opportunity to increase their risk allocations with a long-term horizon in mind. The latter point is particularly important since there is always the possibility that market anxiety – if prolonged - could prove self-fulfilling. As the British Medical Journal observed in a wide-ranging study in 2016, those who needlessly worry about serious illness may, in fact, increase their risk of heart disease.


Important legal information
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is no indicator for the current or future development.
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