Every three months I knock on my colleagues’ doors and ask them what they’re thinking about the markets. It’s interesting to hear what’s keeping them up at night. Even more interesting is what they are worried about. What moves a market is, by definition, not what investors have already priced in but what they have missed.
Perhaps the commonest refrain on my latest tour of the office might be paraphrased as ‘Goodbye Goldilocks’. The consensus view is that 2017 was as good as it gets - not too hot and not too cold - and that 2018 will be trickier to navigate. Last year saw an unusual combination of positives: accelerating growth, stable interest rates, subdued inflation and an absence of volatility. This year, three of those factors look likely to deteriorate: interest rates are going to rise; inflation is stirring; volatility is on the up; only growth still looks OK. To mangle Churchill, none of these signal the end but they probably do point to the beginning of the end.
A second common observation is the narrow leadership of the stock market, which is typical of the late stages of a bull market. In particular, I would point to the share price chart of Netflix which spent last year on a steep upward trajectory before turning left at the start of 2018 and heading more or less vertically up on my screen. For anyone who experienced the dot.com bubble in 1999 and 2000 this is history repeating itself. Netflix started the year at $192 and last week hit $325. It is very likely that all the market’s gains this year are accounted for by a small handful of technology stocks. If the mood in tech were to change, the overall market picture might look very different.
What the sour-away performance of the technology ‘disruptors’ is disguising is the broken business models of the ‘disrupted’. This is particularly the case in sectors which have been protected by an abundance of cheap debt. When borrowings were plentiful and consumers buoyed by rock-bottom interest rates, it seemed sensible to flood the High Street with a plethora of indistinguishable restaurants. In an environment of rising interest rates and households squeezed by stagnant earnings and higher inflation, the trickle of closures and redundancies in this area is turning from a trickle to a flood. As Warren Buffett said: ‘when the tide goes out, you discover who’s been swimming naked’.
In this environment, mindlessly buying out of favour stocks in the hope that they will bounce back may not work as well as it used to. The rules of investing may have changed for good and apparently cheap stocks may get cheaper still, perhaps all the way to zero. This explains why companies that disappoint are being hit by what seems like disproportionate market reactions at the moment. If you think that a company’s problems may be terminal, the temptation is to shoot first and ask questions later.
An interesting side-effect of this dispersion of returns between the market’s winners and losers could be a reassessment by many investors of their enthusiasm for low-cost passive investments. Most of my colleagues are stock-pickers so they see this as a good thing. In an environment in which some shares rise a lot while others are clobbered when they fail to live up to expectations, active managers have a chance to justify their fees by picking the winners and avoiding the losers. After a long period in which shares have moved in lock step with each other, a sharp reduction in correlation could see trackers fall from favour. If we end up with a sideways moving market, investors will want to leave dead-money passives out of their portfolios.
Almost everyone I spoke to mentioned inflation. On the face of it, inflation is bad news. If leads to higher interest rates, it reduces consumers’ spending power and it raises company's costs. But for some investors it is also providing opportunities. If growth and inflation are back, then investors will see less reason to chase the defensive quality stocks that performed so well when growth was hard to find. It is no coincidence that the moment when bond yields turned upwards in September 2016 was also the precise moment when growth stocks handed the baton over the value shares. In an inflationary environment, companies with pricing power start to look interesting. So, too, do companies with relatively high debts. Most investors have forgotten how to invest in an inflationary environment which fixed debts are eroded by rising prices. It’s the corporate equivalent of taking out the biggest mortgage you can afford, conventional wisdom in the inflationary 1970s.
So growth, inflation, tighter policy, disruption and late cycle euphoria are on investors’ minds. What didn’t they mention? Brexit barely registered. Geo-politics has fallen off the radar - indeed the outbreak of civility between Trump and Kim seems to have put this very much on the back burner. Finally, steel tariffs and trade wars are not in the spotlight, perhaps because few investors seem to think that these will materialise in the form promised by the White House. It’s not just America’s trading partners who reacted with dismay to the tariff bombshell. Plenty of sensible Republicans also think they are a crazy idea. To present them under the cloak of national security is, moreover, nonsense when you consider where the steel comes from (Canada, Europe and South Korea). I hope investors are right to be relaxed about trade wars. Of all the things my colleagues failed to mention, this feels like the elephant in the room.