It's been one of those unbelievable weeks. A client phoned to ask if the valuation was right because it seemed to be too high. (Yes, it was right). Markets continued their move upwards. Commodities rose, US shares rose, UK shares rose, Asian shares rose. It makes being an investment manager seem easy. If only. You should have made money when most things are going up rapidly. It is always important to remember pride comes before a fall. A rising tide raises all boats, but after a bit the ones that are holed below the waterline sink.
Underlying the client's question was another good one. Can markets continue like this, given the poor news background out there in the factories, offices and shops of the global economy? The bulls say "Yes, it can". They say the sky is blue all over, so it cannot rain. Interest rates are low, the US and UK are printing money, the worst of the banking crisis is behind us, profits will start to rise, inventories cannot be run down any more, governments are stimulating activity. Go out for a long walk in the market, and don't weigh yourself down with a mac and umbrella. To them it's a win win bet. If all goes well, the economies will enter a self sustaining recovery, and the special stimuli can be slowly and gracefully withdrawn. The money making machines will turn again naturally, without quantitative easing. Turnover and profits will rise, rents will be paid and dividends start to go up. If that does not happen, it just means there will be more money printing and persistent low interest rates, so markets will rise in anticipation.
The bears say this crisis is by no means over. The next move in interest rates will be up. That has already happened in Australia and may have to happen elsewhere in Asia. It could be forced on a country like the UK if currency markets lose confidence in policy. Some of the big US and UK banks are not mended. That means slow growth ahead, and more capital required. It means less lending. Unemployment may rise some more and wages stay down, limiting consumer demand. The big imbalances between the exporter high savings economies and the importer high borrowing economies have not adjusted much. The heavily indebted countries like the UK, Spain, Ireland and the USA have to start paying off debt. Real incomes will be squeezed, consumer spending will be constrained, and growth will be slower than before. Quantitative easing has to end, and that may drive down government bond prices, raising interest rates. The countries with the biggest deficits will be required to cut spending.
So who us right? Both may have some truth in what they are saying. In the short term it may continue as a one way bet. There could be a change of mood or an accident in the riskier countries any time. So we think now is the time to cut the risk of a portfolio a bit, and to make sure you are oriented to the stronger countries that do not have to tackle huge deficits.