Market Commentary –1st January 2018
At this time of year our major preoccupation is not concerning ourselves with forecasts for 2018, but pondering over how 2017 panned out so quickly and what we have learned from its passing.
Forecasts are financial candy. Forecasts give people who hate the feeling of uncertainty something emotionally soothing.” Thomac Vician Jnr student of Ed Seykota.
And equally damning is this – The Illusion of Certainty – Gerd Gigerenzer – “Many of us smile at old fashioned fortune tellers. But when the soothsayers work with computer algorithms rather than tarot cards, we take their predictions seriously and are prepared to pay for them.”
“Our industry is full of people who got famous for being right once in a row.” Howard Marks
History has taught us that in the long run there is correlation between market fundamentals and prices such that deviations above and below trend will mean revert. In the short-term markets can move to extremes and stay there for periods that defy those very same fundamentals. Why does this happen? In today’s world of high frequency and algorithmic trading discrepancies between fundamentals and price should be arbitraged away very quickly, but this didn’t happen in 2017 and the question everyone is asking is, “When will it?”
Logically there must be a third factor in play and the conclusion is that it is “us.” Not every player is looking at the market through a valuation lens, and if those players are big enough, then distortions in market prices will be inevitable. A classic example can be found in European bond world. In the normal course of events it is inconceivable that European high yield bonds should trade anywhere close to the yield on 10-year US Treasuries, but they do courtesy of the ECB’s policy of “Doing whatever it takes.”
In the desperate search for yield “investors” – or are they “speculators” – assume that this state of affairs will last indefinitely. It won’t will it? The ECB is already on the path of reducing its bond buying program and over the pond the Fed raised rates again in December and three more rises are on the cards for 2018. On top of that they too are reducing their debt holdings, while, at the same time, the latest US tax bill will lead to more issuance of US Treasuries to fund the ever-growing deficits. Who is going to be the buyer? Central bank action has been responsible for both creating and deflating bubbles and we doubt that it will be different this time.
We do not currently hold high cash levels, but are nevertheless defensively positioned as market volatility plumbs new lows and uninformed buyers chase increasingly expensive stocks and bonds. There will be bumps along the way, some of them significant, which will allow us to take advantage of better long-term opportunities at a lower valuation.
The year ended with the UK markets making new all-time highs; playing catch up with US equities after some lingering concerns over the Brexit negotiations, yet to be resolved. The latter will be the cause of spikes in volatility, which will also affect the sterling exchange rate. Over the New Year period, uncharacteristically, both equity markets and sterling rose together. Much has been said about the non-correlation of these two, price series since 2009, but it is becoming apparent that the tie is starting to come undone; trends don’t last forever. In the 2005/09 period UK equities and sterling rose and fell together and there is no reason to believe that we should not get a repeat performance at some stage.
The S&P, the DJI and NASDAQ have again made new highs in December. 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 a significant one off boost has come from increased economic activity after the summer hurricanes and flooding. GDP with all the adjustments stripped out is barely higher than the 2009 lows. This economic “recovery” has been one of the longest, yet most ineffectual, on record.
The recently enacted tax bill will have little economic impact. Although capex intentions are rising, we suspect that the majority of 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.
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. Italian and Spanish bond yields are on the way back up, if you consider over 2% as “Up!”
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 upside 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 PM Abe has in mind.
The very strongly held consensus view is that the US dollar will remain strong which of course helps Japanese exporters. If Japan is to regain its former status the yen may well be the currency to own along with domestic companies. Maybe we won’t get those US rate rises after all.
Asia Pacific and Emerging Markets
Both 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 an opportunity to increase exposure. Long term the demographics of this region are the big positive. The Emerging Markets chart shows a very similar pattern being very much overbought in short term.
Commodities and Gold
The continued backwardation in oil contracts has pushed the price of crude back above $60. There is still significant available capacity and new supply is likely to bring prices back down rapidly as the winter weather morphs into spring.
Gold has had a strong year in 2017 also helped by the relative weakness of the 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 relative lows; the fate of the unloved…
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.
It is still too early to 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, then they have 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.
With interest rates on the rise and central bank buying of debt on the wane this is the final curtain call for the bond market and we won’t be waiting around for it.
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 real 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.
- Property is attractive as a real asset offering a higher spread against most fixed interest markets, but with the gating of many UK bricks and mortar funds in 2016, due to large redemptions, their attractiveness is now questionable. REITs are equities in disguise.
- Elections are coming back to haunt European markets and a second election in Germany is providing markets with an uncertain outlook. With the prospect of more to come in Italy next year a degree of caution of caution might be required. 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. 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; domestic issues are preferred. 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. Mining shares are not unattractive
- Commodities have potentially reached a bottom relative to equity markets.
- 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 January 2018
If you would like to go on the mailing list, please visit www.aspim.co.uk to subscribe
©2018 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.
Albemarle Street Partners is a trading name of Thornbridge Investment Management LLP, which is authorised and regulated by the Financial Conduct Authority (“FCA”)