Market Commentary – 1st December 2017

Whilst some commentators, and the Federal Reserve, insist that there is no bubble in US equity markets – we will return to that assumption later – we can be in little doubt that Bitcoin is beginning to make the South Sea bubble episode, in the 1720s, look like a small blip in the share price. Last month we mentioned that Bitcoin had risen from the start of 2017 from $1000 to $6500. Well in the space of a month it has soared to $11380, plunged back to sub$9000 and in phoenix like fashion risen again to $11800 as of Sunday 3rd December! By the time you read this it could be $20000 or $200! Quite how one puts a value on a crypto currency we have no idea, but that’s the last thing a speculator worries about; they just want the latest “get rich quick” pill. Ignoring the psychological damage that 30% plus retracements inflict (last week’s move back to $9000 was a mere 20%) the returns on offer have revised the definition of greed. From a low in January 2015 an investment of $10,000 would now be worth $650,000. This year alone a $10,000 “investment” would have reaped $110,000. Is it any wonder that people have been “betting the ranch”? The chart for Google searches on Bitcoin has taken on the same shape as the price. A futures contract is due to be introduced early in the new year, which will almost certainly assist in redefining the word “volatility”. The block chain technology that facilitates these crypto currencies is potentially a game changer for many industries and will have significant value but as a serious payment system Bitcoin isn’t going to make the grade in its current guise. Who would take payment and see the value halve? It might of course double, but that just turns your business plan into a lottery ticket…

Meanwhile the Senate has managed to cobble together a tax reform bill complete with handwritten amendments; all thoroughly thought through of course…The main item for the markets is the reduction of corporate taxes from 35% to 20%. The Dow rose nearly 3% in the week preceding the vote despite this cut seemingly having been priced in many months earlier. The original intention (fable…) was to create a revenue neutral bill, but in the event over the next 5 years the budget deficit will rise by a further $1 trillion. The major beneficiaries are of course corporates and the already well paid. Tax cuts for “middle America” are very modest by comparison, a category of employees who have not seen their real inflation adjusted wages rise since 2010. The bill runs to 469 pages much of which addresses the pork barrel effect to get the thing passed. The huddles of senators we have seen on television are not so much discussing the merits of their legislative changes as much as “what’s in it for me”; one provision allows for the Arctic National Wildlife Refuge to be opened to oil drilling…Since 2009 the Dow has risen by nearly 300% – not up to Bitcoin standards, but pretty bubblicious wouldn’t you say?

There can be little doubt that markets have been aggressively manipulated – how many know the true value of the stock market ex QE or can calculate the risk-free rate to determine it? It may feel different this time, but can we really say that low government bond yields have justified high market valuations, when those bond yields have been artificially suppressed? When the music stops, it won’t be different this time.

 UK

FTSE is still languishing in the “distribution” zone and is being pushed around as much by the £/$ exchange rate as any economic data. Sterling is pretty much back to pre-Brexit levels against the dollar, but still weak against the euro, which has had an impressive run against most currencies given the negative real rates on offer across Europe. The budget was a non-event as too it would appear are the Brexit negotiations. David Davies problem is that the EU negotiating style is “take it or leave it” with zero movement from their opening gambit. The EU’s share of global trade has been declining for some time and they will eventually cut a deal.

US

The S&P, the DJI and NASDAQ have again made new highs in November. Given our comments in the overview this is a time for caution especially as the Fed looks set to continue raising rates into a potential economic slowdown. The official GDP numbers look strong on the face of it, but inflation numbers and employment data have been changed and manipulated to create the rosy scenario effect when in fact GDP with all the adjustments stripped out is barely higher that the 2009 lows. This economic “recovery” has been one of the longest and most ineffectual on record.

The recently enacted tax bill will have little economic impact, although we suspect any corporate savings will be used to continue the share buyback regime, which has in part kept market valuations at a high level. It would make more sense to buy shares back when valuations are at a low would it not? That is our strategy.

Europe

Elections are coming back to haunt European markets. Merkel has been unable to form a coalition and may have to hold a second vote. The AfD (the “right wing” Alternative for Germany) who took 12% of the vote last time could well improve on that, which is why the Chancellor is not keen to go to the polls again. In Italy the opposition parties most of which are of the Eurosceptic tendency are gaining traction in the polls too. Renzi may end up with the same problem as Merkel although it would be the greatest irony if Berlusconi’s Forza Italia party end up holding the balance of power.

Japan

Abe’s win at the polls has propelled the Nikkei above long-term resistance at 21,000, which is now important support. We anticipate a pull back after a near 10% up move since the election and will be adding to our positions. The next target is between 23,000 and 27,000, levels not seen for over 20 years.

 Asia Pacific and Emerging Markets

Both market sectors are heavily influenced by the moves in the US dollar index. A weak dollar is generally good for these markets as we have witnesed so far this year, but there are signs that the dollar may be on the turn presaged by the anticipation of higher interest rates. Long term the demogrphics of this region are the big positive.

Commodities and Gold

The oil price has pushed above $50, which, in itself, doesn’t mean higher prices, but a backwardation in the futures contracts suggests that it may well be on the cards. If longer term prices are lower than shorter term, which is what occurs under a backwardation, then producers will be less inclined to invest in future capacity ultimately leading to shortages and hence higher prices.

Having rallied strongly since the beginning of the year gold is having a pullback, which is not at all uncommon and goes to prove the adage that nothing ever goes up in a straight line (something that champions of the S&P 500 should be aware of…) Retracements in commodities can often be quite deep so a test of $1200 and possibly lower would not be out of the question before the next leg up which should test $1400 and beyond.

Commodities in general have been out of favour for some time as the chart of the GS Commodity index relative to the S&P 500 clearly shows. A rising line indicates commodities outperforming the S&P and vice-versa. Given our views on the US equity markets and the bullish potential for gold this trend could be about to change.

Bonds

It is still early too early call the end of the 35-year bond bull market. The market does appear to be bottoming with the 2016 low only marginally below that of 2012, but we have had similar spikes up in yield before. However, the change in central bank rhetoric has added to the impetus for higher bond yields and a break above 3% for US Treasuries would be significant. In the short-term any equity market weakness could well induce some risk-off buying of bonds and if the Fed’s rate rises do tip the US into recession they have hinted at negative interest rates which would keep the bond bull market going although buying paper with a built in negative real return is the current definition of insanity.

Summary

Central bank rhetoric has changed and options for withdrawing QE are on the table. As usual they caveat their prognostications and are likely to return with further accommodation if asset markets show any significant weakness. We doubt that such an outcome would be as well received as the central banks anticipate.

  • Government bonds are heroically expensive – the trend in rates appears to be on the turn.
  • Spreads on corporate bonds are still tight and several European issues are trading on negative redemption yields. On that basis, they are ridiculously expensive and default risk can only rise from here, also making high yield potentially less attractive. Is the yield premium adequate? There is also significant concern over liquidity risk, despite central bank buying and regulatory stress testing.
  • Western equity markets are long overdue a correction, although new highs in the Dow, S&P and the FTSE remain a possibility.
  • Property is attractive as a real asset offering a higher spread against most fixed interest markets, but with the recent gating of many UK bricks and mortar funds, due to large redemptions, their attractiveness is now questionable.
  • Elections are coming back to haunt European markets and a second election in Germany is providing markets with an uncertain outlook and with the prospect of more to come in Italy next year that requires a degree of caution. Conventional wisdom says that ECB QE should be beneficial for financial assets, but the Greek issue and the recapitalisation of European banks are yet to be fully resolved, plus Draghi has threatened to start removing the QE punch bowl. The banks are improving capital ratios, but, in some jurisdictions, there is more to be done. However, it is unlikely that the ECB would allow things to get out of hand, but how well will any response be taken? The Nikkei index has punched through resistance at 21,000 and looks poised to move higher perhaps after a pullback following the 10% rise in October. Emerging and Asia Pacific markets are not overly expensive as a long-term position, but will continue to be volatile and affected by dollar machinations and Chinese economic weakness.
  • Demand for the physical metal continues to be strong and sentiment is returning with new gold markets opening in Shanghai and Dubai plus the world contemplating the latest North Korean threat. In the short term a retracement is underway.
  • Commodities have potentially reached a bottom relative to equity markets. Oil and gold are both poised to go higher at some stage over the next 6 months
  • The central banks have a significant unknown variable to contend with; the US President. Sovereign bond yields are rising on expectations of higher interest rates; not for the first time in recent history. Global economies are still fragile and any shock to the system is likely to be met with further central bank “largesse”. We observe closely for signs of success…or failure.

Clive Hale – 1st December, 2017

If you would like to go on the mailing list, please visit www.aspllp.com to subscribe

Albemarle Street Partners is a trading name of Thornbridge Investment Management LLP which is authorised and regulated by the Financial Conduct Authority.

©2017 Albemarle Street Partners Ltd. All Rights Reserved. The information, data, analyses, and opinions contained herein (1) include the proprietary information of Albemarle Street Partners, (2) may not be copied or redistributed without prior permission, (3) do not constitute investment advice offered by Albemarle Street Partners, (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. Albemarle Street Partners 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.