Carmignac’s Didier Saint-Georges foresees a ‘danger zone’ emerging over the first half of the year as a result of rising inflation creating a base effect, rising oil prices and salary pressures.
‘What we see this year is the continuation of a trend but with a pretty big hump on the way,’ the managing director said, as he expected this year to be very different to 2017.
Saint-Georges said a short-term market correction, or ‘hump,’ will happen during the second quarter and markets will overreact only to discover very little has changed.
This could be made worse if it coincides with the realisation of markets that, despite the tax package and strong news coming out of the US, the US cycle is starting to slow down, he said.
'You will have this situation where inflation is telling you your central banks might have to be a bit more hawkish but then the economy is giving you the opposite signal. Depending on how the markets react to that, it could be very tricky.’
The direction markets take depends on whether the inflation scare starts first or if the slowdown does, Saint-Georges said.
'We are still in a world of disinflation, so this inflation scare should be short lived and likewise, in the economic growth per se the slowdown will happen but we can't see how we could move to a recession any time soon.’
Forecasts of this short-term market correction have not changed Carmignac’s portfolio construction, However, the hump will still have to be managed in case of a larger reaction on bond markets spurring a correction, he said.
‘If there is an inflation scare, the question is when does the correction on bond markets start spreading to other asset classes?'
Saint-Georges compared the coming year to 1987, he said: ‘In 1987 there was no economic problem but interest rates were rising and equity markets were rising as well.
'Just like they are doing now because equity markets were saying rising rates are not a big issue if they reflect the fact that the economy is improving and that inflation is nicely picking up.
‘And so rising rates didn't prevent equity markets from going up except that somehow, around October, it reached a point where equity markets discovered that when you raise rates at one point.
'You have to adjust your discount rate when you calculate your cash flows and suddenly valuations became scary and you had an equity correction.'
The power of passives
The impact of passive funds is very difficult to calculate, Saint-Georges said, as there is a risk that quantitative, passive and algorithmic funds will get triggered into a sell off as a stop-loss mechanism if certain thresholds are passed.
‘On average, passive funds can represent up to 70% of daily flows on the S&P so if those were to start selling and then trigger more selling, you get a snowball effect. Then the market movement becomes much more brutal.’
The expected market correction will be a very important test for markets, he said. ‘This year will test what passive funds will do to a market correction so it's going to be a lot more interesting than last year.
‘Being active fund managers, we are more "buy-the-dip" kind of investors but we have to be careful to judge how low the dip will go. It's impossible right now to gauge the extent to which there could be an overshoot due to passive funds.
‘It is an animal that has become very important in flows and in assets held globally. We have never experienced how it behaves when we're not in a bull market any more.
'It is true they have been a huge factor in last year's bull market and that's concerning because that can flip very quickly.'
Buy the dips?
In the US, the investment approach of buying the dips, has almost become a joke, he said. ‘You have those supposedly smart investors who say I only buy on dips. Yes, except there was no dip, they never got the chance to buy.'
However, that is set to change this year, the manager predicts, as he said this year there could well be dips.
Even so, passive funds are at risk of misjudging the dips, he said. ‘The first dip they’re going to see they might take for a big sell-off and freak out.’