Miton’s David Jane: A Hard Look at the Data

• The narrative remains negative despite favourable data
• Policy makers won’t tighten too early as they tend to fight last year’s battles
• Commercial banks have plenty of scope to expand lending
• Favour economically sensitive sectors and emerging markets
• Also identifying investments that can do well in higher inflation environment or weaker economy

David Jane, manager of Miton’s multi-asset fund range, comments:

“As the long bull market continues, there’s plenty of talk on why it’s going to end, much of it surrounding the reduction of monetary stimulus. So what is the truth behind the fears of rapid tightening leading to a market correction, recession, or according to some pundits, a meltdown?

“In terms of simple interest rate policy, the US equivalent of the Bank of England base rate remains at or below zero in real terms, i.e. hardly tight and in fact still at levels which in the past would have been regarded as very loose. The shape of the curve, the difference between short term interest rates and longer term rates, is regarded as a recession predictor, because markets set the long term rate based on their expectation of short term rates, so a flat or downward sloping curve suggests the Fed will be loosening policy in the future. While the curve is currently flatter than in the recent past, it still implies expectations of economic expansion.

“When we consider liquidity, this is a more intangible concept in some ways, but the simplest measure would be to look at excess bank reserves at the Federal Reserve. The central bank can tighten policy by withdrawing deposits from the system, forcing banks to constrain lending both to the real economy and financial markets.

“Since the era of quantitative easing there has been a huge rise in these reserves (through the mechanism of government purchase of government bonds) and while they’re shrinking, they’re still vast by any historical norm. So this mechanism to tighten is no longer available, or at least a very long way off. In essence, commercial banks have plenty of scope to expand lending.

“Broadening the argument, we can combine with these metrics a number of other indicators such as credit spreads, interbank lending rates and others to get the Bloomberg Financial Conditions Index. This shows that things are as good as they have ever been and accelerating since the start of 2016.

“Looking forward, it’s possible to expect the Fed to continue on its tightening path, but not to the degree which would historically be regarded as tight, and this is in a background of a global financial system where two of the major players, the ECB and BoJ continue to run policy extremely loose.

“Despite this favourable data, the narrative remains quite negative in many quarters, particularly the media. Whether referring to the recent small correction in high yield bonds or any weak day in equities, calling the next bear market remains a fashionable pastime. We would count the narrative as neutral to negative, which with the data being positive would lead us to remain positive on markets, particularly with the benefit of strong affirmation from the current strength.

“More importantly, however, our philosophy of managing not to a base case but to a range of scenarios demands we consider what the bounds are around the base case. To us, it seems less likely that policy makers tighten too early, leading to financial instability and/or a recession, as they tend to fight last year’s battles and the most recent crisis was a financial one. Financial instability is what they most fear and are trying to avoid.

“More likely to us is the scenario that inflation exceeds to the upside as policy remains too loose for too long, particularly as the ECB and BoJ continue to supply liquidity while the Fed attempts to tighten. Ultimately this would lead to later but more aggressive tightening.

“How can we allow for these scenarios in our portfolios? The base case is straightforward, more of the same with rising markets favouring economically sensitive sectors and emerging markets. However, we also need to find investments that can do well in the alternative of higher inflation or a weaker economy.

“If we consider infrastructure assets, we can gain some exposure to rising inflation while being less sensitive to a weaker economy, so we have recently added some of these following a period of weakness. Looking at oil, it can give us upside from rising inflation and a good hedge against potential political risk (in the Middle East and Venezuela), while in the meantime offering some attractive valuations. There are other inflation hedges such as commodities and, of course, gold which also have a role to play.

“The most obvious asset to benefit from our alternative scenarios would be index linked bonds, however, these are not so much a beneficiary of inflation as a play on real yields, and since UK index-linked bonds now trade at negative real yields, we get a return that is baked in to be below inflation. The same goes for longer dated bonds in general, we can get little upside in the event of a weaker economy but significant downside in the event of higher real yields or inflation.

“So, while we can reasonably allow for potential higher inflation than the base case in the portfolios, dealing with a potentially contracting economy is more difficult and the main approach would need to be if the data changed to make this scenario more likely, we would need to change the portfolio. As pragmatists, this approach is one we have always been comfortable with.”

• The narrative remains negative despite favourable data
• Policy makers won’t tighten too early as they tend to fight last year’s battles
• Commercial banks have plenty of scope to expand lending
• Favour economically sensitive sectors and emerging markets
• Also identifying investments that can do well in higher inflation environment or weaker economy

David Jane, manager of Miton’s multi-asset fund range, comments:

“As the long bull market continues, there’s plenty of talk on why it’s going to end, much of it surrounding the reduction of monetary stimulus. So what is the truth behind the fears of rapid tightening leading to a market correction, recession, or according to some pundits, a meltdown?

“In terms of simple interest rate policy, the US equivalent of the Bank of England base rate remains at or below zero in real terms, i.e. hardly tight and in fact still at levels which in the past would have been regarded as very loose. The shape of the curve, the difference between short term interest rates and longer term rates, is regarded as a recession predictor, because markets set the long term rate based on their expectation of short term rates, so a flat or downward sloping curve suggests the Fed will be loosening policy in the future. While the curve is currently flatter than in the recent past, it still implies expectations of economic expansion.

“When we consider liquidity, this is a more intangible concept in some ways, but the simplest measure would be to look at excess bank reserves at the Federal Reserve. The central bank can tighten policy by withdrawing deposits from the system, forcing banks to constrain lending both to the real economy and financial markets.

“Since the era of quantitative easing there has been a huge rise in these reserves (through the mechanism of government purchase of government bonds) and while they’re shrinking, they’re still vast by any historical norm. So this mechanism to tighten is no longer available, or at least a very long way off. In essence, commercial banks have plenty of scope to expand lending.

“Broadening the argument, we can combine with these metrics a number of other indicators such as credit spreads, interbank lending rates and others to get the Bloomberg Financial Conditions Index. This shows that things are as good as they have ever been and accelerating since the start of 2016.

“Looking forward, it’s possible to expect the Fed to continue on its tightening path, but not to the degree which would historically be regarded as tight, and this is in a background of a global financial system where two of the major players, the ECB and BoJ continue to run policy extremely loose.

“Despite this favourable data, the narrative remains quite negative in many quarters, particularly the media. Whether referring to the recent small correction in high yield bonds or any weak day in equities, calling the next bear market remains a fashionable pastime. We would count the narrative as neutral to negative, which with the data being positive would lead us to remain positive on markets, particularly with the benefit of strong affirmation from the current strength.

“More importantly, however, our philosophy of managing not to a base case but to a range of scenarios demands we consider what the bounds are around the base case. To us, it seems less likely that policy makers tighten too early, leading to financial instability and/or a recession, as they tend to fight last year’s battles and the most recent crisis was a financial one. Financial instability is what they most fear and are trying to avoid.

“More likely to us is the scenario that inflation exceeds to the upside as policy remains too loose for too long, particularly as the ECB and BoJ continue to supply liquidity while the Fed attempts to tighten. Ultimately this would lead to later but more aggressive tightening.

“How can we allow for these scenarios in our portfolios? The base case is straightforward, more of the same with rising markets favouring economically sensitive sectors and emerging markets. However, we also need to find investments that can do well in the alternative of higher inflation or a weaker economy.

“If we consider infrastructure assets, we can gain some exposure to rising inflation while being less sensitive to a weaker economy, so we have recently added some of these following a period of weakness. Looking at oil, it can give us upside from rising inflation and a good hedge against potential political risk (in the Middle East and Venezuela), while in the meantime offering some attractive valuations. There are other inflation hedges such as commodities and, of course, gold which also have a role to play.

“The most obvious asset to benefit from our alternative scenarios would be index linked bonds, however, these are not so much a beneficiary of inflation as a play on real yields, and since UK index-linked bonds now trade at negative real yields, we get a return that is baked in to be below inflation. The same goes for longer dated bonds in general, we can get little upside in the event of a weaker economy but significant downside in the event of higher real yields or inflation.

“So, while we can reasonably allow for potential higher inflation than the base case in the portfolios, dealing with a potentially contracting economy is more difficult and the main approach would need to be if the data changed to make this scenario more likely, we would need to change the portfolio. As pragmatists, this approach is one we have always been comfortable with.”