Market Commentary – 1st November 2017

There seems to be no stopping the rising tide that has lifted almost every asset class including bonds. We can’t remember a period like it when everything went up together; including Bitcoin which now has a price tag of $6500 against just under $1000 at the beginning of the year. The latest rise has been inspired by the news that the CME plan to launch a futures contract which will no doubt beget a proliferation of ETFs both long and short and geared to boot.

With equity markets deemed to be a safe haven, bond markets are going through a serious reappraisal and portfolio managers are looking to “diversify” away from this asset class by seeking out a bewildering (for some) variety of alternatives. We are not alone in believing that investing for a guaranteed negative real return makes little sense. The yield spread between European junk (high yield as purveyors of product prefer to call it) and US Treasuries is now as good as zero, courtesy of the ECB bond buying programmes. They have extended it to September 2018, but increased the rate at which the buy backs will be reduced. Bond world is still in denial that the central banks in Europe and the US are now in a tightening cycle that signals the end of the asset price binge. Unless “unforeseen circumstances” arise that necessitates a return to the old discredited ways of more QE.

The central banks seem to have no idea what is going on. Yellen openly admitting that she has no clue about the path that rates of inflation are taking. It would appear that she won’t have long to worry about this conundrum as Trump is about to appoint her successor. The Fed’s interest rate forecasts are wrong to the extent that the correlation with the actual outcome is -0.6; not totally wrong, but pretty close to it. Their fervent wish is to generate some decent inflation that will make the debt problem more manageable; but they have failed. Lower interest rates have not resulted in more borrowing and spending. Business don’t want to borrow as the economic “recovery” is still in intensive care. We hear that in the US, labour conditions are tight, but what that really means is that companies are unwilling to pay the “clearing rate of compensation” ie they won’t pay enough, as they can’t see how they will make a decent return if they do. Savers are equally non-plussed. If they earn little from their deposits rather than spend more they feel it necessary to save more to provide a bigger pension pot; thus perpetuating the economic malaise.

In the UK Carney has said that central bank policies are not the cause of low rates, but responses to them! “We are actors in a play written by others.” He does seem to have found some new script writers as the BoE have just announced a 25bps rate rise!

Two asset class are not in high demand; one is cash and, with markets blowing a variety of bubbles, having a cash buffer makes a lot of sense. General and unforeseen expenditures can be paid from this source rather than disturbing portfolio investments that might come under pressure from a long overdue corrective phase. The second is the precious metals complex. When euphoria abounds, who needs the protection of gold and silver…we are looking to add holdings here into the end of the year if the weakness persists.

We do not currently hold high cash levels, but are nevertheless defensively positioned as market volatility plumb new lows and uninformed buyers chase increasingly expensive stocks and bonds.

UK
FTSE has not managed to make a new high as have the US indices and is becoming something of an exchange rate proxy. If sterling is weak our stock market in dollar terms becomes more attractive, bringing in foreign buyers (and vice-versa), as well as increasing the sterling value of overseas earning for UK listed companies (well over 50% of FTSE 100 company earning are from overseas).

Today’s interest rate rise has had a negative effect on sterling most likely because the accompanying statement was on the dovish side – “All members agree that any future increases in Bank Rate would be expected to be at a gradual pace and to a limited extent.”

US
The S&P, the DJI and NASDAQ have all made marginal new highs in October on relatively low volume, mainly from the ETF brigade. 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 rebuilding work post the dreadful Texas and Florida hurricanes will give an apparent boost to GDP, but where would that money have been spent without the devastation? Or are they just going to print more money?

Europe
The narrative from the ECB has also changed and Draghi too has more than hinted at the intention to remove QE at some unspecified stage in the future, but at the same time he pretty much reiterated the “whatever it takes” doctrine in case things don’t go as planned.

Compared to the rest of the world Europe is a long way from the 2007 highs, so still has some catching up to do, but we are rapidly approach a very strong resistance level that stopped the market going higher in 2014.

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 in October 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.

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 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.
• European markets have shown some resilience since the French election results, but the rise of the populist movements in Germany with the prospect of more to come in Italy next year 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 now have another 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 November, 2017
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