Stockwatch: Why a "risk-on" strategy will prevail - for now

Sometimes you wonder if equity investing boils down to a binary view: does the environment encourage sentiment towards "risk-on", or "risk-off"?

In the last month, central banks' posturing has renewed appetite for stocks and, as yet, there's no summertime jitters in thin markets with people away. In the US and UK, these officials have affirmed any interest rate rises will be small and slow, in a context of sluggish growth and modest inflation.

It's a supportive "Goldilocks" scenario that's neither too hot (inflation) nor too cold (recession), where zilch returns on cash maintain "risk-on" demand for equities in the search for yield and capital growth. Capital protection, however, is no longer people's first priority like it should be.

A relaxed approach is manifest, from UK lenders creating a "sub-prime" boom in new car purchases to speculators chasing growth stocks according to "the story" than consideration of value.

Quite for how long this persists before a rude interruption, such is the lesson of financial history.

Insufficient bad news from companies, to jolt markets

There just isn't enough - yet - to tip sentiment towards "risk-off". Reporting stays resilient; indeed in the US was better than expected for the second quarter.

Here, Carillion has been a chief clanger, albeit "an accident waiting to happen" according to a massive 20%+ of stock shorted. Surprise profit warnings - enough to manifest a trend - remain elusive.

Very strong progress and prospects declared on 26 July by Robert Walters, the UK/Asia Pacific/Europe recruitment group for professionals, affirm robust momentum at this company after it guided expectations upwards a fortnight ago. You'd need a contrarian "glass half-empty" mentality to declare this peak prosperity.

While 72% of net fee income recently has been derived from international business, with Europe up 19% and Asia Pacific 10%, encouragingly the UK showed 13% like-for-like progress with activity strongest across financial services, commerce and IT recruitment in London; and UK regions also produced good growth.

Admittedly this involves "professionals" and "services" and UK manufacturing/construction have their challenges; but the Walters update implies economic strengths despite well-publicised worries.

Is it really different this time?

Bearish claims that (expectations of) monetary tightening would puncture an asset bubble have so far proved false; if anything, the demand for equities is galvanised by central banks' theme of "a new normal" where interest rates remain substantially lower than previous decades.

Or have Messrs Yellen and Carney succumbed to new-era illusions like so many others?

But unless inflation surprises on the upside and growth is hit by a systemic financial shock, historically high valuations on equities look likely to persist adjusting for (near) zero returns on risk-free capital. It will take the proverbial black swan event(s) to float around the corner and shift sentiment to risk-off.

History informs us it will eventually happen, though, pace the economist Irving Fisher who declared in September 1929 that "stocks have reached what looks like a permanently high plateau".

Recalling bullish sentiment ahead of crashes - in summer 1987, late 1999/early 2000 and mid-2007 - now does feel less fevered, with a definite fear element manifest: e.g. serial warnings on the UK economy, retail discretionary spending equities down, larger housebuilders priced for 6-7% yields.

The vast majority of growth stocks show froth but is this enough to mean the wave breaks into a reversal? Other triggers from the wider economy are needed.

UK consumer debt is the greatest domestic risk

Where cautions creep into company updates they tend to involve consumer discretionary spending, which has supported the economy since the EU referendum: consumer credit rising 10% while incomes edged up just 1.5%.

Borrowing to top up wages is probably now breaching record levels of 2007: average debt per household excluding mortgages was £13,200 last year, £100 below the record.

The Bank of England has started to fret publicly about lax lending: e.g. the average advertised length of 0% credit card balance transfers has doubled near 30 months; and over the past decade new car buying has soared from being 2% 0-80% linked to finance plans - effectively leasing arrangements - where lenders stand to lose if car prices fall, even if borrowers make all monthly payments.

Figures for recent months show consumer credit growing broadly around 10%, probably to plug the gap of rising inflation versus slack wage growth. One in four people currently seeking a loan apply for at least half their annual income.

Yet central bank officials are crying into their beer as architects of this low interest rate regime, rates on £10,000 personal loans having fallen from 8% to 3.8%. The dilemma is, unless rates rise meaningfully, people have re-rated their credit behaviour just like equities have soared.

Bank of England responses involve closer supervision of banks, tighter mortgage lending standards, and checking that lenders hold enough capital to deal with losses. Maybe altogether it will manage the UK economy through its consumer debt issues, but it's a close call.

Brexit supposedly clips 1% from growth

Within a 0.3% rise in second-quarter GDP, services are up 0.5%, albeit a 0.4% slip for the relatively smaller manufacturing sector with construction down 0.9%. Retail has been the leading contributor (reflecting credit expansion), then film activities, office administration, health and property trading.

This follows 0.2% growth in the first quarter, the worst six months since 2012 albeit as expected. Commentators have seized on a weak first half of the year as evidencing Brexit woes, although fractious domestic politics must have contributed also to uncertainty.

The example of EU/Greece two years ago implies plenty of jockeying, if not walking out in the negotiations ahead.

Pro-Remain economists argue the UK would otherwise be growing at 2.5% or higher, with strong gains in real wages and business investment. Instead, 1.6% GDP is projected for 2018 and 1.7% in 2019.

I'd steal for better or worse scenarios: While an exports resurgence is awaited, industries such as yacht-building are already benefiting from sterling's fall. But as UK public debt breaks new records alongside private debt, the economy is not in a strong position to withstand a wider financial shock.

Weakening US dollar alters diversification tactics

Post the EU Referendum, dollar-earning equities were an obvious hedge. But, against an overall basket of currencies, the US dollar has trended to a 13-month low as the Federal Reserve takes a more-dovish-than-expected line towards "normalising monetary policy".

This means foreign exchange traders are liable to extend the trend unless some fresh crisis breaks to re-affirm the dollar as a safe haven. Meanwhile a return of the US debt ceiling controversy may just keep eroding the currency: Congress looks unlikely to smoothly reach an agreement to raise the ceiling, given Republicans in the Senate have been unable to bridge their divides on a healthcare bill.

So, for the short to medium term dollar earners may remain unhelpful as a hedge for sterling-based investors. Frankly, it's looking a difficult few months ahead to define new tactics: UK politics/growth/debt being unlikely to give sterling much respite, and European or Asian investment alternatives implying a commitment to funds.

Best grit teeth: Stay with your existing portfolio but ensure some cash; you just can't predict when a shift will happen to "risk-off".