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Market Commentary - May 2015

April has witnessed a long overdue correction in most bond markets, mainly at the longer end of the yield curve. The yield on the German 10 year Bund has risen from 0.06% to 0.37%. Doesn’t sound like much of a move from an almost negative yield to something marginally higher, but it represents a 3% capital loss, which has wiped out all the “income” for the 10 years and then some. If it were to return to the heady levels of 1.5%, where it stood just 12 months ago, the loss becomes 13%! And bonds are supposed to be low-risk assets? Of course the ECB has a lot of ammunition in the form of €1 trillion worth of quantitative easing to throw into the pot so we don’t expect yields to rise that much in the short term (ex a Greek exit), but anyone “investing” at these levels needs to be aware of the longer-term risks.

In the US however the employment data, which the Fed watches very closely, is improving (depending of course on which of the many series you look at!) and the mere thought that they could start to raise rates this summer has sent US yields higher too, from 1.8% to 2.1%; just short of a 3% capital loss. UK 10-year yields bottomed in February and anyone buying at the low yield of 1.32% is now nursing a loss close to 5%. Surprisingly high yield bonds have produced positive returns as funds escaping from negative rates on many securities search almost frantically for a “real” return. We wonder how long this can go on. Not forever that is certain, but the ECB and the BoJ still have plenty of capacity so we expect the increasing volatility in bond markets to remain a feature. Bonds are behaving more like equities every day.

And what of equity markets? Apart from the US , and odd pockets like India, they did pretty well. UK large, mid and small cap were all up over 3%, but the star performers were Brazil, Russia and China. Commodities have had a good month and given that Brazil and Russia had been sold down into the unloved category a solid bounce was no surprise. The rise and rise of the Shanghai market has been impressive; up 28% year to date and 62% over the past 12 months. However Barron’s magazine has just run an edition with a front cover extolling the virtues of Chinese stocks so we are probably near an important top! Their PMI data has been weak and believe it or not China has a smog problem. Estimates suggest that cleaning the country’s air would come at the price of a 40% decline in industrial production. The Chinese are likely to sweep that problem under the carpet, or more likely up the chimney, but the stock market could be due to take a serious “rest”.

United Kingdom

The general election is this Thursday, the 7th, and will result in a hung parliament. The horse trading will then begin and most of the election pledges will go out of the window to placate one minority or another so that a government of sorts can be formed. Labour has said they will not align with the Scottish National Party, who look to be heading for a clean sweep in Scotland, almost totally at Ed Milliband’s expense. The Tories have just the one seat and that looks almost certain to go to the SNP too. The current coalition partners with the Tories, the Lib Dems, are likely to lose seats too, and UKIP have been sidelined as the EU referendum debate has hardly been on the agenda. If Labour do manage to form a government then UK markets will likely have a fit of pique.

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United States

We mentioned earlier the stronger jobs data in the US and none other than the former Fed chairman believes there has been a rapid decline. Here’s a section from a recent edition of the Wall Street Journal. “Mr. Bernanke defends the Fed’s over-optimistic economic growth forecasts by saying the central bank has been overly pessimistic about unemployment. “The relatively rapid decline in unemployment in recent years shows that the critical objective of putting people back to work is being met,” Mr. Bernanke writes.

Now, that’s over-optimism. One reason the jobless rate has fallen to 5.5% is because so many people have left the workforce. The labour participation rate has plunged to 1978 levels during this supposedly splendid expansion. Most economists acknowledge that if the participation rate had stayed constant, the jobless rate would still be close to 8%. The failure to attract the long-term unemployed into the job market is one reason the Fed continues to hold interest rates so low.

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An egg has yet to be laid on the Greek debacle. Their “rock star” finance minister Yanis Varoufakis has been side-lined by Alexis Tsipras who intends to go it alone with Angela Merkel. Some €3.5 billion is due in May for IMF loans and Greek short-term bill redemptions. They may be able to fudge that amount, but for the rest of the year Greece needs to find another €20 billion; where will they find that? Anyone with cash in a Greek bank account needs certifying…

A Greek exit from the eurozone would be a nightmare in practical terms and not just for the Greeks. Greece’s Target 2 imbalance (the amount they have “borrowed” from the European clearing system to keep their banks stocked with cash) amounts to nearly €100 billion, 60% of which would fall to the Germans to make good. It is hard to see how it will end well, but with Draghi still promising to do whatever it takes the sun will continue to shine on Europe for a while yet.

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On a relative basis Japan still has one of the lowliest rated stock markets, despite an impressive start to the year, with the broad equity market up 16%. It is finding it tough going to get above 20,000 (roundophobia is a curious quirk of investment markets) but, when it does so, there is not a lot of technical resistance until the 25,000 level.

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Nikkei 225 Index

Asia Pacific and Emerging Markets

As expected there has been some loosening of monetary policy in China as the non-performing loan issue becomes a bigger concern for the banking system. The market has been on a tear, but the authorities are likely to put a dampener on things to reduce the speculative frenzy for which the Chinese punter is famed. That could well represent a good entry point when it happens. The rest of Asia had a strong month too.

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Commodities and gold

There has been a tentative bounce in commodity markets and Brent crude has reached $66 from a low in January of $45. This should not come as a surprise as these markets have been heavily sold off since last summer. Will it last? The global economy is still fragile overall so perhaps more sideways than up is the best we can anticipate.

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We have said much already in the introduction. Value is almost impossible to find and the other major concern in these markets is liquidity, especially in corporate debt and not just the high yielders.

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In summary

The central banks, as ever, hold the key to market movements. The ECB has gone all in with a €1 trillion QE programme stretching out until September 2016 and a US rate rise seems as far away as ever although the markets have not entirely ruled out a summer hike.

• Government bonds still look expensive; sovereign yields surprised on the downside in 2014 and of course could continue to surprise, although in the short term we have seen a rise in longer dated yields. 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. There is also concern over liquidity risk.

• Western equity markets are still expensive and the December correction was just that; a correction. Some froth does need removing, notably in the US, but short term 2,250 on the S&P looks possible.

• Property remains attractive as a real asset offering a higher spread against most fixed interest markets, but not without risk.

• The German and French markets, potentially the main beneficiaries of QE are showing some signs of renaissance, but can Greece still throw a spanner in the works?. The Nikkei index is on the move upwards again towards our initial target at 21,000. Emerging and Asia Pacific markets are not overly expensive, but will continue to be volatile and negatively affected by dollar strength.

• Central banks are committed to negative real yields; the ECB, the SNB and the Danish central bank have all gone for negative nominal rates! 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 are still in a bottoming out phase as long as support at $1,200 holds.

Clive Hale, Director - May 2015

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