Market commentary - August 2014
Somewhat surprisingly, given the flow of positive data, capped by a 4% rise in US GDP for the second quarter of 2014, Western markets were negative for the month of July. Technically they are all still in uptrends, but during the last few days of the month we may have seen a few chinks in the armour develop.
In June, Yellen Capital (the latest nickname for the Federal Reserve on the basis that its burgeoning holdings of US Treasuries makes it the world’s biggest hedge fund…) opined that they could not detect a bubble in equity prices. This month Janet Yellen observed that some individual stocks may be on valuations unsupported by earnings notably, in the technology sector.
The Fed are also aware that unemployment (as reported by the Bureau for Labor Statistics, so a quantity of salt may be appropriate here) has come down a lot faster than they anticipated. In fact the current lower rate was not supposed to happen until the second half of 2015. That got the markets to thinking about interest rate rises and stocks have fallen as a result.
No one has told the government bond markets, where yields have fallen yet again. Something just doesn’t add up. In Asia and most of the emerging markets it has been a very different story with markets positive for the month, most notably in China, where it appears they have quietly embarked on another round of quantitative easing.
The central banks, as ever, hold the key to market movements. The Fed will have completed the tapering exercise by October and will be contemplating a rate rise in early 2015, if the economy has not suffered a relapse, but the Bank of England may well beat them to it. The ECB have moved nominal rates into negative territory in an attempt to encourage borrowing and the Bank of Japan is rumoured to be planning more QE measures. The outcome of these machinations is as hard to predict as ever.
The UK index has finished the month down, but not that far from where it started. All the signs are that UK plc is in good shape, but the recovery is still acknowledged to be fragile. Mark Carney, the governor of the Bank of England, has been making noises about interest rate rises and the market seems to believe that the UK will be the first to make a move. The market’s record in predicting rate changes is not good so every utterance from Threadneedle Street is taken as gospel. In reality the Bank has as little idea about the timing as anyone else, so one wonders what all the fuss is about…If the economy continues to strengthen then rates will rise, but in very small increments, to test the waters as it were.
On the political front, having failed to see off Juncker as EC president, Cameron must now deal with a threat from the same source; namely the Luxembourger’s desire to introduce a regulator to regulate the City of London….from Brussels. The socialist dream of a federal Europe is a long way off, but this would be one more nail.
FTSE has failed again to make new highs above 7,000 and, with the monetary spigot in the off position at the Bank of England and the suggestion that rate rises might come sooner rather than later, the market is facing something of a headwind for the time being.
In the face of improving data on the economy, some of which needs taking with a dose of salt, the US equity markets have stuttered as the Fed flips and flops between an inability to see a bubble and a suggestion that some sectors are unrealistically valued. In the normal course of events, bull markets are punctuated with corrections, some quite sharp, and we haven’t had a decent one since the summer of 2011.
So it would be not unsurprising to see a 15% or so down move from here. The recent sharp fall could not be blamed on any one event – there are so many potential triggers – and is symptomatic of a market that has gone too far in the short term. We will be watching the next correction, when it comes, to see if it takes the form of earlier such moves or whether we are in for something completely different!
In Europe the spectre of deflation is alive and well. In Italy the inflation rate is very close to zero and for Europe as a whole it is not much higher. The ECB is constrained to some extent by the German constitutional court that believes that quantitative easing, as practised elsewhere, is illegal in the eurozone.
In the US the Federal Reserve’s independence allows it to act arbitrarily and, if needs be, the President can change the state of the playing field with flourish of his pen. No such luxuries in Europe where the ECB’s balance sheet continues to shrink. Unless they can restart the bank lending program soon, then deflation Japan style is a given, along with long-term sub-par economic growth.
Although he has control of both houses of the Japanese parliament, the popularity ratings of the Prime Minister, Shinzo Abe, continue to fall and are not helped by the 3% hike in the sales tax in April. The last time they pulled this trick in 1997 the economy slumped and has been recovering pretty much ever since. This time it will be different we were told, but now business sentiment is turning down, export orders are falling, along with retail sales, and unemployment is rising again.
As in Europe, if the Bank of Japan does not provide more liquidity into the system, and soon, the attempt to introduce some inflation into Japan’s economy will fail yet again. It may of course only induce temporary relief, as has been the case in the past, but there is an increasing band that believes that a lot more quantitative easing is the only option. We suspect the Japanese will take this line, which will have a positive effect on their equity markets, but we have no idea what the long-term impact, unintended or otherwise, will be.
Asia Pacific and Emerging Markets
These markets have continued to make progress in July, despite concerns over the Chinese economy, and geo-political upheavals in many parts of the world. The Chinese have quietly embarked on another round of quantitative easing and the Shanghai composite is showing some signs of life once again, having never recovered from the 2008 financial crisis, whilst most other global markets are at, or close to, all-time highs; a lot of catching up to do here.
Commodities and Gold
Industrial commodities (copper and oil in particular) are indicating that global growth is still a rather weak affair. While Western economies are showing signs of recovery, China is slowing down under the weight of a bad debt-laden banking system. Gold is still being subjected to “unaccountable” swings, despite the banks owning up to manipulation of the London gold fix. High frequency traders are now being blamed…Support at $1,200 is key for the yellow metal.
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Bonds have surprised everyone. Yields are heading back to 2012 lows for the major sovereigns and for the peripherals, notably Italy, Spain and Greece, they are well below; a degree of complacency has set in to bond markets. The ECB and the BoJ may well start printing again in one shape or another, but remember that the Fed will have stopped providing QE by the late autumn and at some stage they – and the Bank of England - will be obliged to start raising rates. Only the spectre of deflation, particularly in Europe, is keeping the bond markets buoyant. If equity markets do have a meaningful and overdue correction then high yield bonds may catch a cold as well.
The central banks as ever hold the key to market movements. The Fed will have completed the tapering exercise by October and will be contemplating a rate rise in early 2015, if the economy has not suffered a relapse; the Bank of England may well beat them to it. The ECB have moved nominal rates into negative territory, in an attempt to encourage borrowing, and the Bank of Japan is rumoured to be planning more QE measures. The outcome of these machinations is as hard to predict as ever.
• Government bonds still look expensive; sovereign yields have surprised on the downside so far in 2014.
• The yield spread between government and corporate bonds is still very low, so corporate bonds are not cheap and default risk (of income or capital payments) can only rise from here, making high yield in particular less attractive.
• Western equity markets are all beginning to look increasingly expensive and are overdue some form of correction.
• Property remains attractive as a real asset offering a higher spread against funding costs, but not without risk.
• Although it has been playing catch up, Europe is still relatively cheap, as are some emerging markets, but they too are due a corrective phase at least. The “catch up” baton has been passed to China.
• Central banks are committed to negative real yields; the ECB has even gone for a negative nominal rate! Ultra loose monetary policy will create inflation eventually, but currently deflation is back on the agenda and it is getting harder to see where anything other than tepid growth is going to come from.
• Gold and gold mining shares may have seen a turning point, but we don’t rule out some more short term downside.
*Clive Hale, Director - August 2014*
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