Thursday, December 18, 2014

Economic Summary for the week ended 17th Dec 2014

Market movements
Last week was a very poor week for equity investors. Around the world, there were signs of slowing growth: weak data from China; multiple downgrades of global oil demand accompanied by further declines in prices; more stringent collateral requirements in China; and renewed angst over European politics. The dichotomy between the US and other countries was sharply represented this week by fund flows, with US exchange-traded funds gathering $2.5 billion of inflows, while those in Europe saw $1.6 billion of outflows. It was a particularly poor week for equity investors in Europe, led by the Greek stock exchange, as there is potential for the Syriza Party to triumph in a series of presidential elections, which start on 17th December. The Greek stock market plunged 18.6% on the week, and Greek bonds sold off. Other equity markets in Europe were also weak as the potential risk to global growth suggested by the declining oil price led to people fleeing those markets in anticipation of earnings downgrades.
In spite of a still-resilient economy, US assets are demonstrating that they’re not immune to the global slowdown. The S&P 500 traded down to a five-week low, with technology and energy leading the way down. Volatility, as measured by the VIX index, rose above the 20 threshold for the first time since October. This increase in volatility was consistent with the further widening of credit spreads, which are now at their highest level since June 2013. The sell-off in high yield has been largely driven by growing concern over energy issuers. Indeed, since the OPEC meeting at the end of November – when no cut in the quota was suggested – we’ve seen the spread on energy stocks rise by 260 basis points. The oil price is the central topic of the moment. Is it the canary in the coal mine, warning us about global growth declining, or is it actually a stimulus to global growth? It’s probably a bit of both in that we’re seeing reductions in energy intensity in a number of countries (China, in particular), but we would expect there to be some activity boost from consumers, who are now finding it cheaper to fill up at the pump. And that is the dilemma that investors find themselves in, because bond markets are rallying strongly: last week, US 10-year Treasuries touched 208, which is the lowest level in over a year, and government bond markets in Europe also rallied.
Another big event of the week was the re-election of Prime Minister Shinzo Abe in Japan; the market will now be looking for an acceleration of institutional and structural reform over the next few months. However, it must be said that investors are a bit nervous as we head into year end. A couple of important things to look out for this week: firstly, as mentioned, there will be a Greek parliamentary vote for a new president, the final round of which will be held on 30 December. If the Syriza Party should prevail, we will need answers to the following questions: will they pull out of the euro? (They’ve said that they will not.) Will they renegotiate or ignore Greece’s International Monetary Fund payments and loans? (In terms of austerity, almost certainly, yes.) And would that be a crack in the eurozone’s recovery? Our view is that while there are some extreme parties in Europe, this is an unusual case, because Greece has suffered more than most in terms of the aftermath of the crash. The decline in European assets has as much to do with the falling oil price and the time of year, but there are concerns that the Greek presidential election will set off a kind of snowball effect. The other thing that spooked people about Europe last week was the relatively small take-up of the European Central Bank (ECB)’s targeted long-term refinancing operations. Investors still hope for quantitative easing involving sovereign-bond purchases by the ECB in the first quarter of 2015. Otherwise, as we head into year-end, Wednesday will be an important day, with the Federal Open Market Committee’s last meeting of the year. All eyes will be on the language of their statements regarding, specifically, whether they remove the reference to not changing rates for a “considerable” amount of time. Also, purchasing managers’ indices across Europe will give us a sense of how flat that economy is.
There is a hangover from this party; it’s being felt in high-yield markets & leveraged-loan markets most of all
It’s important, with regards to economic policy, to look beyond the stream of economic releases and remind ourselves that this is the time of year when markets tend to trade quite thinly. The only major issue that people are having difficulty with is the decline in the oil price. We can see this if we look at stock market indices again, because much of the decline in those indices and the widening in spreads is down to the energy sector. And the question that people want to look into as we move into next year is: has there been a lot of bad lending to energy companies that will impact our capital markets and our banking ratios? The answer is: there probably has been a lot of bad lending, because the oil price has been remarkably stable at a very high level for three years, which set off an increase in global exploration and production. So there is a hangover from this party; it’s being felt in the high-yield markets and the leveraged-loans markets most of all, and in the equity markets in terms of downgrading earnings forecasts for energy companies. But there are bright spots as well: this fall in energy prices is essentially a tax cut for consumers, and as we move into the new year, we feel that investors will start to look at the positive side of the coin as well, and will almost certainly be looking to bargain-hunt in equity markets.

Tuesday, December 16, 2014

Economic Summary for the week ended 10th Dec 2014

Market movements
As we move toward the end of 2014, the themes that we expect to drive markets in the coming year are really starting to take shape. Foremost among them is the divergence of monetary policy. To that end, the past week has seen two major events that we believe will set the scene for 2015. So far, the divergence theme has been dominated by the easing camp, with action in Asia and talk in Europe. The latest instalment of the European quantitative easing (QE) debate came in the form of the December meeting of the governing council of the European Central Bank (ECB). Expectations for more easing in Europe has risen sharply over the past month, and the collapse in oil prices has, once again, raised the fear of deflation in the Eurozone. In fact, yet more disappointing data has driven the inflation swaps market to price headline inflation dropping below zero for the first time ever in the first quarter of 2015. The hope for more action has been exacerbated, both by the rise in rhetoric from ECB members and by the actions of other central banks. In this regard, the recent easing by both the Bank of Japan (BoJ) and the People’s Bank of China (PBOC) have piled increasing pressure on the ECB to do more.
In line with our expectations, ECB President Mario Draghi stopped short of announcing any new policy tools. However, it was clear from the tone of the Q&A that sovereign QE in Europe remains very much in the cards. With a nod to one of the conditions he laid out last month – i.e. that if existing measures prove too little, they may have to do more – Mr Draghi said that the current policies will be reviewed in early 2015. This, for the first time, helped set a timetable to review the policies, and, if deemed necessary, to move to the next stage of monetary easing. The first sign for that condition will be the announcement of the take-up of the second-tier of targeted long-term refinancing operations (TLTRO) on 11 December. Also notable was the clear message that legal hurdles are surmountable. In fact, according to Mr Draghi, the only illegality is allowing the ECB to move away from its inflation and growth mandate – a clear shot across the bowels of the QE doubters. Market reaction to the announcement (or lack of an announcement) was to price out some of the more exuberant price action of recent weeks, in both peripheral bonds and European equities, on Thursday afternoon. However, the disappointment didn’t last long, with markets bouncing back sharply on Friday – helped by some positive press on the chances for QE in 2015 – most notably in Germany.
On the other side of the Atlantic, the divergence theme has been particularly quiet. In fact, US Treasury yields have been held low, driven by the widening gap in yield with core Europe and the expanding search for income around the world. Behind the scenes, though, the drivers of the tightening camp are starting to pick up. This was confirmed by the latest non-farm payrolls data, which showed the strongest positive surprise since January 2012, coming in at 321,000 versus a survey estimate of 230,000. With October revised upward as well, and hourly earnings beating expectations, it was a strong report all around. Coming on top of the increase in the recent employment cost index – the Federal Reserve (Fed)’s favoured measure of income – the pressure for rising wages is clearly growing. And this is key: the missing link of wages and incomes in the US looks to be appearing fast. As we move into 2015, it is difficult to see the Fed not moving to a more hawkish stance as it prepares for what we believe will be a first hike in the Fed’s funds rate by the middle of next year. That step could come as early as this month, when the Fed may adjust the language regarding timing in a Federal Open Markets Committee meeting.
The strong growth data was taken positively by equity markets, with the S&P 500 creeping up to end on yet another weekly high – its seventh in a row – and the Dow Jones fast approaching 18,000. So far, the good news of an improving labour market is outweighing the bad news of what it might mean for the Fed’s easing stance once they start the hike. This is no small measure, due to the baton change of central-bank QE from the Fed to the BoJ, and possibly the ECB, next year. Even bond markets were relatively sanguine: the 7 basis-point (bps) rise in 10-year yields on Friday took them to 2.31%, still below where they were before September’s Fed meeting.
The winners continued to be Japan & China
While the main news came from Europe and the US, for markets, the winners continued to be Japan and China. Both sustained their positive recent momentum, with A shares up another 9% and the Nikkei up over 2.5% to close at a seven-year high. Rising volumes in A-share markets are encouraging hopes that domestic investors may finally be buying back into their own equity market. The strength of the US dollar also continues to provide strong support to Japan, with the dollar-yen exchange hitting 121.5 on Friday. For emerging markets, the dollar strength remains a significant headwind: broad emerging-market indices were down just shy of 2%. The combination of ongoing European QE hopes and the spectre of the Fed has pushed the euro-dollar exchange below 123, which will continue to help both exporters and Germany. After months of disappointment, tentative signs of a cyclical improvement in the Eurozone economy are appearing, with factory orders in Germany rising strongly. Note that autos helped drive the pick-up in these orders; this is a sector we think should benefit as we move into next year.

Friday, November 7, 2014

Economic Summary for the week ended 7th Nov 2014

Market movements
Last week was a strong one for risk assets, with equity markets leading the way. Most equity markets were up by 2.5%; in fact, the US equity market is back to the year’s highs. The standout performer was Japan, which reached a seven-year high, up 7% on the week. There was also a surprise announcement from Japan, which is increasing its quantitative easing programme substantially and including the purchase of equities within that. The announcement surprised the market, pushing equities higher and weakening the yen. Combined with that, Japan’s Government Pensions Investment Fund announced a significant increase in its weighting to Japanese equities – from 12% to 25%. This fund is at $1.2 trillion – the largest pension fund in the world – giving scope to add significant new exposure to equities. This supported the move by the Bank of Japan (BoJ) on the quantitative easing side, resulting in very strong performance from Japanese equities.
Elsewhere, in bond markets, US Treasuries ended five basis points (bps) higher in yield, at 2.34%; in the gilt market, yields were flat over the week, with 10-year gilts around the 2.25% mark. Corporate bonds were stronger over the week; yield spreads to government bonds were narrower, in line with the rally that we saw in equities.
The stronger dollar theme continued, particularly versus the yen after the aforementioned move by the BoJ, where the dollar strengthened 3.5%. Elsewhere, commodities remained under pressure, particularly oil, which briefly dipped below $80 per barrel during the week. Gold was also weaker by about 5% as investors continued to move away from precious metals.
The future looks bright in the US
So the obvious question is: given the nervousness we’ve seen over the last couple of weeks and during the middle of October, what has changed? Firstly, we think the BoJ’s actions are very positive on the liquidity side for markets – but that happened on Friday, and markets were already rallying before then. So there is clearly something else at play? Turning to the macroeconomic data: it was positive in the US and this clearly benefited markets. We saw third-quarter GDP data coming in better than expected, up 3.5%. The last two quarters of economic data in the US represent the strongest back-to-back GDP gains since 2003. On the employment side, the situation in the US continues to be very supportive, with fewer Americans having filed for unemployment than at any time in more than 14 years. The unemployment rate is now below 6%. So the economic backdrop of the US is currently supportive of markets. Additionally, we are in the middle of the earnings season, and again are seeing some positive surprises. Within the S&P 500, we’ve seen over 70% of companies reporting, and in terms of performance versus expectations, 60% of those companies have beaten sales estimates and 80% have beaten on earnings.
The picture in Europe is less supportive, but you would expect that to be the case. The economic backdrop remains subdued. Markets continued to digest the results of the European Central Bank’s (ECB) asset quality review, where over 130 banks were reviewed in depth and tested against various economic scenarios. Only nine of those were seen as needing to raise further capital, and most of those were quite small banks. So markets seem to be taking some comfort over that. And while there are some questions regarding the toughness of the scenarios that analysis was conducted under – there was no deflation scenario, for example – it seems that markets are taking some reassurance that substantial amounts of capital are not required at this stage in terms of boosting banks’ balance sheets. This it does give considerable clarity about the state of play within the European financial system. In fact, some of the ECB’s data on lending continued to be modestly positive.
All in all, it was a good week for markets. But what happens looking forward? There will be a lot of data out this week: in the US, we will see the ISM survey and employment; within Europe, we have retail sales and an ECB meeting; and in the UK, we have manufacturing purchasing managers’ indexes and Halifax house prices, as well as industrial production and a Bank of England (BoE) meeting.
It’s worth noting is that we do not expect anything from either the ECB or the BoE this week. There will be a continuation of the earnings season in both the US and Europe, and there is scope for positive surprises there. In terms of market outlook, we are seeing significant flows coming back into equities, which do have the potential to continue further. We are now getting into the tail end of the year, so there is a question mark over the extent to which investors are willing to increase any risks they’re taking so late in the year. So the macro and the earnings backdrops should continue to be supportive on funds flowing back in, which could push equity markets higher. But at this stage in the year, it’s difficult to see that going significantly further, given investor sentiment.

Monday, November 3, 2014

Economic Summary for the week ended 1st Nov 2014

Market movements
This week, we focus on how to interpret the last few rather interesting days of market activity. The theme underlying recent weekly reviews has been the market sell-off – in particular, what caused it and whether it will continue. The common view is that the sell-off reflected a genuine slowdown in the global economy, particularly in Europe. However, the market reaction was – not for the first time in the history of financial markets – greater than the macro data in isolation might have warranted. We also stated that we are not expecting a sustained slowdown in global economic conditions. The severity of the sell-off also appeared to reflect technical issues, in particular some widespread long-equity and short-duration positions that were cut as risk assets fell, contributing further to the selling pressure.
So how does this analysis currently stand up? Last week there was a material rebound in risk assets: equity markets rose, spreads over high-quality sovereign bonds fell, and government bond yields themselves rose. As of Monday afternoon, some of this had reversed; there’s nevertheless been some recovery in markets. As a broad rule of thumb, the equity correction has been around 10% on average, and the average rebound up to the end of last week was some 4%. Government bond yields have reversed at a broadly similar proportion to their previous decline.
So what do we know now that we did not know a week ago? First, there has been some good economic data. The European purchasing managers’ index rose in September; Chinese GDP for the third quarter and industrial output for September surprised on the upside; and industrial output also rose strongly in the US last month. It’s also worth pointing out that the current earnings round in developed economies has also been very supportive. US corporate earnings over the year to the third quarter rose at close to a double-digit rate (based on some of the companies that have reported so far) and numbers look similar, if a bit lower, for companies which have reported elsewhere in the world. Finally, in Europe, the recently released results of the European Central Bank’s stress test on bank capital suggest that there is no longer a glaring hole in the heart of the European banking system, even if some individual institutions, particularly in Italy, may have more work to do in that context.
“Perfectly feasible” does not mean “inevitable”
If you add it all up, the soft patch that the global economy hit during the summer does appear to be reversing, although as always, we remain vulnerable to short-term noise in the data. Concerns that the market correction may have reflected some sense of deeper malaise in the global economy have therefore moved a little further offstage. Looking ahead, it does seem perfectly feasible that the global economy will continue to struggle through and that the remainder of 2014 to 2015 will be a period of positive, if less than stellar, growth. After all, global monetary conditions are very loose, global fiscal policy is becoming much less restrictive, financial conditions are easier than a couple of months ago, and there has just been a major fall in the oil price, which will help to put money into consumers’ pockets. And it also seems perfectly feasible that in this environment, inflation will remain low; inflation expectations will remain close to central-bank targets in the long term, and therefore, there will be little or no pressure for central banks to tighten monetary conditions. And if all of this happens, then it’s feasible to expect a diversified portfolio of growth assets to outperform very defensive assets such as cash or high-quality bonds – albeit, at pretty modest absolute returns given the extent to which valuations have normalized. Remember, there are few very cheap asset classes around, and there are some at which the pricing is more aggressive. Still, the correction in high-yield spreads in recent weeks means that some valuation support is now back in that asset class. However, “perfectly feasible” does not mean “inevitable.” The fundamental message behind the market correction is that the feasibility of the scenario just described may no longer be what it was. One month of good data does not, after all, suggest that the Chinese growth model is fixed or that Europe is on the verge of a strong, self-sustaining recovery that will push deflation concerns to one side. Indeed, last week, the good news from the output side of the purchasing managers’ report for the euro area was offset to some extent by a sharp decline in inflation in the services survey for the same area. The recent market correction has also led markets to push out potential monetary tightening from the US Federal Reserve (Fed) and the Bank of England from mid-year to the end of next year.
However, the lower level of bond yield does mean that fixed-income markets remain more vulnerable to a reversal of sentiment. This week, the Fed is likely to announce the end of its asset-purchase program, which over recent months has already been minimized very considerably. The largest casualty of the events of recent weeks is volatility, which had previously been very low across all asset classes for an extended period. This development was not irrational; we were simply in a very low-volatility macro environment. But as the range of possible macro outcomes broadens, so does the potential for markets to flip from pricing one regime to another. It’s difficult to believe that this process is going to stop. Therefore it is highly likely that volatility is not going back to the low average levels that we’ve seen over the past couple of years.

Tuesday, October 21, 2014

Economic Summary for the week ended 21st Oct 2014

A week is a long time in politics, and this last week has felt like a long time in financial markets: the first half of the week with plunges in equity markets worldwide, the second part of the week with a sharp recovery, both in equities credit and high yield. There were almost unprecedented swings on a daily basis – sometimes on an intra-day basis – in the trading of US 10-year Treasury bonds. It was a week that led people to ask a lot of questions about investment policy, the world economy, and the enormous spike in volatility. Before addressing those, let’s briefly remind ourselves that for a long time volatility has been extremely low. Until recently, the volatility of commodities, of bonds, of currencies and of equities has been, by historical standards, exceptionally low. Uncertainty presents itself in many ways. It’s rather like holding a beach ball under the water – when you let the beach ball go, it bounces up further. That’s what I think we’ve seen; that’s what we continue to see. The proximate cause has been a reconsideration of the race of economic growth globally. Interestingly, although much of the commentary has been on Europe, the sector volatility in the equities space and the bond market volatility has been far greater in the US, probably because it was a given part of everybody’s investment thesis that US growth is recovering strongly and it wouldn’t be long before the Federal Reserve (Fed) would be starting to raise rates.
The turning point came this week when a number of Fed governors said that they would not rule out further stimulus in the future, or that they are arguing the case for an interest-rate rise to be pushed further out into the future. The markets rallied around that. That’s a straightforward signal that global markets still need either price stimulus or quantity stimulus, or that they’re going to reset their valuation base very rapidly. We think that the valuation base has already been reset, because even if rates are going to rise, they’re going to rise quite gently. That was true before the last two weeks, and it’s truer now. The higher-yielding end, and the slightly riskier end, of the fixed-income complex really has got some considerable value in it, and it’s worth looking closely at exposures there.
By contrast, long-duration government bonds have rallied very strongly because they’ve been the only diversifier around, and are almost certainly overvalued. For equities, the case still remains that they are the asset with the real rate of return whereby corporate earnings, as we’re seeing in the current earnings season, and cash flows are rising, and the ability to reward shareholders to increase dividends and corporate activity still remains very much in place. At the centre of this somewhat disastrous last couple of weeks has been economics. This week, we will get a number of economic releases which will be closely scrutinised, particularly on Thursday, when Japan, China, France, Germany, the Eurozone, and the US release their purchasing managers’ index figures for October. The market will examine those numbers very closely. It will also examine China’s figures on Tuesday for investment retail sales and third-quarter GDP. All the evidence suggests that the government in China is working overtime to ease policy on housing and the availability of credit at this stage, partly to meet the 7.5% GDP target the central government has set, and partly because they are probably concerned that things are slowly down too fast. Over the next few months, we expect a cyclical, but not a secular, recovery in the low levels of Chinese output led by upgraded activity in the housing market. We’ve also got a series of corporate earnings this week: from the pharmaceuticals sector, Glaxo, in Europe; from the banking sector, Credit Suisse, in Europe; and consumer plays such as Daimler and Amazon and, finally, Caterpillar. The latter will paint a picture of very considerable traction in the demand for global construction equipment. The reason for focusing on that is that it leads one back to the epicentre of the change in views about the economic outlook, which has been filled with disappointing numbers from Germany. We believe that the European economic outlook is very flat, but that there will be some cyclical improvement in numbers over the next six months. Fiscal easing and a little bit of policy change will help things along. We believe that the overselling of cyclical stocks in the stock market has provided a deep valuation opportunity.
Fortune could favour the brave
In summary, volatility has come back; it’s probably risen too far. Economics are low and flat, but in some areas they are going to improve relative to quite low expectations. Positioning has been flushed out quite a bit. There is some good value at the longer end of high-yield and emerging-market debt as a consequence of recent events, and for those who want to be brave, deeply cyclical shares have fallen so considerably in value and might just be positioned for a bounce-back.

Thursday, October 16, 2014

Economic Summary for the week ended 16th Oct 2014

The past week has been a very difficult one for many financial markets as the severity of the risk-off phase – which began a few weeks ago – intensified further. Global equities are now more than 5% down from their previous peak. The year-to-date gains in global equities have now been eliminated: of the main indices, only US equities are still in positive territory. There has also been a major correction in commodity prices and, while the weakness this past week has been across the board, the $20 decline in the oil price over the past few months remains the most noteworthy move. Credit spreads have widened in recent days, but the selling pressure on investment-grade spreads has been relatively muted. Almost inevitably, high-quality government bond yields in this environment have declined further, but they have edged lower rather than collapsed. They still remain within recent ranges in the US and the UK, but the 10-year German government bond yield has hit new lows. So what’s driving these moves? Are we looking at a technical correction within a bull market, or a more fundamental change in the global financial background? And if this is a more fundamental move, exactly what fundamentals are we talking about? It’s important to emphasise that some of this correction does appear to be technical. The consensus in the global financial community has been more risk-on than risk-off, hence the chance that positions would get closed out if markets move in the opposite direction. This factor does appear to have been at work in recent weeks, with volumes relatively high. On a technical basis, many markets do now appear to be rather oversold. However, if we focus more on the fundamental factors, it appears that you’re potentially spoiled for choice. The dominant fundamental factor at the moment seems to be – not for the first time this cycle – about global growth, or rather, the lack of it. It’s pretty clear that the global economy had been subdued at the first half of the year, but there’s been a fairly widespread expectation of some lift-off occurring in the second half and into 2015. However, this expectation has been challenged, to date, rather than confirmed by recent data. At the global level, industrial production just seems to have stalled over the summer.
Digging deeper, there’s been some acceleration in US growth, but not really a powerful lift-off. Elsewhere, there have been clear losses in growth momentum in China and the Eurozone. The rebound in economic activity in Japan, after the inevitable slowdown following the tax rise earlier in the year, has been muted. Digging deeper still, within the Eurozone, it’s Germany – rather than the more troubled peripheral countries – that is at the core of the slowdown. German growth had been negative in the second quarter, and has been soft again recently, raising concerns about a potential shift back into recession. It’s worth emphasising that the markets are reacting to what is a fairly small incremental change in the global growth backdrop. There is little evidence that there is a marked slowdown in economic activity underway. There is a case to be made that the weakness in commodity prices is telling a different story, but this week, this appears to be as much supply-driven as demand-driven. We have seen many fluctuations in global growth before, and while we know that these are important, it is also potentially dangerous to extrapolate them.
Eyes on US earnings
It is possible to make some broad generalisations about recent events in the global economy. First, underlying demand conditions have remained stronger than output growth. Weakness in industrial output does seem to have been partly the result of inventory reductions, which are more likely to prove a temporary rather than permanent influence. Second, this inventory challenge has been concentrated in the global auto industry, where output looks likely to rebound quickly and possibly strongly. And third, some corrective mechanisms are potentially coming into play. In particular, much lower food and energy prices should increase consumer spending power. There is also the possibility that slower growth would lead the Federal Reserve and the Bank of England to delay rate rises, which are a particular issue hanging over markets. So our current conclusion is that the global economy is not in free-fall, and there is scope for a rebound as we go into 2015. However, in environments like the one we’re in, the market’s sensitivity to macro data is even greater than usual, so the upcoming earnings season in the US will be particularly important in providing a greater outlook on what really is going on in the global economy

Monday, October 13, 2014

Economic Summary for the week ended 9th Oct 2014

Market movements
It was an interesting week in markets, with new themes emerging, old themes persisting, and some resumptions of themes that we saw earlier in the year. It’s fair to say that one new theme has been the increase in volatility across equity markets (most of which were down 1% to 2% on the week). The driver of this has been fear about growth and ongoing concerns about deflation. To that end, it’s fair to say that on both sides of the Atlantic, investors’ expectations for inflation continue to fall. For example, let’s look at bond markets and what they’re pricing in for inflation over the next 10 years: in the US, that level of expectation has fallen below 2%, when historically it’s been closer to 2.5%. In the Eurozone, that number is now below 1.5%, where typically it has been closer to 2%. In fact, on a data front, we saw Eurozone-wide inflation (CPI) drop to 0.3%, getting very close to that zero-deflationary level that people have begun to become fixated on. Perhaps another way of thinking about inflation expectations is to look at the price of gold. Gold last week fell below US $1,200 per ounce: with the exception of the start of this year, you have to go back to August 2010 to find a point when gold traded less than that number. This is also an indication of the broader weakness that we’re seeing in commodities, which is adding to this expectation of inflation being lower that we had previously assumed.
On the growth side of the equation, it’s fair to say that Eurozone growth remains weak, particularly in northern Europe. On Monday, German factory orders were released for September, which had almost 6% on the month and is now down 1.3% year-on-year. The picture is better in the US, where we saw decent employment data on Friday, with the unemployment rate falling to 5.9%. But even there, people are concerned. For example, we saw the forward-looking indicator of manufacturing data come out weaker than expected, although very much in positive territory. In terms of new themes for the market, this idea of equity volatility is largely driven by concerns about growth and deflation. As mentioned at the start, old themes – such as the strength of the US dollar – continued to dominate the week. In fact, the dollar continues to hit new highs for this cycle across many of the major currencies. For example, the currency is getting very close to 1.10 versus the yen, dropping to about 1.25 versus the euro, and with sterling, falling below the 1.60 level. It’s a continuation of monetary policy driving this theme, specifically expectations for the Federal Reserve raising interest rates early next year and the European Central Bank (ECB) and the Bank of Japan continuing to pump liquidity into the system.
Last week, we saw the ECB give further details of its asset-backed securities purchase, which some are alluding to as being very similar to quantitative easing. One question around this is that sterling has been particularly weak versus the dollar, yet expectations in the UK are still tilted towards a rate rise at the start of next year – which is puzzling. But you have to look at this through the lens of the Eurozone, where sterling has been trading very closely with the euro. And in fact, some of the worries are focused around how the economy will be impacted by this slowdown we’re seeing.
Where do we go from here?
The obvious question raised by the dollar strength is “where do we go from here?” The strength of the dollar last week suggests that there are still many people tempted to jump onto this trend; but we have moved a long way and I would expect that, while that trend of dollar strength will continue, price action isn’t likely to be much more two-way going forward.
The third of last week’s themes was the resumption of a topic that dominated markets earlier in the year. Emerging markets started 2014 very weak – they outperformed over the summer, but there are a couple of things now driving that re-emergence of weakness. The first relates to the broader volatility in equity markets and concern around growth, but also the dollar strength. Historically, it’s worth noting that, in periods of dollar strength, emerging markets have generally underperformed or been weak. I would caution against reading too much into this: if the dollar is strong due to some positive momentum from an economic perspective, that could be an environment that is broadly more supportive for emerging markets, particularly those in Asia. We continue to see some idiosyncratic issues at play in emerging markets.
Russian assets were very weak last week. Democratic demonstrations in Hong Kong are putting pressure on all things Chinese. From a perspective of growth, we remain very confident about the outlook for the US; any slowdown in data should be examined in context with what is actually a robust growth picture for the country. There are some challenges around the Eurozone, particularly for some of the larger economies: some of those are starting to weaken quite markedly. Linked to this is an important point about deflation. Central banks will do all they can to avoid deflation, but the market is getting more and more concerned about it.

The economic background of being broadly positive should continue to be supportive for equity markets, but I think the question marks that are coming through in terms of that pattern of growth and the uncertainly around rates means that we can expect higher volatility as we head toward the end of the year. The message is one of being reasonably constructive about equities, but we shouldn’t expect the very low levels of volatility and risk that we’ve seen over the summer to continue into the end of the year – it’s going to be a bumpier ride.

Saturday, September 20, 2014

Economic Summary for the week ended 20th Sep 2014

Latest market views from the BlackRock Investment Institute
This week is set to be a key one for risk assets as we head towards the final quarter of the year. On the geopolitical side, Thursday’s Scottish referendum and the Ukraine situation dominate the headlines.
Less tweeted about, but equally, if not more, important, is the spectre of real central-bank divergence as we head into Wednesday’s Federal Open Markets Committee (FOMC) meeting in the US. Over the past week, these looming developments have reversed the recent positive momentum in markets. For equities, it was a down week. The S&P 500 fell back below 2000, while Europe’s recent European Central Bank (ECB) resurgence came to a grinding halt. Spain was hardest hit, both in stocks and bonds as the potential repercussions of a ‘Yes’ vote in Scotland raised claims for the unofficial Catalonian referendum to be granted more prominence by Madrid. Italy was also weak, partly on profit-taking from the ECB-fuelled peripheral asset rally, which reminded us that Prime Minister Renzi faces a testing time in the coming months for his reform drive.
Elsewhere, this week in France will see a confidence vote and speech from President Hollande on reform. However, for once the UK is centre stage, with markets finally waking up to the closeness of the Scottish referendum. Last Sunday’s poll giving the Yes campaign the lead for the first time sent sterling from 1.63 towards 1.6 against the dollar. By the end of the week, however, it was back above 1.62. Various polls in recent days show the result as too close to call. The only certainty is that the referendum will lead to changes in the UK, regardless of whether the result is a yes or a no. So currency volatility in sterling is likely to continue.
All eyes on central banks
Away from the UK, this is a key week for the US Federal Reserve (Fed). Recent economic data has shown steady improvement, but only limited signs that the drop in unemployment is feeding through to rising wages – the main focus for the Fed. This has allowed bond markets to remain largely sanguine. Two-year yields have risen over the summer and the dollar has embarked on a broad-based strengthening, but the longer-dated end of the yield curve has remained very range bound, until now.
The past week has seen the first signs that the extremely low bond-yield environment of the summer may now be shifting, with the 10-year bond moving up 15 basis points to 2.6%. On an absolute basis, 2.6% is still very low, but remember we started the year at 3%. The backup in yields has been quick and comes at a time when US equities are at record highs. The front end of the US yield curve has moved to price in earlier rate hikes, with June now favoured. In our mid-year outlook, we saw the Fed as the main threat to risk assets in the autumn. So far, that has been overshadowed by the ECB. But now it’s the Fed’s turn again, with this month’s FOMC meeting. Analysts’ eyes will be on whether the phrase ‘considerable period’ is again used. The 2017 ‘dots’ (the Fed’s own projections of where interest rates may be) will also be released, possibly giving more insight as to the likely terminal rate.
Back in Europe, this week sees the first TLTRO allotment – the targeted long-term repo operation announced by the ECB back in May. A total of up to €400 billion will be allotted to banks, with conditions to encourage lending to ensure the money enters the real economy. The original LTROs were successful at stopping the liquidity crunch that was enveloping the European banking system two years ago, but did little to spark lending activity, as most of the funds went into the ‘carry trade’ of buying peripheral government bonds. The TLTRO takeup is likely to be large, but questions remain about what banks will actually do with the money. Meanwhile, German bund yields are back above 1%, pulled up by the move in Treasuries and some realisation that sovereign quantitative easing is not a done deal.
China and Brazil reverse their rallies; Japan a bright spot
Further afield, emerging-market (EM) equities’ recent performance reversed, led down by China and Brazil.
For China, concerns over the government’s GDP targets are back, with recent economic data showing industrial weakness. China’s equities rally has gone long way, but needs a short-term catalyst to keep it going, given the economic reality of rebalancing. This could raise pressure for more government or central- bank easing support. The convergence of A-shares and H-shares has been helped by the ‘Shanghai Connect’ test trades, whereby offshore investors can now buy domestic equities. Similarly, the Bovespa has given back some of its exponential rally – a rally driven purely by hopes that political opposition can create another ‘Modi moment’. This has been enough for the equity market to defy the reality of a rapidly deteriorating economy on its way to stagflation with zero growth, but the risks are clear. For broader EMs, this compounds the risk of a more hawkish Fed that has seen EM currencies weaken versus the dollar. It is important to watch the ‘fragile five’ to see if the currency sell-off accelerates. Within Asia, our preferred area, Korea, has struggled recently, in part because of the weaker yen.
Finally, one bright spot in global equities is Japan. The Topix outperformed other major indices by rising over 1% last week. Having been range-bound all year, the dollar/yen has moved quietly, by 5 points to 107, and the Topix has pushed over the key threshold of 1300. With a weak yen, and news due about government pensions, Japan looks set to continue its stealth outperformance as markets’ attention stays firmly fixed on developments in Edinburgh and Washington.

Monday, September 15, 2014

Economic Summary for the week ended 11th Sep 2014

Last week was eventful, both in terms of policy and economic data. Equities were typically up between 0.5 and 1%. In the US, the S&P closed above 2000 for the first time and managed to sustain that level throughout the week. European equities rose by 2-3%, helped by the actions of the European Central Bank (ECB).
In Asian markets, both Japan and China were strong, boosted by confidence that China was doing reasonably well from a policy and growth perspective. The main laggard of the week was the UK, on evidence that the Yes vote in the Scottish independence poll was gaining ground. The biggest impact of this was on sterling, which saw considerable weakness, particularly against the dollar.
On the fixed- income side, both government and corporate bond yields drifted higher, largely on profit-taking but also on concerns that the US Federal Reserve’s view is becoming increasingly hawkish, making an early rise in interest rates more likely. The other main theme across markets was the stronger dollar, most in evidence against sterling, but also versus the euro, the yen and emerging-market currencies.
Quantitative easing – by another name
The key event of the week was the meeting of the European Central Bank (ECB). There had been much speculation that we would see the ECB establish a quantitative easing (QE) programme, as economic data over the past few months had shown sustained weakness in the core heartlands of Germany and France, and inflation was slipping below the 1% level.
The ECB did take action by cutting interest rates, but more meaningful was the ECB’s announcement that it would purchase asset-backed securities – this was dubbed “private QE” by the market. While there was some disappointment that the purchase of government bonds hadn’t been announced, it is quite possible that we’ll see this further down the track. Overall, this action was taken positively, and is obviously supportive of European banking because it helps free up the bank- lending channel. It is also positive for European equities, where we believe markets are among the cheapest on a global basis. The weak euro also helps corporate earnings.
Geopolitical crises dominate politics
On the politics front, last week’s focus was the Nato meeting in Wales. The focus was twofold: the approach to dealing with Russia and Ukraine, and a more coherent plan for the crisis in the Middle East. On the first point, despite the announcement of a brief ceasefire, we expect to see ongoing friction on the Russia/Ukraine border. This isn’t currently creating a huge amount of volatility but, given Europe’s dependence on Russian natural gas, especially as we approach the winter months, energy supply could cause problems. In the Middle East, pressure is building on western governments, particularly the US, to articulate a more coherent plan of action. The challenge is that this would require working more closely with the Assad regime in Syria, and negotiations with Assad could involve Russia. So in some ways, the two crises are linked, which gives a sense of how difficult the situation is from a political - negotiation perspective. While events in the Middle East have also had little impact on markets yet, with crude-oil reserves still high and the oil price weak, this could turn around pretty quickly, especially as the winter months approach and demand increases for heating supplies.
The implications of Scottish independence
The biggest focus in terms of market volatility here in the UK is the Scottish independence vote. The referendum takes place next week – on the 17th, with the results available two days later on the 19th. (I would draw your attention to a 10-page document our BlackRock Investment Institute produced in March, which runs through the implications of a Yes vote.) The key focus is the currency, where Chancellor George Osborne has made it very clear that he would not be willing to let Scotland use sterling on a longer-term basis. It’s worth pointing out that nothing would happen immediately following a Yes vote, because the first date at which independence could take place would be March 2016. But it seems likely that a Yes vote would create a great deal of volatility and uncertainty, particularly in terms of currency, and exactly how much of the gilt market Scotland will own.
A Yes vote would also have implications for a number of large companies that are currently headquartered in Scotland, as they would need to decide where to base themselves.
Policy highlights in the coming week
In the UK, house-price data, retail sales and industrial production figures will be published. Given the focus on the strength of the UK, and the potential for interest-rate rises, these will all be considered important pieces of the economic jigsaw puzzle. So we may see some volatility based on these releases. In the US, official releases include retail-sales data, and in the eurozone, inflation data, which has so far been a key influencer of ECB policy. Last but not least, it’s clear that the geopolitical issues described above will not go away any time soon and will continue to generate news headlines and cause volatility. But at this stage, markets are not paying a huge amount of attention to events in Ukraine and the Middle East.

Wednesday, September 10, 2014

Economic Summary for the week ended 9th Sep 2014

Market movements
August was an excellent month for investors in both bonds and equities. We saw government bonds in Europe rise sharply with the best monthly performance since the beginning of 2012. This also helped US Treasuries produce strong returns. In Europe, returns were variously 1.9–2.0% for the month as a whole. US Treasuries were up 1.2% and gilts rose 3.5%. This hauled credit up with it.
Of particular note was the recovery in US high yield, which posted a positive return of 1.8% for the month after outflows in July. For equities generally, markets were led by the S&P 500 index, which breached 2000 for the first time.
This represented a 4% rise, with financials outperforming. European stockmarkets were variously up between 0.5–2%. The UK market was up 2.1%. In emerging markets, Brazil was the star performer, up nearly 10% as people scented a political change coming. Indian and Chinese assets also rose. Only commodities were weak: copper was down 3%; sugar fell 5%; corn was flat after a weak July; and Brent crude oil was down 3.1%. The most important event was in currencies – the dollar strengthened, particularly against the euro, which declined nearly 2% against the US currency.
Quantitative easing for Europe?
Policy (or expectation of policy) linked all these developments together, as has been the case for the last two to three years. In August, we heard the admission by European Central Bank (ECB) Governor Mario Draghi – speaking at the Jackson Hole retreat – that the ECB was beginning to be concerned about the decline in European inflation expectations, which indicated a move towards some form of quantitative easing (QE). This was key to the stronger performance of European bonds, with 10-year German bond yields dropping by 27 basis points in August. French yields dropped by 28 basis points, from very low levels. People now hope the ECB will move towards implementing sovereign QE. However, real policy action remains some way off.
The first step along the way will be approval - possibly as early as Thursday of this week - of the beginnings of a programme to purchase asset-backed securities. This is a relatively small market in Europe, some 500 billion euro, so the injection that the ECB could make in terms of existing stock would be stretched over a period of time. The expectation is that the ECB would buy new asset-backed securities, and help companies reduce their cost of funding as a consequence.
Sovereign QE is some way off and we saw, as expected, a rather cutting response from Germany’s finance minister Schaeuble, who suggested monetary policy had reached its fullest extent in Europe. This is consistent with everything we’ve seen in the dance of ECB policymaking over the last two or three years: an initial proposition from Mr Draghi, followed by a period in which the hawks object, followed by a re- examination of still-softening data and a grudging acceptance. Nevertheless, I think we’re several months away at least – it may be the middle of next year – from full-on quantitative easing in the sense of buying sovereign debt. However, the markets anticipate, and that’s what we saw in relatively thin volumes in August.
Policy highlights in the coming week
In the coming week, the ECB has its meeting on Thursday this week. On Friday, payroll figures are announced in the US. Regarding the ECB, the market will be focused on whether or not the bank actually announces the beginning of QE, and Draghi’s remarks at the following press conference.
In the US, there is some expectation, given the softening trends in retail data and personal consumption, that the payrolls number will be sufficiently low – around 200,000 or below – to mean that the Federal Reserve’s meeting on 16 and 17 September will produce no significant change in the outlook.
One other central-bank policy point to note in August was the Bank of England’s (BoE) Monetary Policy Committee voting by seven to two in favour of retaining interest rates as they are. This was the first time under Governor Carney that the vote was not unanimous.
We believe that the BoE is slowly moving towards some form of tightening, but that this is several months away from materialising. Monetary policy is still wholly supportive and will remain so. This means holding cash is a rather painful experience, with bonds likely to continue to perform strongly, and equities even more so, particularly if good funding markets continue to allow buybacks of shares and cash-funded M&A activity. The only major fly in the ointment is geopolitics, especially developments in Ukraine. Here, the line in the sand that would lead to risk expanding well beyond Russian equities would be Europe and the US agreeing sanctions that would exclude Russia from the Swiss settlement system. If that happens, then I think we will see further escalation of geopolitical risk, but at the moment it’s more talk than walk as far as the markets are concerned. We continue to watch Ukraine and the build-up of Russian soldiers there, as it is the key threat to a pro-bonds, pro-equities, anti-cash environment.

Friday, June 20, 2014

Economic Summary for the week ended 20th June 2014

China - Foreign investment in China fell in May to its lowest level in 16 months, partly due to slowing growth. The government says China attracted $8.6bn in foreign direct investment (FDI) in May.
That is a 6.7% fall from the same period last year and marks China's weakest FDI report since January 2013.
Economists say prospects of slower growth in the world's second-largest economy may have deterred foreign investors.
China's economy expanded at the pace of 7.4% in the first three months of this year, down from 7.7% growth in the previous quarter.
U.S. - The International Monetary Fund (IMF) has slashed its U.S. growth forecast, urging policy makers to keep interest rates low and raise the minimum wage to strengthen its recovery.
The crisis lender said it expects 2% growth this year, down from its April forecast of 2.8%, after a "harsh winter" led to a weak first quarter. However it expects 3% growth in 2015.
It also said the U.S. should increase its minimum wage to help address its 15% poverty rate.
"Given its current low level (compared both to US history and international standards), the minimum wage should be increased," the IMF said in its annual assessment of the U.S. economy.
Argentina - Argentina's stock market closed 4.9% lower on Thursday after the country's cabinet chief said there would be no delegation to the US to negotiate with bondholders over a $1.3bn (£766m) debt.
Earlier this week, a US Supreme Court ruling sided with bondholders demanding Argentina pay them the amount in full.
Argentina defaulted on debts in 2001 following a severe economic crisis.
It has been in a legal battle with a number of US hedge funds which lent money to the country.
Many hedge funds have agreed to accept a partial repayment, but others, led by NML and Aurelius Capital Management, are demanding payment in full.
Commodities - India has taken over from the U.S. as the largest importer of Nigerian oil, the West African state's national oil company has said.
The US has "drastically reduced" its demand for Nigeria's crude oil in recent months, the Nigerian National Oil Corporation said. The country is currently buying about 250,000 barrels a day.
India now buys considerably more - about 30% of the country's 2.5 million barrels of production.
U.S. demand for imported oil has fallen sharply because of increasing domestic shale gas and oil production - so much so that the International Energy Agency and oil giant BP both forecast that the country will be largely energy independent by 2035.
Commodities - Investors are moving back towards safe haven assets such as gold as ongoing violence in Iraq hits markets.
Gold climbed to a three-week high of $1,282 an ounce on Thursday, a 0.6% increase and the fifth day of gains as Iraqi insurgents seized control in parts of the country. The metal has risen 6.7% this year on tensions between Russia and Ukraine.
Silver, palladium, and platinum also saw a rise, with silver reaching a one-month high of $19.8 last week.
On Friday, Brent crude oil passed its previous high of $114 per barrel after Iraqi militants threatened to halt repairs to an oil pipeline.
Spotlight on: Will ISIS push oil prices to critical point?
Escalating violence in the Middle East could impact global economic activity as oil prices continues to climb.
In the past week, the Islamic State of Iraq and al Sham has taken several northern Iraqi cities by force and despite the fact the majority of Iraqi oil fields are located in the south of the country, this violence has already made investors nervous.
Capital Economics chief emerging markets economist Neil Shearing says: “The unfolding crisis in Iraq has cast a shadow over the region, causing equity markets to tumble. As it happens, the largest Middle-east and north African economies have only limited trade and financial ties with Iraq, meaning that, in aggregate at least, the economic spillovers should be fairly small.
“But some countries, such as Jordan, do have relatively large trade ties with Iraq while in others, such as Lebanon, the crisis could exacerbate existing sectarian divisions.”
Outside of the region, the price of oil is being negatively impacted by this surge in Iraqi violence and could impact global investors.
The Brent Crude oil benchmark currently pegs the price of oil per barrel as $115.06, very close to the “critical” $120 per barrel level according to Old Mutual Global Investors fund manager Richard Buxton.
Buxton, who manages the £1.4bn Old Mutual UK Alpha fund, says: “Ongoing conflicts in the middle east are absolutely at the top of the worry list. We have been concerned all year about this but this is clearly spilling out in a much more dramatic fashion.
“Oil is currently hovering below that critical $120 per barrel level which we have seen several times in recent years. If it goes over this it slows in terms of economic activity. We have to keep a very close eye on this and it would have a very material impact.”
BlackRock global chief investment strategist Russ Koesterich argues a prolonged price rise in oil would pile additional pressure onto the global economy as it suppresses stocks and raises volatility.
As a result, Koesterich says: “Higher oil prices, coupled with still reasonable valuations in the sector, support a continued overweight to energy stocks.
“At the same time, higher oil and gas prices represent yet another headwind for a consumer already struggling with slow wage growth and high personal debt. In a world of modest growth and a strapped consumer, we believe a cautious view toward consumer discretionary companies is warranted.”
With debate now raging as to the possibility of western intervention into Iraq, Ashmore head of research Jan Dehn sees a resolution to this crisis via this route as unlikely due to past geopolitical crises.
Dehn says: “The west’s loss of moral authority to act has already inflicted diplomatic defeats on western powers in the Syrian conflict and over Crimea and in Georgia. “We see very little chance that the west will be able to significantly ramp up its influence in the region from current levels, which means that the west’s most important allies increasingly have to rely on their own financial and military means to see off the threat to their rule from militants.”

Wednesday, June 11, 2014

Economic Summary for the week ended 9th June 2014

China - China's service sector grew at its fastest pace in six months in May, helping allay fears of a sharp slowdown in its economy.
The non-manufacturing Purchasing Managers' Index (PMI) rose to 55.5 in May from 54.8 in April. The PMI is a key indicator of the health of the sector and a reading above 50 indicates expansion.
It comes just days after China reported that the manufacturing sector grew at its fastest pace this year in May.
China's service sector, which includes construction and aviation, accounts for nearly 43% of its overall economy.
Spain - Spain is set to introduce a new stimulus package totalling €3.6bn ($4.9bn) in a bid to bolster the country’s nascent economic recovery.
Spanish prime minister Mariano Rajoy has announced that the new measures will be brought in next week in an attempt to create jobs and encourage the competitiveness in the economy.
“Next Friday, the government will present a package of measures to increase competitiveness and productivity,” he said.
“The plan will include investments totalling €3.6bn, of which €2.67bn will come from the private sector and €3.63bn from the public sector.”
As part of the new package, Spain’s main rate of corporate tax will be cut to 25% from 30%.
Middle East - Qatar’s shares fell for a third day on Wednesday and bonds dropped on concern that the Persian Gulf nation may lose the right to host the 2022 soccer World Cup, potentially jeopardizing some of its $200bn investment plans.
Qatari stocks, among the world’s best performers this year, have lost 4.1% in the past three days after the U.K’s Sunday Times reported that payments were made to soccer officials in return for allowing the Arab country to host the tournament. Rashid al Mansoori, chief executive officer of the Qatar Exchange, maintaining that the nation won the bid with “credibility” and corruption allegations were“noise.”
“If countries are asking for a re-vote, this will hurt the market further,” Hisham Khairy, the Dubai-based head of institutional trade at Mena Corp. Financial Services LLC, said. “I would stay away at the moment and wait for things to settle.”
Japan - Japanese shares gained this week, with theTopix index rising for a tenth day on Wednesday, its longest winning streak since August 2009, as the yen weakened and steelmakers advanced.
The Topix rose 0.4% at the close of trading in Tokyo after falling as much as 0.1% throughout the day. About three shares rose for every two that fell. The gauge posted its longest winning streak since the 13 days through Aug. 4, 2009.
“The future is looking brighter for Japanese shares,”said Hiroichi Nishi, an equities manager in Tokyo at SMBC Nikko Securities Inc., citing factors such as a weaker yen and the relative cheapness of stock prices. “However, the danger of overheating is increasing.”
Brazil - Brazil’s industrial production in April contracted for the second month in a row, as output of capital goods and consumer durables fell.
Production dropped 0.3% from the previous month after contracting 0.5% in March, the national statistics agency said Rio de Janeiro. The decline was smaller than the the median estimate of a 0.4% fall from economists surveyed by Bloomberg. Production declined 5.8% from the year before, versus a 6.1% fall forecast by analysts.
Brazilian industry has sputtered as the central bank raised borrowed costs over the past year to combat above-target inflation, leading to a slide in business and consumer confidence. Manufacturers have also been hit by economic troubles in Argentina, Brazil’s third-biggest trading partner. Analysts expect the currency to weaken by year-end, improving the outlook for exporters.
Today’s data “add to the building sense of concern in this sector,” Daniel Snowden, emerging markets analyst at Informa Global Markets, said. “No matter what the government seems to do, no matter what the central bank seems to do, the sector just doesn’t want to put together any kind of consistent run. It’s been lifeless.”
Spotlight on: More life left in the U.S.?
Fidelity Worldwide Investment's Dominic Rossi says questions over the ability of the U.S. to keep leading global indices higher are misplaced, with the region in the middle of a bull market and capable of climbing another 25% from here.

Some investors are beginning to question whether the U.S. economy and its stock markets can continue to provide leadership to global equity markets after a strong run during which valuations have re-rated.
In my view, the answer is a firm yes. While the U.S. economy has had a subdued start to 2014, the strength and duration of its resurgence will surprise investors.
Market volatility remains anchored, valuations are not expensive, and profits can move higher despite concerns over ‘peak’ profitability.
With the prospect of supportive liquidity conditions, a return to the ‘cult-of-equity’ could drive a multi-year bull market in stocks.
Anchored volatility allows valuations to expand
It has been a solid first quarter for equity markets after a strong 2013. The resilience of markets has been particularly impressive given they had ample opportunity to take flight. But equity markets have shrugged off uncertainty over the crisis in Ukraine and weak U.S. growth.
It was striking how resilient equity markets proved to be and how contained volatility stayed during this period.
Equity market volatility is being anchored at low levels by confidence in the positive structural outlook for the U.S. economy. When implied volatility (VIX) falls below 20, we have a favourable environment that allows valuations to expand.
Lower volatility was a pre-requisite for the re-rating in markets we saw in 2013, and it is currently well below 20. While many investors got used to elevated volatility through 2008-2012, it can stay low for a sustained period, much like it did in the 1990s, so investors should be wary of only looking at the recent past.
In terms of what might trigger volatility, the interest rate cycle has become the key focus. U.S. Fed chair Janet Yellen recently let slip at a press conference the phrase “six months” in response to how soon the interest rate cycle could start after tapering is completed.
While there was a small spike in volatility and equities fell on the news, there was no reaction from U.S. 10-year treasuries, indicating the lack of concern among bond investors about inflation risk.
Resurgent U.S. will continue to lead global stock markets
In the US, the news is only going to get brighter. I think we are at an inflection point in the U.S. economy, and I am not convinced the market is fully recognising how rapidly the economy is strengthening.
The data is improving across the board, whether it is loans data, manufacturing PMIs, services PMIs, or consumer confidence data.
The speed of the improvement in the budget deficit is remarkable. Since 2009, the fiscal deficit has shrunk to around $600bn from $1.5trn. It is not implausible President Obama will finish his term with a fiscal surplus.
In this case, I think we are looking at a U.S. equity market that is similar to the late 1990s, one in which equities should be well supported by liquidity.
Valuations and earnings can go higher
Equity markets are no longer cheap, but nor are they expensive. In the U.S. market, we have a slightly unusual situation in earnings expectations at present.
Usually, we start the year with high and unrealistic earnings forecasts which have to be revised down. The opposite is the case this year, and we are likely to have a strong earnings season versus subdued expectations.
Beyond that, it is prudent to consider the standard counterargument to the buy case for the U.S., which has lately become commonplace. This argument points out the U.S. is on a P/E of 16 times, yet corporate profitability is at record highs.
If we cyclically adjust for peak profits, then the P/E is 22 times. Given we are approaching an interest rate tightening cycle, the bears say this makes the U.S. market a sell.
This is naïve in my view. Profit margins may well be at record highs, but I think they can move higher. The distribution of profits between capital and labour in the U.S. is going through a fundamental shift.
There are a number of reasons why profit margins can stay high, such as the globalisation of labour forces, less organisation of labour, technological change, and the ability of markets to press companies to focus on profit margins in a way that just did not happen 30 years ago.
Overall, the outlook for corporate earnings remains favourable.
Buy on the dips
The U.S. market is going to break out strongly on the upside from its current period of consolidation. With compressed yields on U.S. and euro credit, equities will look attractive versus credit as earnings come through.
The danger is U.S. equities have a too-strong rather than a too-weak year, given the positive outlook for both liquidity and earnings.
It is evident some investors have been left a little traumatised by the bear market in equities and are still relatively fearful.
However, I believe we are in the middle of a bull market and, in a bull market, you buy the dips.
In this light, if we get a mid-cycle correction based on the expected onset of the interest rate tightening cycle in 2015, this would be a buying opportunity, and, the S&P 500 could move to 2,000-2,300 from its current level of 1,800.

Friday, May 16, 2014

Economic Summary for the week ended 15th May 2014

Japan - Japan's economy grew at the fastest pace in nearly three years in the first quarter, due to increased spending ahead of a sales tax increase on 1 April.
Official data showed GDP rose 1.5percent in the January-to-March period, against a revised 0.1percent in the prior quarter. The figure beat forecasts for 1% growth, and was led by consumer spending which rose by 2.1%.
Private consumption accounts for approximately 60percent of Japan's economy. However, economists warned that spending may taper off now that the April tax hike has been introduced.
"Japan's economy expanded rapidly ahead of the sales tax hike, but is set to slump thereafter," Marcel Thieliant, Japan economist at Capital Economics, said.
"Looking ahead, the economy will certainly contract in the second quarter of the year, as consumers rein in spending after the tax hike, and residential investment is set to plunge."
Germany - German economic growth picked up pace in the first three months of 2014, while France's economy failed to grow, the latest figures show.
German gross domestic product (GDP) grew by 0.8percent, driven by stronger domestic demand, the country's statistics office said.
In contrast, growth in the French economy was flat, with an official figure of 0percent.
Russia - Russia’s first-quarter economic growth will likely prove to be the slowest since a 2009 recession, as the country’s standoff against the U.S. and its allies over Ukraine hampers investment, a survey of economists showed.
Gross domestic product advanced 0.7percent in January-March from a year earlier after a 2percent gain in the previous quarter, according to the median estimate of 19 economists in a Bloomberg survey. The Economy Ministry projects that output expanded 0.8 percent in the period. The U.S. and the European Union responded to President Vladimir Putin’s takeover of Crimea from Ukraine with sanctions and warned they are ready to take further measures if the former Soviet republic’s May 25 presidential election is disrupted. The $2trillion economy was stalling even before the penalties hit. The International Monetary Fund said April 30 that Russia is already in recession.
“The main driver for the slowdown is the contraction of investment,” Vladimir Osakovskiy, chief economist for Russia at Bank of America Corp. in Moscow, said. “Investment weakness is due to a combination of much higher borrowing costs and the deterioration of the political and economic outlook. The latter is at least partly due to rising sanction risk from the West.”
Gold - Gold sales at jewelers in Hong Kong have declined as mainland shoppers buy less, the Chinese Gold & Silver Exchange Society reported, adding to signs of a slowdown in consumption by the world’s largest user after 2013’s surge.
Demand dropped about 30percent from a year ago, during the Golden Week break that began May 1, owing to the holiday being shorter this year and there were fewer visitors as luxury spending fell and gift-giving slowed.
While China surpassed India as the biggest user last year, the buying frenzy sparked by gold’s slump into a bear market last April hasn’t been repeated, according to Heraeus Metals Hong Kong Ltd. Lower consumption in China this year may help to extend declines in prices as investors press on with sales from exchange-traded products.
India - Indian stock markets have risen to a record high this week, after exit polls suggested the Narendra Modi-led Bharatiya Janata Party (BJP) and its allies are on course to win the general election.
India's main stock index, the Sensex, rose 1.7% to 23,941.32 points in early trade on Tuesday. This follows a 2.4% gain on Monday, ahead of the exit poll results.
Analysts said investors were hopeful that a BJP win could help reverse the slowdown in India's economy.
Exit polls released by Indian media organisations on Monday evening showed the BJP-led National Democratic Alliance (NDA) well ahead in terms of predicted seat wins, and the governing Congress trailing badly.
Spotlight on: The World Cup effect
For most Brazilians, winning a World Cup on home soil would be priceless. For companies ranging from retailers to airlines, the event is bad for business.
More than two-thirds of malls expect a “significant” drop in traffic during the World Cup next month as soccer fans stay in front of their TVs and shopping centers restrict hours because of public holidays, an Ibope poll released May 13 shows. Banco Santander SA says a drop in business travelers will cut sales for airlines like Gol Linhas Aereas Inteligentes. Hotels and restaurants are also bracing for a slowdown.
With less than a month to go before the tournament starts, the international soccer championship isn’t giving Brazil’s sluggish economy the lift supporters like former President Luiz Inacio Lula da Silva and Finance Minister Guido Mantega had hoped for. Latin America’s largest economy missed a chance to use the World Cup to fuel long-term growth by not following through with all planned projects to modernize infrastructure, while economic activity in the short term isn’t likely to get a boost, said William Nobrega, managing partner at The Conrad Group, an investment advisory firm for private equity.
“It would have had a positive impact not only on short-term but also long-term economic growth, that didn’t happen,”Nobrega said. The World Cup will“at best” have a neutral impact on gross domestic product.
2 Percent Growth
The tournament comes at a time Brazil is heading toward its fourth straight year of GDP growth below 2percent. The prospect of host cities granting workers more days off may hurt the economy further, Santander said in a report dated May 9.
“With a substantial number of additional holidays during the 32 days of the tournament, our economics team expects a slowdown in economic activity that could impact all companies, ”Santander analysts including Pedro Balcao-Reis said.
Retail businesses like clothing, pharmacy and gasoline stations are also expected to see a decline in sales during the period, according to Moody’s Investors Service analyst Barbara Mattos.
“Possible holidays during the games damage the companies’productivity as they won’t have the same number of working hours,” she said in an e-mail.
UM Investimentos, a brokerage in Rio de Janeiro, is one of those companies. “Volume is lower on the days of the games,” Chief Executive Officer Marcos Maluf said, adding that the day after a game trades will be back to normal.
Route Changes
Brazil’s national air regulator, known as Anac, expects carriers to change routes ahead of the games to adjust for lower-than-expected demand. As of May 1, airlines had sold only 21percent of the seats on flights in June to and from the 12 host cities, Anac said.
Santander estimates that Gol’s revenue during the month-long event will be cut by about 13percent, as an increase in tourists won’t be enough to offset a 70percent drop in business travelers. The negative impact on bigger rival Latam Airlines Group SA will be about half of Gol’s as Brazil represents 50percent of the company’s carrying capacity, the bank’s analysts wrote.
“As corporate clients pay much higher prices, even with the expected increase in leisure prices, the overall impact on prices should also be negative,” the analysts said. “We expect a negative impact on both volume and prices.”
Hotels in Sao Paulo, South America’s business hub, are also suffering.
Occupancy Rates
While World Cup hotel occupancy rates in Rio are already above 90percent, only about 30percent of the rooms are booked in Sao Paulo, where the opening game takes place on June 12, said Joel Renno Jr., director for strategic development at Hotel Urbano, a Rio-based online travel agency. Agencies blocked a large number of rooms in Sao Paulo, hoping to boost rates for a surge in demand that never followed, he said.
“There was overshooting, everybody is much more bullish than what’s really the situation,” Renno Jr. said on May 6.“What we have heard from the market is that it’s about to start a process of super-aggressive promotions from hotels, with rates dropping drastically.”
To be sure, the World Cup is turning out to be a financial boon for some Brazilians. Real estate broker Norbert Hartmer said he is renting luxury apartments to Asian billionaires in Rio’s best neighborhoods for as much as $180,000 for the month.
A three-bedroom residence in Leblon, Rio’s most exclusive neighborhood, goes for an average of 3,500 reais ($1,590) a day during the World Cup, according to Rio’s regional real estate brokerage council.
Government Estimates
The Brazilian government expects the event to mobilize 3.7 million local and foreign tourists, generating 6.7 billion reais in spending linked to the tournament, according to a May 13 statement from the country’s communication secretariat.
Some host cities including Rio, where the tournament’s final will be played on July 13, have declared public holidays on game days to try to ease traffic jams.
“Productivity levels for Brazil during the entire month of the games are just going to go through the basement because you are going to have rolling holidays,” The Conrad Group’s Nobrega said. “Even without official holidays, there are a lot of people who are just not going to go to work.”