“Exuberant health is always, as such, sickness also” - Theodor Adorno
The world economy seems to be heating up a little. For the first time in several years, economic data are strong in the US, UK, Europe and China whilst clearly improving in Japan and broader emerging markets. Inflation is rising and global earnings growth has turned positive again after 10 quarters of commodity-induced funk. Credit is widely and cheaply available and business and consumer confidence are at their highest levels in over a decade. The major central banks still run exceptionally easy monetary policy, getting easier still in inflation-adjusted terms. Fiscal policy is already loosening in Japan and Europe, and is expected to loosen significantly in the US. With US and developed world stock markets hitting successive record highs, are we witnessing the next bubble inflate?
The madness of crowds?
In spite of the relative proximity of two of the more famous bubbles seen over the last 350 years, investors should be reassured by the fact that they are relatively rare phenomena. Using data from a range of countries going as far back as credibility allows, gives us over 100 years of equity market performance data to analyse. Yale Professor of Finance, William Goetzmann’s analysis of this impressive dataset finds that the probability of a severe market decline increases marginally if that market has more than doubled over the previous year. However, based on the same dataset, the chance of the market doubling from that point is still twice as likely as halving in value over the same time frame. In simple terms, a large price increase in markets is twice as likely to be followed by another year of high returns compared to a severe market decline.
Boom or bubble?
As well as being rare, it is also notoriously difficult to separate the bubbles from the justifiable booms – at least without the benefit of hindsight. Generally, bubbles occur when investors push prices of the asset in question beyond what is revealed ex post to be their fundamental values. As noted above however, what can at the time appear exuberant to the hard-nosed investor, more often than not turns out to be changing reality - a step change in technology or innovation.
Increasing signs of warmth?
There are some signs in the survey data that the so-called animal spirits are starting to return. However, so far, this is yet to show up in the hard economic data. US households aren’t looking stretched when it comes to servicing their debt, while the recent pick-up in inflation is primarily a function of energy base effects rather than a materially overheating economy. There is still plenty that could get in the way of those returning animal spirits too of course, from a more protectionist US to a Eurosceptic French president and all the unknowables in between. However, right now we would argue that, in terms of tail risks, the return of a little too much exuberance over the next few years is looking a little more likely than not enough.
If we are indeed entering what tends to be known as the ‘high conviction’ phase of the economic cycle, then remaining fully invested in portfolios leaning towards stock markets tends to become even more important. This phase of the economic cycle can last several years and tends to be characterised by stocks strongly outperforming bonds. It also tends to be the terminal phase of the cycle, suggesting that asset allocators should be extra vigilant to any signs of the next recession, and be ready to adjust portfolio risk accordingly. For our part, we still see the cycle end as a reasonably distant prospect, but welcome any signs of tentatively returning animal spirits as evidence that the world economy is less structurally impaired than only recently feared by many.
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