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3 October 2016

Finance and investment wrap - October 2016

By Clive Hale, Director

The central banks have been busy over the past month. Whether they can keep the plates spinning longer term remains to be seen and we can be sure that the UK’s Brexit saga has many more twists and turns to keep the markets preoccupied. Chinese yuan devaluation, European banking issues and the outcome of the US elections all add to the uncertainty.

We take a look at the key events you need to know about, region by region, in October.

Markets in brief:

United Kingdom

Politics remain centre stage in the UK. Firstly, we have seen the reappointment of Jeremy Corbyn as leader of the Labour party with an increased percentage of the vote compared to the previous occasion and secondly Theresa May has confirmed that the triggering of Article 50 will take place before the end of March 2017. The latter may have something to do with the sharp fall in sterling especially against the dollar.

On the manufacturing front, the UK has picked up, which should feed through into the third quarter economic growth numbers. Sterling weakness has helped our exporters, but it will almost certainly trigger inflation concerns as our trade gap is still yawningly wide.

The market continues to defy gravity on the back of central bank largesse in terms of lower interest rates as well as further quantitative easing.

United States

The US election pantomime does little to inspire confidence in politicians and for the time being it has become something of a sideshow for market participants. The indicator most people are watching is the US dollar/Mexican peso cross; if the peso weakens, Trump-the-wall-builder is in ascendancy. A Trump victory still seems unlikely right now, but then so was Brexit two months before the referendum, so the uncertainty remains.

Although there is every chance that both the American and the UK stock markets could continue to make new highs, this could be the final hurrah. Trying to eke out the last few percentage points of this current uptrend may turn out to be quite a risky strategy.

Europe

The European banking crisis has gained some traction, but still appears in stealth mode for many market participants, who continue to bid the markets onwards and upwards. The US Federal Reserve (the Fed) has assisted keeping rates on hold yet again. The European Central Bank (ECB) remains circumspect about the fate of Deutsche Bank, Europe’s largest bank, although its CEO John Cryan has been in full vent against “those hedge funds spreading rumours about Deutsche Bank and shorting its stock”. Some of those same hedge funds have been switching counterparties from said bank to other allegedly safer homes.

The latest round of speculation surrounding the banks centres upon the $14 billion fine levied by the US Department of Justice (DoJ) on Deutsche for mis-selling mortgage securities in the US. Interestingly not one board member has been taken to account by the DoJ for this not insignificant misdemeanour; they must have known what was going on in their own bank surely. By contrast, the Italians have been much more authoritarian and issued writs against six managers and former managers of Deutsche for falsifying the accounts of Italy’s third largest bank, Monte dei Paschi di Sienna. Deutsche has naturally denied any guilt.

A reduction in the DoJ fine is a possibility; as it stands it is nearly equal to Deutsche’s market capitalisation, but relative to the fines dished out to other banks it could be deemed 'reasonable' – if only by the DoJ! Deutsche's share price has fallen by more than 90% since May 2007, before the great financial crisis. Rarely do shares 'see the light of day' after a decline of such magnitude. Whether the European Central bank, Angela Merkel or the company itself can come up with a solution remains the current great imponderable.

Whatever the outcome, the rumours will continue until the European banking system makes much more stringent efforts to recapitalise. It would help if the ECB went back on its negative interest rate strategy, which is having unintended consequences in the financial sector; insurance companies as well as banks find it very difficult to operate in such an environment and we haven’t yet mentioned the plight of the saver. Faced with negative rates, savers are actually saving more. The logic being that if their income is being eroded they need more 'in the bank' to make up for it.

The only trend in the eurozone that is 'improving' is the inflation rate, which in more normal times would be as a result of 'loose' monetary policy (i.e. low rates and quantitative easing). However, at the moment, energy prices account for much of the rise as the oil producers make a tentative agreement to cut production. Unemployment on the other hand is stubbornly stuck above 10%, while youth employment (15–25 year olds) remains above 20%. Neither statistic is encouraging for further European harmonisation and the immigration issue is far from resolution.

Unlike the UK and the US, European markets are a long way off their all-time highs … and for a reason.

Japan

We continue to be concerned about the machinations at the US Federal Reserve, but the Bank of Japan must be getting close to the end of their tether. Whatever they have tried recently has back-fired spectacularly and Haruhiko Kuroda, the present governor, looks very much like a scapegoat in the making. He moved interest rates into the negative arena, added more bond buying and continued to purchase Japanese equity ETFs, all with the intention of weakening the yen, raising the inflation rate and boosting the stock market. So far this year the yen has strengthened against the dollar by more than 15%, the 'deflation' rate is now minus 0.5% and the stock market has fallen 10%. Nought out of three; he is on his way out.

The market itself has been stuck in a trading range between 17,000 and 15,000 and a break above the former is required soon to keep prime minister Shinzo Abe’s Japanese dream alive.

Asia Pacific and emerging markets

China’s slowdown is still a concern, as is the ongoing devaluation that it is exporting deflation to the rest of the world. Economic growth is still a quite respectable 6%, but it is the fall from 15% that attracts the attention. The politburo is gamely coping with the banks massive loan books, which have resulted in much mis-allocation of capital and a very tricky resolution of non-performing items on their balance sheets; does this sound familiar?

China's inflation rate is also falling. The peak before the financial crisis was nearly 9%, after which it spent a bit of time in the deflation camp and that, currently, is the direction of travel.

The Shanghai market has traded pretty much sideways since February, but there has been some action in Hong Kong as mainland Chinese will be able to buy mid- and small-cap stocks there, from December. There is a monthly cap on the level of buying, but we could see some rotation between the two markets.

Commodities and gold

Oil has captured the headlines again after a tentative deal by the oil producers to cap production and has spiked again to the US$50 a barrel level. Historically the range between $40 and $60 has contained the price. A rise above $50 and the US fracking community can turn on more taps, which will naturally keep the price in check, assuming we don't have another flare up in the Middle East.

Gold and silver meanwhile are in corrective mode and prices could go lower before a resumption in the uptrend.

Bonds

Bond world just keeps getting curiouser and curiouser. A fresh trip down the rabbit hole of negative interest rates was reached on Tuesday, when Henkel and Sanofi became the first public companies to sell euro bonds to investors for more than the redemption proceeds. The sales are the latest sign of how European Central Bank policies result in unintended consequences and have turned assumptions about the way financial markets operate on their heads. German consumer goods group Henkel sold €500m of two-year debt with a yield-to-maturity of minus 0.05 per cent, while French pharma company Sanofi sold €1bn of 3½ year debt at the same negative rate.

In Japan, another of Kuroda's remedies, which thus far is working, is to cap 10-year Japanes government bond yields to 0%. The key bell weather to watch is the 30-year US treasury bond. A move back above 3.2% yield would herald a change in a very long running trend, but sub 2% and the US may be about to join the barmy army and go for negative rates. The UK is even closer to that boundary, with 2-year government bonds yielding all of 0.1%.

Where to next?

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. Clive's views are his own and do not constitute financial advice.

©2016 FundCalibre Ltd. All Rights Reserved. The information, data, analyses, and opinions contained herein (1) include the proprietary information of FundCalibre, (2) may not be copied or redistributed without prior permission, (3) do not constitute investment advice offered by FundCalibre, (4) are provided solely for informational purposes and therefore are not an offer to buy or sell a security, and (5) are not warranted to be correct, complete, or accurate. FundCalibre, shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, this information, data, analyses, or opinions or their use.