Market Commentary – 1st October 2017

Some of our readers will remember that nearly 30 years ago one of those hurricanes that usually befall the inhabitants on the other side of the pond turned up on our shores, much to the chagrin of the Met office and Michael Fish in particular. A viewer had phoned in – no email or Twitter in those days…oh joy… to say that she had heard that said hurricane was on its way. “Not a chance,” said our Michael; thus consigning his name to the history books for all time. The hurricane arrived during the night of the 15th October, ravaging much of South England, and for once the railways had a plausible excuse. Very few trains ran, trees had fallen across most major roads and London and the stock market were shut for the day.

Also on the 15th, Iran hit the American-owned (and Liberian-flagged) supertanker, the Sungari, with a Silkworm missile off Kuwait’s main Mina Al Ahmadi oil port. The next morning, Iran hit another ship, the U.S.-flagged MV Sea Isle City, with another Silkworm missile. The crash began in Far Eastern markets the morning of 19th October, but accelerated in London time and by 9.30am the London FTSE100 had fallen over 136 points. Later that morning, two U.S. warships shelled an Iranian oil platform in the Persian Gulf in response to Iran’s Silkworm missile attack on the Sea Isle City. By now the FTSE was down over 250 points (-13%) and the Dow eventually finished the day off 508 points down; -22%. A popular explanation for the crash was selling by program traders, most notably as a reaction to the computerized selling required by portfolio insurance hedges; in other words, selling begat further selling.

Could this happen today? Whilst Iran is still very much an area of concern on the geopolitical landscape North Korea currently holds the baton for conflict potential. The White House is allegedly talking to North Korean officials, but given their diplomatic skills thus far it is of cold comfort. Portfolio insurance; computerized selling? Sounds very much like high frequency trading and algorithmic programing does it not; neither of which have been tested in a real crisis.

It can’t happen, allegedly, as most exchanges now have circuit breakers that close trading temporarily when markets go into free fall. In commodity futures trading they have a system called “limit down”. Here, if the market falls by a preordained amount it closes and doesn’t reopen until the following day. Limit down in equity markets can happen multiple times in one day in theory, the point being that even with circuit breakers there is no guarantee that markets won’t continue to fall. Perhaps the best back stops are the central banks who claim to be able to “do whatever it takes”. History as Mark Twain is purported to have said doesn’t repeat but it does rhyme.

Valuations are high, notably in the US, but economies are not showing signs of distress… according to official figures; anecdotal evidence paints a less rosy picture. A reliable precursor of recession, the bond yield curve has not yet inverted, mainly due to the suppression of short term interest rates. (The yield curve is said to be inverted when short term rates are higher than long term.)

On the political front Theresa May’s hopeless task is becoming more hopeless as she tries to reverse the flood of supporters from her party…hopelessly one suspects…and the Labour party are seeing a resurgence of support. The shadow chancellor is a confirmed Marxist and talk of “confiscation of property” abounds. Some of us go back before the UK hurricane season and remember the socialist governments of the 60s and 70s – the eternal sterling crises – the pound in your pocket quote – marginal tax rates of 98% – union unrest and inflation over 20% not to mention gilt yields at 17%.

It won’t be like that though – there’s that rhyming history again – but with both parties, and their supporters, at each other’s throats, the Benthamite principle of “it is the greatest happiness of the greatest number that is the measure of right and wrong” is still a very long way off; more’s the pity. This is something to keep a wary eye upon. Popular political movements seemed to have had their moment in the sun then faded post Brexit (UKIP) and into the French elections (Le Pen) but the AfD in Germany now have 13% of the seats in the Bundestag; up from zero. And the Madrid government seems hell bent on letting populism “explode” in Spain. The Italian elections are likely to be early in the New Year. Commenting on the political scene in the US is tricky as I don’t have a Facebook account…suffice it to say that if anyone has their hand on the tiller could they please let us know.

Market price action in the UK (see chart below) is showing all the characteristics of a distribution phase which happens when long term holders of stock become sellers to newcomers, eager for a piece of the action. In the US the exchange traded band wagon has kept the momentum going for longer, making expensive large capitalization stocks ever more expensive; this can’t go on indefinitely can it?

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) This is the commonly perceived wisdom and with “cable” (the market nickname for the £/$ exchange rate) currently on a piece of elastic courtesy of Brexit negotiations – or the lack thereof – determining the market trend has become even harder to divine. Uncertainty – aka change – is always with us and this bull market continues up the “wall of worry”, but having more than doubled since the dark days of 2009 may be at a critical juncture

US

The S&P, the DJI and NASDAQ have all made marginal new highs in September on relatively low volume, mainly from the ETF brigade. Given our comments above this is a time for caution especially as the shennanigans in the White House go from bad to farcical and the Fed look 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

Despite its proximity to North Korea and the overflying of their missiles the Nikkei has had a very solid year and now Prime minister Abe has called a snap election one year early. Earlier scandals had reduced his popularity rating to below 50%, but he is now having something of a renaissance and the opposition parties seem to be in disarray. If he gets the mandate he is after then the reform measures he has been struggling to implement stand a better chance of succeeding and with it more gains from the stock market if it can breach the critical 21000 level, which has acted as both support and resistance since the late 80s

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 is closing in on strong resistance at 21,000 but we don’t expect any significant move ahead of the election. 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 October, 2017

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