Market commentary - October 2014
Back in early August we suggested that we might have seen a few chinks in the armour of the markets only to be derided when the powers that be pressed the “buy me now” levers yet again. The central bankers have truly been the markets' best friends and Dr Aghi and Kuroda-san have been taking over where Ms Yellen has all but left off, but even they can do little in the face of protest and dissent by various members of the global populace and the continuing unnerving geo-political issues ranging from Ebola to the Ukraine. Equity markets now appear to have started a corrective phase.
One area of the market that is returning to its senses is high yield or junk bonds as we affectionately used to call them. The realisation that yields were perhaps a touch on the low side has happened slowly but like bankruptcy it could all too quickly come all at once.
In Europe all bond yields are artificially low courtesy of ECB policy, but, historically, in the high yield sector they have tended to be higher than in the US. Some catching up is on the cards here which will be painful for bond holders. The “Bill Gross” effect will also be putting upward pressure on yields. The King of Bonds has moved to Janus and redemptions from his PIMCO funds are likely to continue at significant levels. There will inevitably be some “round-tripping” if the redemptions merely get reinvested with his new company but many bond investors may take this opportunity to look elsewhere.
Having seen off the Scottish referendum, made far more news worthy by what turned out to be a rogue poll (how does that happen?) the2015 election “race” is underway. Ignoring UKIP for a moment, things had started to look much better for the Tories as the Ed Miller band have proved utterly incapable of mounting anything close to “opposition”. However two defections to the Farangist cause make it increasingly likely that UKIP will be the party with which the Tories will have to “coalesce”.
Cameron will most likely lead the party into battle but is unlikely to survive the encounter as Borisconi is standing for parliament and is the anointed one as far as the powers that be are concerned.
So more uncertainty ahead for UK plc. A weaker pound will help large cap dollar earners, but any revival in Labour’s standing in the polls will not go down well in the City and with Mark Carney at the BoE keen to pull the interest rate lever the 7000 target for FTSE looks further away than ever.
This month sees the end of QE as we know it. What is not generally appreciated is that the US budget deficit has been falling quite quickly (it is still very long way off being balanced) so the need to issue Treasuries has been muted and the banks have taken up the running from the Fed to improve the look of their balance sheets under the new Basle 3 regulations. So whilst there are no indications that the Fed will engage in “reverse QE” – selling Treasuries back to the market – the gradual tapering seems to have worked quite well.
Bond market rates remain very low (although as we mentioned earlier spreads of high yield issues are widening rapidly) and with the current corrective phase in equity markets that pattern is likely to continue and yields could go even lower should geo political events escalate. Technically the large cap equity indices are still in bull trends but the Russell 2000 index looks ominously toppy.
Dr Aghi now has his work cut out. He has jawboned interest rates to unfeasibly low levels – Italian and Spanish 10 year yields remain below both US Treasuries and UK Gilts – but without US style QE the European economies have stagnated and not just in the South Med. Germany is feeling the effects of the weak global economy especially in Asia and France is rapidly looking like the new Spain / Italy / Greece / Portugal – take your pick. Euro weakness look to be overdone in the short term but in our opinion is a one way bet for the longer term.
The Nikkei index has caught a cold along with equity markets in general, but is still technically stronger than most. Whilst Yellen is about to turn the monetary spigot off in the US, the actions of the BoJ will continue to see a weak yen / strong dollar which doesn’t mean a stronger equity market by right although that has been the effect since the BoJ started printing with a vengeance back in 2012.
Asia Pacific and Emerging Markets
The demonstrations in Hong Kong and signs that the Chinese economy continues to weaken have had a negative effect on these markets this month. China is wrestling with a number of problems at the moment but news that Chinese President Xi Jinping may replace People's Bank of China (PBOC) Governor Zhou Xiaochuan could be the catalyst for the next up move. Zhou, as a political appointee has done nothing wrong, but when a change of course is needed to a looser monetary policy stance then he has to fall on his sword…or the Chinese equivalent. It does look as though the “long sleep” for the Shanghai index may be coming to an end.
Commodities and Gold
The commodity complex is still 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. Support at $1200 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. However the Fed will have stopped providing QE by the end of October 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 the equity markets continue to correct then high yield bonds will be the first to catch a cold.
The central banks as ever hold the key to market movements. The Fed will have completed the tapering exercise by the end of 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.
• Government bonds still look expensive; sovereign yields have surprised on the downside so far in 2014. Low interest rate sensitivity is the strategy to follow for “fear” assets.
• Spreads on corporate bonds are still tight. They are not cheap either and default risk can only rise from here making high yield in particular less attractive.
• Western equity markets are expensive and look to be tracing out some form of corrective pattern. How deep and for how long is not yet clear but a 10% move to the downside would not be a surprise and would take some of the froth off.
• Property remains attractive as a real asset offering a higher spread against funding costs, but not without risk.
• Although it has had a reasonable run Europe is still relatively cheap as are some emerging markets, but they too are due a corrective phase at least. Monetary policy is still very accommodative in Japan. 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 - October 2014*
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