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Market Commentary - January 2016

If ever a chart showed the connection between the markets and US Fed (Federal Reserve) policy, it is this one. As the Fed’s balance sheet – the blue line - grew (as a result of QE [quantitative easing] by buying US Treasuries and other assets), the S&P 500 – the red line - rose in similar fashion as the proceeds of the sale of assets to the Fed were invested. It should be no surprise that as the Fed tapered its asset purchases, the stock market flattened off too.

<span class="teal">**Fed balance sheet vs S&amp;P 500**</span>

The chart is courtesy of FRED – Federal Reserve Economic Data – supplied by the Fed’s St Louis office, a staggeringly large data base of useful information on pretty much any economic series you could wish for!

Now that the Fed has moved on interest rates, it would seem unlikely that its balance sheet will resume its upward trajectory, so, at best, we can expect more sideways ranging in the S&P 500. Over 2015 the index is pretty much flat, but this disguises the disparity between the FANG (Facebook, Amazon, Netflix and Google) stocks, which have been making new highs throughout the year and the rest. On an equal market capitalisation basis the index would be significantly lower. The four FANGs grew by around $500 billion during the year, and the remaining 496 stocks in the S&P 500 collectively fell by a similar amount. The market capitalisation of Amazon alone more than doubled in 2015 from $145 billion to $325 billion and, on a free cash flow (cash generated after accounting for capital expenditures) basis, the P/E (price of a stock compared to its earnings i.e. how expensive its value is) is extremely high. It is a sobering thought that after the tech bubble burst in 2000 you could have bought stock at $7 which is currently trading at $675…

Elsewhere, European and Japanese central banks continue to expand their balance sheets, but this is not yet being reflected in stock market performance. In both regions economic growth remains sluggish at best. Much of Europe is in the grip of “austerity” measures apparently being imposed in an attempt to reign in debt, which seems a trifle “cart before horse”, and in Japan, manufacturing output and consumer spending are a long way from where Prime Minister Abe would like them to be. And then there is China, where trading on the stock market was suspended twice in the first week of the year having fallen 7% at the opening bell on both occasions. The commodity complex is on its knees and it may be time to dip a very small toe in what is beginning to look like a very cheap pool of oil, but issues in the Middle East mean there is little prospect of significant upside.

Our view of the world is not much different from that of Paul Singer, of Elliott Management Corporation, who said this recently “The ‘risk’ case is only being made circumspectly by people who are being ridiculed as clueless Cassandras. Our belief is that the global economy and financial system are in a kind of artificial stupor in which nobody (including ourselves) has a good picture of what the next environment will look like. The difference between ‘them’ and ‘us’ is that they mostly think that policy makers will muddle through, but we assume that a very surprising and scary environment lies in wait.” We will be watching the central bank narrative as closely as ever.

United Kingdom

With no signs from the Bank of England that they will follow the Fed in raising interest rates, sterling has come under pressure, which theoretically helps our exporters and adds to our import bill. This is usually the sign of a weak economy, but we are currently having a better time of it than the rest of Europe. It does highlight that we can pursue similar economic policies, but with a freely floating exchange rate we are not shackled to a one size fits all policy. How good would it be if the EU could quietly revert to being a trading zone and that the euro could be consigned to history? If we can’t move significantly in that direction then ‘Brexit’ (the possibility of Great Britain leaving the European Union) looms ever larger.

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United States

After what has seemed like an eternity, the Fed has raised interest rates and intends to have four more bites at the cherry during 2016, with a target of around 1.35% by year end. The Atlanta Fed’s GDPNow indicator is something of a volatile series, but ever since the interest rate rise the movement has all been one way, and the estimate for Q4 is now below 1.5%. The consensus forecast, although still above 2%, is also trending down. Q1 in the US is usually a weak affair, but the unseasonably warm weather, if it continues, may have less of an influence for a change. The Fed must hope so too, as backtracking on rates would come with an extreme penalty to their faltering credibility on which many still depend.

Atlanta Fed GDPNow real GDP forecast for 2015 Q4

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Europe

Data across Europe is improving, but is still a long way off a proper recovery. The improvement in corporate loan growth (household loans are following a similar trajectory) may help, but political uncertainty continues to pose risks. From Spain to Finland (as we increasingly hear the word "Fixit"), the concerns are likely to persist during 2016.

Euro area corporate loan growth year-on-year

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Japan

Japan is beginning to become a case for concern and we will be monitoring events closely as the New Year unfolds. Money printing has failed, yet again, to light a fire under the economy. In fact, the reverse seems to be true, judging by the article from Reuters which hit the wires on December 27th, when we were all suffering from a surfeit of Christmas pudding.

"Japan’s factory output fell for the first time in three months in November and retail sales slumped, suggesting that a clear recovery in the world’s third-largest economy will be delayed until early in 2016. While manufacturers expect to increase output in coming months, the weak data casts doubt on the Bank of Japan’s view that an expected pick-up in exports and consumption will help jump-start growth and accelerate inflation toward its 2% target.

Industrial output fell 1.0% in November from the previous month, more than a median market forecast for a 0.6% decline, data by the trade ministry showed on Monday.

Separate data showed that retail sales fell 1.0% in November from a year earlier, more than a median forecast for a 0.6% drop, as warm weather hurt sales of winter clothing."

Japan retail sales month-on-month

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Asia Pacific and Emerging Markets

The greatest risk to global economic growth comes from China, where recent survey data has again disappointed. Commenting on the PMI (Purchasing Managers’ Index - An indicator of the economic health of the manufacturing sector) data, Dr. He Fan, Chief Economist at Caixin Insight Group, said: “The government needs to pay more attention to external risk factors in the short term and fine tune macroeconomic policies accordingly so that the economy does not fall off a cliff.” “Fine tuning” the Chinese economy will be an interesting exercise. It’s easy on the way up; managing expectations on the way down…not so easy.

China Caixin Manufacturing PMI

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Commodities and Gold

On the face of it, the tiny bounce in oil from the low on December 18th can hardly be classified as a turning point, but it just managed to stay above the December 19th low in 2008, which, for now, is positively bullish! We are seeing similar bounces in copper and steel, which again is encouraging in the short term. Low oil and commodity prices will be of some help to economies already growing strongly, but will not themselves revive a shrinking or stagnating one.

The battle for supremacy in gold is still raging, with the bears marginally in the driving seat. A move above the long term average at around $1,150 is required for the baton to be passed back to the bulls.

Oil (1st West Texas)

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Bonds

Bonds had a mixed time of it in December. Most classes suffered small losses, but European corporate bonds were the stars as the market realised that Draghi’s latest attempts to fire up the European economy and drive away inflation meant that they were on his buy list.

The US 30-year Treasury is at an interesting juncture. Yields have been trending up since the markets got wind of the interest rate rise, but long-term, the trend is still declining. The battle lines are drawn around 3% it would seem.

US 30-year Treasury Bond Yield

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Summary

The central banks have declared their hands. The Fed has marked the turn of the US interest rate cycle, whilst in Europe and Japan the presses are still printing, and will do so for as long as it takes for those in Mario Draghi’s camp. We observe closely for signs of success…or failure.


• Government bonds still look expensive despite deflation yet again being discussed as the bigger problem.
• Corporate bonds are not cheap and default risk can only rise from here, making high yield potentially less attractive. Is the yield premium adequate? Defaults in the US outside the energy sector in 2015 accounted for more than 50% of the total. There is also significant concern over liquidity risk despite central bank and regulatory stress testing.
• Western equity markets appear to have started a long-expected correction although a new high in the S&P remains a possibility. Is the reaction to the August lows the start of a new uptrend or a rally in a bear market? The jury is still out.
• Property remains attractive as a real asset offering a higher rate of income against most fixed interest markets, but not without risk.
• European markets are in a state of flux. Conventional wisdom says that ECB (European Central Bank) QE should be beneficial for financial assets, but the Greek issue is yet to be fully resolved. The Japan Nikkei index has reached our initial target and is still relatively cheap, but economic concerns are surfacing once again. Emerging and Asia Pacific markets are not overly expensive now, but will continue to be volatile and negatively affected by dollar strength and Chinese economic weakness.
• Central banks are committed to supporting the markets, but their aura of invincibility is beginning to slip. Ultra-loose monetary policy will create inflation eventually, but currently deflation is still an issue, and it is getting harder to see where anything other than tepid growth is going to come from; even China is succumbing to the malaise.
• Gold has fallen through support at $1200, driven down by unusually aggressive and abnormal selling on the futures market. Physical demand remains strong and there will be a significant buying opportunity when this market shows signs of bottoming, but not, we suspect, for a while.
• Commodities generally will not see a sustained trend change until the global economy shows more signs of life, although in the short term, expect geopolitically induced rallies.

Clive Hale, Director - January 2016


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