Is the "sweet spot" getting sour

Financial markets have enjoyed what has been dubbed the ‘sweet spot’ in recent months – a recovery in economic growth coinciding with extremely loose monetary policy. This, in part, explains why recently risky assets such as equities, corporate bonds and commodities have risen at the same time as government bonds. By flooding financial markets with cash and committing to low interest rates for “an extended period”, central banks are determined to get asset prices up, or put another way, get the value of cash down. The Bank of England, for example, is explicit about this goal. (For further information click here.)

How long can this go on for?

The ’sweet spot’ assumption has two elements – economic growth and low interest rates – and therefore two opposing risks. Barring a serious policy blunder, we should not worry about both occurring simultaneously.

First, there is concern that the structural difficulties facing Western economies - notably, high public and private debt levels, impaired banking systems and high unemployment - are simply too great for a robust recovery to take hold.

Alternatively, it is not growth, rather prolonged low interest rates that are unsustainable. As the global economy recovers, concerns over inflation and asset price bubbles will provoke central bankers into taking away the punchbowl earlier than most investors anticipate. A material rise in commodity prices could heighten fears of rising inflation and amplify the risk of interest rate hikes.

There has been very little in the way of significant news that can explain recent weakness in global equity markets, but a growing realisation that the “sweet spot” cannot continue forever is a plausible explanation. That said, it is not clear exactly whether investors have been worrying about a growth relapse or reduced policy stimulus, or simply realising that risks to a seemingly benign backdrop are rising. The bond market is not yet indicating a sudden material change in interest rate expectations; and the news relating to growth in global GDP and corporate profits has generally been positive in recent weeks.

So where does Ashburton stand on these issues?

While events have clearly taken a turn for the better since March, there remains considerable uncertainty over the global economic outlook. As such, both risks to the ‘sweet spot’ argument are legitimate. While a very anaemic economic recovery would arguably be more pernicious from an equity market perspective; tighter monetary policy is the more likely outcome, in our view. The strength of China’s recovery, the potential for a powerful inventory rebound, the recovery in financial markets and the lagged effects of fiscal and monetary policies yet to come through underpin our optimistic bias regarding the 12-month outlook for global growth.

The Federal Reserve and ECB have begun to outline exit strategies from ultra loose monetary policies and will likely start to tighten in 2010. However, given how far Western economic output is below potential they are likely to move gradually, mindful of avoiding a shock to interest rate expectations that could destabilise financial markets and put recovery at risk. Donald Kohn, Vice-Chairman of the Federal Reserve has made this clear:

“The unusual nature of our actions and the uncertainty about when and how they will be unwound suggest an even greater payoff than usual from being as clear as possible in our communications with the public.” (Click here to read in full.)

The ‘sweet spot’ will not last forever. Investors have to prepare themselves for a period of either higher interest rates or disappointingly weak growth. This will mean bumps in the road. However, in our view, the general backdrop for financial markets is likely to remain relatively benign for some time to come – a global recovery is underway and monetary policy will remain accommodative.

Ashburton Investment Strategy

While further downside risk is of course possible, in our view the current set-back in global equity markets should be seen as a buying opportunity. Having reduced equities across our Multi Asset Funds in late August (see Strategy Update 28 August 2009) we therefore anticipate using the current period of weakness to rebuild equity weightings.

There has been little change to bond strategy in our Multi Asset Funds. We see risks to short-maturity bonds as investors may start to price in more aggressive interest rate hikes. The steepness of yield curves in US and European bond markets suggest longer maturity bonds offer better value, although we view the latter as less risky and our US treasury holdings are concentrated in inflation-linked bonds currently. We continue to believe Australian bonds offer a decent risk-reward trade-off given the extent of interest rate hikes already priced into the market over the next several years. We also have modest exposure to corporate and emerging market bonds.

As suggested above, we believe a material rise in commodity prices (especially oil) could create renewed fears of inflation and induce central banks to raise interest rates earlier. High commodity prices therefore pose a risk to both equity and bond markets. Accordingly, we are gradually increasingly commodity-related exposure in our Multi Asset Funds.

Our currency views are little changed. On a medium-term view we believe Asian currencies offer the greatest opportunity for significant gains and we have increased exposure to the Indian rupee in recent weeks. Among the four majors, sterling and the US dollar offer the greatest value from a medium-term perspective but loose monetary policy remains a headwind for both in the short-run. The only material position we maintain in the majors is a long sterling position for euro-based Funds.