Better growth, low inflation. It’s the perfect backdrop for risky assets. But in a late cycle environment, one of the driver of financial markets people should always be fearful about is the « fear of missing out », especially when the rise in stock market accelerates and relies more on multiple expansion than fundamental improvement.
This can be a powerful driver of equity performance. Many investors who remained on the sideline of the rebound of financial markets will want to have their cut. But they will probably jump in at the worst possible moment. They are often the marginal investors who’s behavior signal that we are at the peak of the market.
So far, it’s difficult to say that greed or that complacency are at full speed. But optimism is here, fed by still favorable monetary conditions, accommodative monetary policy, better growth and low inflation.
If the corporate sector is able to continue growing earnings that’s supportive, but if psychology (i.e. P/E multiples) start taking the lead of market appreciation, that’s probably less favorable outcome for investors.
Investors should keep in mind the following debates/questions and make sure they understand their implications in terms of asset allocation.
- Monetary policy divergence: end of QE and rising rates in the US; pursuit of dovish stance in Europe and Japan. This scenario depends on how the inflation will evolve going forward. So far, no change in the pace of QE easing, but things could change and affect asset allocations if inflation were to surprise to the upside.
- China has been able to stabilize its growth but did so by increasing leverage in the system. Chinese authorities are trying to control the flow of credit by tightening and rising rates, but also by leading structural reforms. This is not an easy path and there have been mistakes in the past (2015). This time around, things seem to run a bit more smoothly.
- Commodities have stabilized with the oil price in a 45-50 dollars/baril range. This should help inflation numbers move higher.
- Correlation and volatility. The two have moved down in the recent past which is not reassuring. Lower correlation facially means it’s easier to diversify but there’s a catch. Since correlation is cyclical, there is also a possibility that asset classes move into more correlation in the future. The same goes for volatility, which has been at record low levels in the recent past. This can’t last forever.
How to position their portfolio?
Some ideas provided by Morgan Stanley’s strategists team.