The last several months have been a challenging environment for most fundamental investors, as prices have been moving away from fundamental values. It is the type of environment where we try to do our best to preserve capital. At the same time, we are seeing the opportunity set widening.
While the opportunity to take more risk has increased significantly, it is not a game we are willing to play. Central banks are encouraging the taking of risk–at some point that game of musical chairs will end, and we don’t want to be the one caught without the chair. But there are opportunities on the market side – and less dramatically so within currencies – that we will ultimately seek to take advantage of in our portfolios.
So, what are we watching for in order to ascertain when and where to act on these opportunities? We’re watching China, we’re watching oil, we’re watching the Fed, and we’re watching populism.
China: About four years ago, we talked about how the market was overly negative on China. During that time, there’s been a lot of borrowing to stimulate infrastructure growth, and while that was not necessarily a problem back then, it is creating problems now. The problems are large but not cataclysmic. It is something that we will continue to monitor as this borrowing has not yet flushed its way through the financial market system.
Energy: There are a number of factors related to energy. There’s been a surge in supply on tech innovation, the Middle East has an incentive to maintain low oil prices, Iran’s coming online in about a year with another supply source in the region, warm weather has created a demand shortfall, and inadequate storage facilities are creating some technical problems. Bottom line, you’ve got a price disequilibrium in oil right now. It might last one day. It might last a few months. We don’t know, and it’s probably hard to say if anybody actually knows. But we do believe the equilibrium for oil prices is around $45 a barrel.
Fed: When it comes to the Fed, who knows? Never in the history of central banking has anything been done like what the Fed is trying to do now. There is no roadmap. No major central bank since 2008 has successfully raised interest rates. The Fed is trying to do it now. Maybe it will be successful and maybe it won’t. Again, that’s something that we’re monitoring very closely.
Populism: Lastly, there’s populism. The population in many of the developed countries, Europe, U.S., and maybe the Middle East, are losing faith and trust in their leadership. That creates a difficult environment for capital markets when we have to rely on fiscal policymakers and central banks around the world ostensibly maintaining economic growth and stability. So right now, uncertainty reigns.
Again, what are we looking for? While recent market movements begin to emulate the type of capitulation that we were looking for, it is not necessarily complete. We are looking for the market to be screaming for liquidity. This has been a central bank-driven liquidity rally, with central banks encouraging risk taking. Since it’s a liquidity-driven market, we don’t think it will be over until there are fears about insufficient liquidity across the market. While there are definitely liquidity issues in high yield and energy, concerns have not yet reached the level of true capitulation.
Brian Singer, CFA, is partner, head of the dynamic allocation strategies team and portfolio manager at William Blair.
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