A decade after Lehman Brothers failed, what do managers think about banks?
On Monday 15th September 2008, I remember walking into the office, not knowing quite what to expect....
At the end of January, the U.S. equity market climbed to its steepest valuation level in history. From those levels, the expectation is that the S&P 500 will lose value, on a total return basis, over the coming 12-year horizon. That’s not a worst-case scenario or even an outcome that depends on unusual economic outcomes. It’s the standard, run-of-the-mill expectation given the valuation extremes, and it assumes substantial expansion in the U.S. economy over this horizon.
We have been anticipating a correction for some time. A combination of these extreme valuations and rising bond yields globally, has now permeated down into the market mentality. In early February global markets fell by 2%-5% and we were reminded that what goes up, must come down. For now, the correction looks to have been temporary, but we remain cautious.
We have seen periods of much greater weakness during this bull market run from the 2009 lows to 2011 and 2015-2016 in particular – so a very strong rebound (the FTSE has risen over 100 points since I started writing this piece an hour ago), or a new all-time high is not out of the question, but that doesn’t mean that this is the time to abandon a defensive stance as the valuation and yield arguments still persist. On top of which, we have a plethora of geo-political issues that could further unhinge market sentiment. They are being ignored largely because no one knows, or wants to know, what is going on. We shall be keeping a close eye on events and will be keeping you posted.
We are beginning to see some weakness in the stock market and the UK is no exception. Brexit concerns have increased the levels of uncertainty and now SocGen has issued warnings about the inability of some UK companies to pay their dividends after the Capita profits warning and dividend cut. Their dividend risk screen has 50 current names of which 21 are UK listed. However, despite the tabloid headlines, this market is still in an uptrend which will not be tested until we reach 7,200, but the warning bells are beginning to sound off.
Small beer at this stage, but this short, sharp correction is potentially a change in pattern that needs to be watched closely. As we said earlier, the short-run issue is that nothing prevents the speculative inclinations of investors from driving valuations even higher. But, as with the UK, there are some increasing signs of angst not least of all in the bond market where US 10-year Treasuries are approaching the ‘magical’ 3% level. Since last summer ,rates have doubled from 1.4%. The latest US central bank monetary committee statement casually mentions that inflation is rising and that there will be further rate rises in 2018. The odds on four such events are steadily dropping.
In Germany, Chancellor Merkel has managed some sort of coalition deal, but the resolve of all parties is being tested by Trump’s suggested sanctions on EU steel and a quota on automobiles. The UK/US special relationship may be on rocky ground, but when it comes to the EU, the gloves are off!
The Italian elections are on 4 March and things look evenly balanced between the centre left, the centre right and Beppe Grillo’s Five Star Movement. As with all recent European ballots the outcome could very easily turn out to be a surprise to the established order.
Although the EU Commission would like it otherwise, it is possible for good fund managers to find significant pockets of difference (aka value) across the market as a whole; there are still worthwhile opportunities here.
Despite its strong showing in 2017 there is still potential for more gains in Japan, which is still a long way from its 1990 peak, let alone coming close to matching the major western markets. We suspect that local, rather than global, companies are going to benefit most from the reforms that prime minister Abe has in mind. The very strongly-held consensus view is that the US dollar will regain its strength, which of course helps Japanese exporters; not something that Mr Trump contemplates with relish before he goes to bed each night. If Japan is to regain its former status, the yen may well be the currency to own, along with domestic companies.
oth market sectors are heavily influenced by the moves in the US dollar index and, as we have already alluded to, the consensus is that the US dollar will strengthen. In the short-term this may be the case, which will provide opportunity to add exposure on a market pull-back. Longer term the demographics of these regions are the big positive.
Gold had a strong year in 2017, also helped by the relative weakness of the US dollar. If the consensus view on the green back doesn’t materialise then it could be a very good 2018 too; particularly for mining stocks, which still languish at lows relative to the gold price.
Like some equity markets, the oil price is becoming very over extended, but could reach resistance at $70 before a more meaningful correction. The implications for the global economy in the short-term are highly inflationary and this is coming through in rising transportation costs, which feel the immediate impact of higher pump prices.
Commodities in general have been out-of-favour for some time. Given our views on the US equity markets and the bullish potential for gold and oil, this trend could be about to change. Commodity plays are good providers of portfolio diversification.
The canary in the coal mine is, without doubt, the bond market. Some of us have been watching the relentless rise for getting on for 40 years now, starting with yields peaking at 16% in the early 80s. With the Federal Reserve in tightening mode and probably four rate rises to come in 2018 – on top of more Treasury issuance to fund the Trump tax bill – it is no wonder that 10-year yields are on the rise. The perceived wisdom is that, if rates reach 3% (and we are very close to that number), then buyers will return to shore up the market. Let us hope that is the case.
In the short-term any equity market weakness could well induce some risk-off buying of bonds and, if the rate rises do tip the US into recession, the central bank has hinted at negative interest rates, which would keep the bond bull market going for a while. However, buying paper with a built-in negative real return is the current definition of insanity.