Investors should prepare for a market correction as both strong and weak economic growth data could cause a fall in equity valuations, according to Brooks Macdonald’s Jonathan Gumpel.
The manager of the five FE Crown-rated IFSL Brooks Macdonald Defensive Capital fund said while it is no surprise for the manager of a defensive fund is looking for a correction, past cycles suggest there could be one in the short-to-medium term.
In the equity space, the Brooks Macdonald investment director said current starting price-to-earnings (P/E) valuations of markets are high at multiples of around 17x in areas such as the US.
“If you start from a valuation point of 17-18x earnings your five and 10-year returns are pretty limited,” he said. “While if you start with valuations at 7-9x your returns over the next 10 years returns can be very attractive.
“That suggests, from an historical starting point, that equities are not going to be an attractive investment over the next five or 10 years and certainly not as attractive as they have been over the last five or 10.”
Performance of index over 10yrs
Source: FE Analytics
As the above chart shows, the MSCI AC World index has had a strong 10 years, returning 165.87 per cent as central banks have kept interest rates low and embarked on an unprecedented quantitative easing (QE) process in an attempt to stimulate growth.
However, the tide has begun to turn, with the Federal Reserve and other central banks undertaking an unwinding of these measures as growth has picked up and economies appear to be on stronger footing.
“Everything that we are talking about is a sign of good news that the central bankers have achieved some of their aims in terms of using QE to drive market valuations to such a degree to then re-ignite the animal spirits in global economies and global markets. That is happening,” Gumpel said.
He added that while it is not yet clear whether the ‘perma-frost’ seen for much of the decade since the financial crisis has been avoided, economic growth and inflation that some have been hoping for are at least now beginning to show.
This is by far the better outcome for investors, he said, as these attempts could have failed, leading to a falling market while central bankers had little in the way of ammunition to prevent it. 
“Either this bull market was going to fall on not enough growth and earnings, or it was going to fall on too much growth and earnings and that is where we are currently, which is a nice problem,” Gumpel (pictured) said.
While central banks have had success, he said they must now begin to hit the brakes on the global economy in two ways.
The first is to raise interest rates and Gumpel said that the key is the Federal Reserve as the US remains the world’s largest economy.
“The danger for them is that they get behind the curve and that growth and inflation begin to move away too fast and need a sharper rate rise,” he explained.
“That would be a shock, but it started to happen last year. Last year the US grew nicely and inflation, which has been the dog that hasn’t barked due to oil prices being so low for so long, didn’t rise.
“So, world markets had a lovely year last year as accelerating growth wasn’t so great that the US central bank had to step in while low inflation supported this.”
However, there are questions as to whether the Fed, by not stepping in sooner, are already a step behind when it comes to raising interest rates.
“If there were questions about whether the US Federal Reserve was behind the curve last year then it is even more behind now,” he said.
“We all like to close our eyes to this but on all historic indicators there should be increased tightening this year not least because of the Trump tax stimulus which is an additional swing factor that may well accelerate growth in the US.”
As such, he noted that the expectations for interest rate rises should probably be greater than they are currently.
If the Fed does indeed raise interest rates, he argued that this could “hammer equity markets” as the more leveraged companies will struggle to refinance their debt.
“It will hammer pricing of debt for companies and the repricing of debt. It will also remove one of the drivers of the US market which has been buybacks afforded by debt so that is one of the more direct mechanisms,” he said.
Additionally, there is the potential for inflation surprises, as well, through a tightening labour market that could force wage growth higher.
“We think that there is the potential scope for a 1994 moment – i.e. a raising of interest rates at a higher level than is expected by markets,” Gumpel said.
This all coupled with the high valuations of markets, which look expensive heading into a rising interest rate environment.
“Markets may well be able to carry on for a significant period but in order to maintain the high degree of valuation that we’ve got you need to have this high-octane enthusiasm for markets,” the manager warned.
But if growth continues to pick up this at such a pace that this high level of valuation is supported, it is likely that the Fed will have had to raise interest rates faster to cool economic growth, he said.
As such, markets appear destined for a correction at some point, but the best reason for this is the scenario outlined above “where sensible early action” by the Fed leads to them raising their forecast rate hike chart.
Federal Reserve Dot Plot chart December 2017
Source: Federal Reserve
Conversely, he said markets will also struggle if growth expectations are not met, as many companies are valued for sustained growth.
“If it turns out the US recovery isn’t as great as everyone expected then we would have a more problematic reason for equity markets to come down,” he noted.
While it is a “fool’s game” to predict the timing of such a market correction, the manager said, it is unlikely that over the longer term – with valuations where they are – that investors are going to make the strong returns they have come to expect from the last decade.
“We, as a defensive fund, have to look at this and say the best of conventional markets is behind us, so – on a risk-reward basis – how do the risks tally up versus the rewards. For us, at the moment, they don’t,” he said.
“In terms of what we are expecting I don’t know what the trigger might be I just know markets are at extreme valuations and it actually doesn’t matter.
“Starting with that very high degree of valuation we know the risk reward is likely against us. We know it is against us in the long and medium term it is just a question of when is the short term. For a defensive fund it is a case of eking out returns in a defensive manner.”