Market Commentary 1st July 2018
The summer of ‘76
The UK is basking in something of a heatwave reminiscent of 1976 when the early part of the year was unusually cold (it snowed in June) and then hit 90F (32C for some of you) for the next 3 months without a break. England’s green and pleasant land went a distinct shade of brown. The stock market was also feeling the heat. After an extraordinary bear market during 1973/74 (down over 70% from the 1972 peak) the indices had staged an equally significant recovery. That bear market serves as a reminder to those who blindly buy the dip. The same can be said of the 2000/03 bear market (minus 52%) and the fallout from the great financial crisis in 2007/09 (minus 49%). None of these events were “corrections”, but spanned at least 2 years.
Could we be in for another prolonged bear market? Of course we could, but as ever the question of when raises its head. In the US valuations are reaching extremes that we have seen at previous notable peaks, but in the immortal words of Keynes, “Markets can remain irrational for longer than you can stay solvent.” Any corrections since 2009 have been aggressively bought and the markets have moved on to new highs.
The correction from the peak in January this year is showing some different traits. It removed a small amount of the overvaluation, but the subsequent retracement in both the Dow and the S&P has been led by an increasingly smaller number of stocks and sectors. Only two have made any progress in 2018; information technology and consumer discretionary. The FANGs have been responsible for IT’s performance, but two of them, Amazon and Netflix, are in the consumer discretionary sector too. If you remove them that sector actually falls by 1.9% instead of showing a13.3% gain. This very narrow breadth is another sign of an impending peak.
It is very tempting to chase performance, but many of the current crop of leaders including passive strategies will lead on the way down too so taking out some insurance is a sensible strategy right now even though that may not provide anything much by way of returns in the short term; hedge strategies in the main.
We have mentioned valuations and market internals (breadth and volume), the third factor we need to be aware of is geopolitical risk, which is prevalent wherever you look. In the UK the Brexit negotiations are key with both sides proclaiming disaster if their chosen course is not followed. In Europe we can say the same about the EU, the ECB and the steadily rising trend towards populist governments. The political capital invested in the European project is significant, but don’t write off the potential for more surprises. Trump is waging a personal trade war on Twitter and then, in no particular order, we have Korea, Syria, Russia and China, all capable of producing a shock. Caution is the watch word.
Unlike the major US indices, the UK market has made a new high, much of it on the short term strength of the dollar, which means that UK large cap stocks overseas earnings, when translated to sterling, look higher. Given the punditry about the apparent disaster that will be Brexit one wonders why the market is at such lofty levels. The small cap index looks even stronger; however, this is often the last bastion at the end of a prolonged bull market.
We have already mentioned the failing market leadership in the major indices. The inexorable rise in interest rates – the Fed have raised rates 6 times since 2015 – looks set to continue. The White House however is pressuring the Fed to ease on the rate hikes and not worry too much about inflation. In a Fox News interview, Larry Kudlow, a director of the National Economic Development Council said, “My hope Is that the Fed understands that more people working and faster economic growth do not cause inflation.” That’s not a given, but we haven’t seen this kind of rhetoric since the Nixon administration. Haven’t the GOP officials been complaining for years that the Fed isn’t aggressive enough in removing accommodation? What changed? This is an excellent example of why central banks should remain independent.
Having made a new 10 year high the European markets have pulled back decisively, which is no surprise given the fall out in Italian politics that we mentioned last month not to mention Germany’s woes and we don’t mean the football. Merkel’s interior minister has just resigned, and the fragile coalition looks set to break up which would probably be the end of her reign.
Another major worry continues to be the Target 2 imbalances. Germany holds €900 billion in balances due form other EU counties of which Italy represents €450 billion. The ECB will say that this will all balance out in the long run, which shows a disconnect from reality all too prevalent in EU / ECB circles. The new Italian government are already asking for €250 billion of loans to be written off.
Japan appears to be caught unwillingly in the trade war between China and the US. As an export led economy, like Germany, any form of tariff barrier is unwelcome to say the least. However the Nikkei Japan Manufacturing PMI came in at 53.0 in June 2018. Output, and employment increased at faster rates and firms remained optimistic that output growth will continue over the coming 12 months.
Asia Pacific and Emerging Markets
Another index that has made a new ten year high only to roll over decisively. Emerging market debt and currency issues have affected equity markets. The Chinese have allowed the yuan to depreciate by 7% with the commentators suggesting that this is one way to deflect some of the pain from the tarriff rises inflicted by the White House. Xi Jingping is quoted as saying that. “in the West you have the tradition of turning the other cheek when insulted; in China we would punch you in the face.” Trade wars don’t bring out the best in people do they?
Commodities and Gold
Gold has gone no where since the beginning of 2016 and is currently sitting at the bottom of its one year range with a record number of commentators expressing a bearish view; often the sign of an impending up move. Gold is one of those insurance policies against central banks making monetary policy mistakes. Raising rates whilst engaging in quantitative tightening may be one of them.
Oil is making another push towards $80. The implications for the global economy in the short term are highly inflationary and this is coming through in rising transportation costs, which feel the immediate impact of higher pump prices. It is also a de facto tax on consumers and given that the US consumer accouts for over 70% of US GDP this is not an insignificant development.
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 and oil, this trend could be about to change. Commodity plays are good providers of portfolio diversification and will do well in an inflationary environment.
The last five years of the 35 year bond bull market show evidence of a topping process with vital support at the 2015, 20116 and 2018 lows. If these break, we can expect a significant rise in yields. We have already seen a 12 sigma event in Italian BTPs and inflation, anathema to bond markets, is making its presence felt around the world, helped in no small measure by the oil price.
Central bank rhetoric has changed, and options for withdrawing QE are on the table while rate rises in the States are rising apace. As usual central bankers caveat their prognostications and are likely to return with further accommodation, if asset markets show any serious 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? Emerging market debt is the latest casualty. There is also significant concern over liquidity risk, despite central bank buying (Europe and Japan) and regulatory stress testing.
Western equity markets are long overdue a correction; have we had it? The jury is still out.
- 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.
- Draghi is slowly removing the QE punch bowl with the final bond purchases scheduled for December. It is unlikely, however, that the ECB would allow things to get out of hand: but how well will any response be executed? The Nikkei index has pulled back to the 21,000 region 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 they will nevertheless continue to be volatile and affected by dollar machinations, trade wars and Chinese economic weakness as we are seeing currently
- Gold is an insurance policy against central bank monetary policy mistakes. Raising rates at the same time as engaging in quantitative tightening appears to be one of them.
- Commodities have potentially reached a bottom relative to equity markets.
Not for the first time in recent history, sovereign bond yields are rising on expectations of higher interest rates. 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 July 2018
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