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What could possibly go wrong?

Whilst we appreciate it may not have appealed to all our readers, Marvel Studio’s most recent superhero movie, Avengers: Infinity War, recently became the fifth-highest grossing movie of all time. In the Marvel ‘universe’, one sure fire way to become a superhero is to be bombarded with tremendous doses of either cosmic rays (think The Fantastic 4), or high energy electromagnetic radiation (think The Incredible Hulk). Alternatively, a superhero is created after being bitten by an irradiated insect (think Spiderman), which brings us to the photograph that inspired this VFTD.

Despite the introduction – our focus is not on arachnid-based superhuman abilities but, instead, the processes used to control the known-knowns and the known-unknowns of a nuclear reaction within a power plant. In a typical nuclear reactor, atoms of uranium are forced to break apart and – as they split – they release neutrons which cause other uranium atoms to split, starting a chain reaction. The energy released from this chain reaction creates heat; this is used to heat a cooling agent, commonly water, producing steam which drives a turbine to create electricity. To help calibrate just how much heat is created, a ‘standard’ 3,400 MW thermal reactor boils 36,000 gallons of water per minute at full power. This is an enormous amount of energy and, to control its production, a reactor protection system monitors more than a dozen critical plant parameters, enabling the operators to slow the chain reaction, as risks dictate or electricity production needs to be moderated.

The key control mechanism involves the use of what are called control rods – these are dense materials which, when dropped down into the reactor, soak up some of the neutrons being produced. By putting the fuel rods in, or drawing them out, operators can speed up or slow down the chain reaction and, therefore, control how much energy is generated by the reactor.

Despite the monitoring of numerous indicators, access to cutting edge science and oversight by domestic and international regulators, nuclear power plants have, thankfully, only very occasionally gone wrong. What makes this form of power generation so controversial, notwithstanding the potentially catastrophic consequences of plant failure, is the need to control the unpredictability of a nuclear chain reaction and the fact operators are, by definition, ‘blind’ to what is going on in the reactor, which is a closed system. When problems occur, decisions to remedy matters have to be made based on historic evidence from previous events or the operator must second guess what could happen next.

Does this sound familiar?

International regulators, trying to control unpredictable systems based on historic models and a suite of indicators is, clearly, analogous to the task faced by central bankers and other policymakers in managing global financial markets and the macroeconomic environment. The system largely runs smoothly, but every now and again, matters arise which warrant diligent investigation and extremely careful oversight to avert problems amplifying.

To be clear, we are not worried the equivalent of a nuclear accident is about to happen in markets; not at all. We are, however, very mindful some indicators on our instrument panel are flashing and we need to be vigilant. For example, the year-to-date outperformance of US stocks has once again been striking; it is, however, very narrowly based. Amazon, Microsoft and Apple have accounted for 71% of the rise of the S&P 500 benchmark. Four other tech stocks, plus Mastercard, account for the rest. The other 492 stocks are collectively down for the year*. When equity market returns are driven by such a narrow cohort of companies it is sensible, in our view, to take a closer look at other indicators monitoring the system.

Fortunately for us, we do not have to reinvent the wheel and institutions like the World Bank, the IMF and the Bank of International Settlements (BIS) publish a raft of data to help us make sense of things. The BIS – which is owned by 60 central banks, representing countries from around the world that together account for about 95% of world GDP – has recently released its Annual Economic Report 2018 which, as always, has made for interesting reading. The Report highlights global growth rates are roughly on a par with pre-crisis long term averages and the expansion, until recently, was highly synchronised. Unemployment continues to decline and inflation rates have started, albeit slowly, to move closer to central bank objectives. Additionally, investment is expected to strengthen, boosting productivity and fiscal expansion – the OECD foresees an easier fiscal stance in around three quarters of its members (not just the US), this year and next – providing additional stimulus.

So far, so good; however, the BIS has several words of caution. It observes in some countries largely spared by the Global Financial Crisis, there have been signs of a build-up in financial imbalances for quite some time. These imbalances have taken the form of strong increases in private sector credit, often alongside similar rises in property prices. This is typical of the expansion phase of domestic financial cycles and – qualitatively, at least – similar to the situation observed pre-crisis in the economies that subsequently ran into trouble.

Global debt continues to rise

AEs; advanced economies, EMEs; emerging economies

Despite stronger bank regulation and a more robust macro prudential framework, the BIS is concerned aggregate levels of debt may continue to increase. Moreover, in much the same way a power plant predominantly relies on the insertion and withdrawal of rods to control the nuclear reaction, it is fearful the over reliance on monetary policy to control financial conditions has resulted in too-blunt-a-tool being used to manage complex and increasingly connected economic systems. At the same time, the opportunity to increase interest rates themselves are stymied, given the associated rise in debt service levels – the proverbial ‘debt trap’.

Rather than what can go wrong; what can be put right?

To repeat; all is not lost, far from it. The BIS believes the current environment can be safely navigated, providing a few criteria are met. Namely;

  • The open, multilateral trading order – which has served the global economy well and increased prosperity for millions of people around the world – must be safeguarded.
  • Continued product and labour market reforms ensuring flexibility and the opportunity to allocate resources efficiently have to be pursued. This should include the ability to absorb technical innovations more easily.
  • A further strengthening in the resilience of the global financial system – including the completion of regulatory reforms. The latter being something the EU has been criticised for not doing.
  • A clear focus on the sustainability of public sector finances should be maintained and procyclical fiscal expansions avoided.
  • Policymakers should be flexible in the pursuit of inflation objectives. Moderate inflation shortfalls should be accepted, particularly in light of the structural disinflationary pressures still at work.

Implications for portfolios

We remain positioned to capture returns if markets perform positively during the second half of the year but, continuing with the nuclear power plant analogy, we are monitoring our indicators very closely in case we need to dial down the risk. An escalation of the trade conflict between the US and China, Europe, Canada and Mexico; signs the expected ramp up in private sector capital investment is starting to wane; and/or market stability being further shaken by a strengthening dollar – especially across emerging markets – are all indicators front and centre on our control panel.

The rhetoric on trade from the White House is uncomfortably vocal and China and the EU are engaging in a tit-for-tat response. The US has threatened tariffs on a further $200bn of Chinese goods, as well as on autos. A full blown global trade war would inevitably be bad for growth; moreover, the US would not escape either.

That said, a meaningful slowdown in global growth and a full-blown trade war remain tail risks events. Corporate earnings are strong and default rates are low. Risk should remain on the table, but starting valuations across numerous asset classes, regions and sectors mean all investors should anticipate lower nominal returns, compared to the post-2008 recovery period. Lower beta market returns mean alpha resulting from strong, well established investment processes will be even more important.

This is exactly what we look for from our fund managers. Radiation comes in 3 forms – alpha, beta and gamma – and you will not be surprised to hear our ‘superheroes’ are the alphamen and alphawomen delivering just that.

*Source: Gavekal

Julia Warrander and Russell Waite

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