Tuesday, October 21, 2014

Economic Summary for the week ended 21st Oct 2014

A week is a long time in politics, and this last week has felt like a long time in financial markets: the first half of the week with plunges in equity markets worldwide, the second part of the week with a sharp recovery, both in equities credit and high yield. There were almost unprecedented swings on a daily basis – sometimes on an intra-day basis – in the trading of US 10-year Treasury bonds. It was a week that led people to ask a lot of questions about investment policy, the world economy, and the enormous spike in volatility. Before addressing those, let’s briefly remind ourselves that for a long time volatility has been extremely low. Until recently, the volatility of commodities, of bonds, of currencies and of equities has been, by historical standards, exceptionally low. Uncertainty presents itself in many ways. It’s rather like holding a beach ball under the water – when you let the beach ball go, it bounces up further. That’s what I think we’ve seen; that’s what we continue to see. The proximate cause has been a reconsideration of the race of economic growth globally. Interestingly, although much of the commentary has been on Europe, the sector volatility in the equities space and the bond market volatility has been far greater in the US, probably because it was a given part of everybody’s investment thesis that US growth is recovering strongly and it wouldn’t be long before the Federal Reserve (Fed) would be starting to raise rates.
The turning point came this week when a number of Fed governors said that they would not rule out further stimulus in the future, or that they are arguing the case for an interest-rate rise to be pushed further out into the future. The markets rallied around that. That’s a straightforward signal that global markets still need either price stimulus or quantity stimulus, or that they’re going to reset their valuation base very rapidly. We think that the valuation base has already been reset, because even if rates are going to rise, they’re going to rise quite gently. That was true before the last two weeks, and it’s truer now. The higher-yielding end, and the slightly riskier end, of the fixed-income complex really has got some considerable value in it, and it’s worth looking closely at exposures there.
By contrast, long-duration government bonds have rallied very strongly because they’ve been the only diversifier around, and are almost certainly overvalued. For equities, the case still remains that they are the asset with the real rate of return whereby corporate earnings, as we’re seeing in the current earnings season, and cash flows are rising, and the ability to reward shareholders to increase dividends and corporate activity still remains very much in place. At the centre of this somewhat disastrous last couple of weeks has been economics. This week, we will get a number of economic releases which will be closely scrutinised, particularly on Thursday, when Japan, China, France, Germany, the Eurozone, and the US release their purchasing managers’ index figures for October. The market will examine those numbers very closely. It will also examine China’s figures on Tuesday for investment retail sales and third-quarter GDP. All the evidence suggests that the government in China is working overtime to ease policy on housing and the availability of credit at this stage, partly to meet the 7.5% GDP target the central government has set, and partly because they are probably concerned that things are slowly down too fast. Over the next few months, we expect a cyclical, but not a secular, recovery in the low levels of Chinese output led by upgraded activity in the housing market. We’ve also got a series of corporate earnings this week: from the pharmaceuticals sector, Glaxo, in Europe; from the banking sector, Credit Suisse, in Europe; and consumer plays such as Daimler and Amazon and, finally, Caterpillar. The latter will paint a picture of very considerable traction in the demand for global construction equipment. The reason for focusing on that is that it leads one back to the epicentre of the change in views about the economic outlook, which has been filled with disappointing numbers from Germany. We believe that the European economic outlook is very flat, but that there will be some cyclical improvement in numbers over the next six months. Fiscal easing and a little bit of policy change will help things along. We believe that the overselling of cyclical stocks in the stock market has provided a deep valuation opportunity.
Fortune could favour the brave
In summary, volatility has come back; it’s probably risen too far. Economics are low and flat, but in some areas they are going to improve relative to quite low expectations. Positioning has been flushed out quite a bit. There is some good value at the longer end of high-yield and emerging-market debt as a consequence of recent events, and for those who want to be brave, deeply cyclical shares have fallen so considerably in value and might just be positioned for a bounce-back.

Thursday, October 16, 2014

Economic Summary for the week ended 16th Oct 2014

The past week has been a very difficult one for many financial markets as the severity of the risk-off phase – which began a few weeks ago – intensified further. Global equities are now more than 5% down from their previous peak. The year-to-date gains in global equities have now been eliminated: of the main indices, only US equities are still in positive territory. There has also been a major correction in commodity prices and, while the weakness this past week has been across the board, the $20 decline in the oil price over the past few months remains the most noteworthy move. Credit spreads have widened in recent days, but the selling pressure on investment-grade spreads has been relatively muted. Almost inevitably, high-quality government bond yields in this environment have declined further, but they have edged lower rather than collapsed. They still remain within recent ranges in the US and the UK, but the 10-year German government bond yield has hit new lows. So what’s driving these moves? Are we looking at a technical correction within a bull market, or a more fundamental change in the global financial background? And if this is a more fundamental move, exactly what fundamentals are we talking about? It’s important to emphasise that some of this correction does appear to be technical. The consensus in the global financial community has been more risk-on than risk-off, hence the chance that positions would get closed out if markets move in the opposite direction. This factor does appear to have been at work in recent weeks, with volumes relatively high. On a technical basis, many markets do now appear to be rather oversold. However, if we focus more on the fundamental factors, it appears that you’re potentially spoiled for choice. The dominant fundamental factor at the moment seems to be – not for the first time this cycle – about global growth, or rather, the lack of it. It’s pretty clear that the global economy had been subdued at the first half of the year, but there’s been a fairly widespread expectation of some lift-off occurring in the second half and into 2015. However, this expectation has been challenged, to date, rather than confirmed by recent data. At the global level, industrial production just seems to have stalled over the summer.
Digging deeper, there’s been some acceleration in US growth, but not really a powerful lift-off. Elsewhere, there have been clear losses in growth momentum in China and the Eurozone. The rebound in economic activity in Japan, after the inevitable slowdown following the tax rise earlier in the year, has been muted. Digging deeper still, within the Eurozone, it’s Germany – rather than the more troubled peripheral countries – that is at the core of the slowdown. German growth had been negative in the second quarter, and has been soft again recently, raising concerns about a potential shift back into recession. It’s worth emphasising that the markets are reacting to what is a fairly small incremental change in the global growth backdrop. There is little evidence that there is a marked slowdown in economic activity underway. There is a case to be made that the weakness in commodity prices is telling a different story, but this week, this appears to be as much supply-driven as demand-driven. We have seen many fluctuations in global growth before, and while we know that these are important, it is also potentially dangerous to extrapolate them.
Eyes on US earnings
It is possible to make some broad generalisations about recent events in the global economy. First, underlying demand conditions have remained stronger than output growth. Weakness in industrial output does seem to have been partly the result of inventory reductions, which are more likely to prove a temporary rather than permanent influence. Second, this inventory challenge has been concentrated in the global auto industry, where output looks likely to rebound quickly and possibly strongly. And third, some corrective mechanisms are potentially coming into play. In particular, much lower food and energy prices should increase consumer spending power. There is also the possibility that slower growth would lead the Federal Reserve and the Bank of England to delay rate rises, which are a particular issue hanging over markets. So our current conclusion is that the global economy is not in free-fall, and there is scope for a rebound as we go into 2015. However, in environments like the one we’re in, the market’s sensitivity to macro data is even greater than usual, so the upcoming earnings season in the US will be particularly important in providing a greater outlook on what really is going on in the global economy

Monday, October 13, 2014

Economic Summary for the week ended 9th Oct 2014

Market movements
It was an interesting week in markets, with new themes emerging, old themes persisting, and some resumptions of themes that we saw earlier in the year. It’s fair to say that one new theme has been the increase in volatility across equity markets (most of which were down 1% to 2% on the week). The driver of this has been fear about growth and ongoing concerns about deflation. To that end, it’s fair to say that on both sides of the Atlantic, investors’ expectations for inflation continue to fall. For example, let’s look at bond markets and what they’re pricing in for inflation over the next 10 years: in the US, that level of expectation has fallen below 2%, when historically it’s been closer to 2.5%. In the Eurozone, that number is now below 1.5%, where typically it has been closer to 2%. In fact, on a data front, we saw Eurozone-wide inflation (CPI) drop to 0.3%, getting very close to that zero-deflationary level that people have begun to become fixated on. Perhaps another way of thinking about inflation expectations is to look at the price of gold. Gold last week fell below US $1,200 per ounce: with the exception of the start of this year, you have to go back to August 2010 to find a point when gold traded less than that number. This is also an indication of the broader weakness that we’re seeing in commodities, which is adding to this expectation of inflation being lower that we had previously assumed.
On the growth side of the equation, it’s fair to say that Eurozone growth remains weak, particularly in northern Europe. On Monday, German factory orders were released for September, which had almost 6% on the month and is now down 1.3% year-on-year. The picture is better in the US, where we saw decent employment data on Friday, with the unemployment rate falling to 5.9%. But even there, people are concerned. For example, we saw the forward-looking indicator of manufacturing data come out weaker than expected, although very much in positive territory. In terms of new themes for the market, this idea of equity volatility is largely driven by concerns about growth and deflation. As mentioned at the start, old themes – such as the strength of the US dollar – continued to dominate the week. In fact, the dollar continues to hit new highs for this cycle across many of the major currencies. For example, the currency is getting very close to 1.10 versus the yen, dropping to about 1.25 versus the euro, and with sterling, falling below the 1.60 level. It’s a continuation of monetary policy driving this theme, specifically expectations for the Federal Reserve raising interest rates early next year and the European Central Bank (ECB) and the Bank of Japan continuing to pump liquidity into the system.
Last week, we saw the ECB give further details of its asset-backed securities purchase, which some are alluding to as being very similar to quantitative easing. One question around this is that sterling has been particularly weak versus the dollar, yet expectations in the UK are still tilted towards a rate rise at the start of next year – which is puzzling. But you have to look at this through the lens of the Eurozone, where sterling has been trading very closely with the euro. And in fact, some of the worries are focused around how the economy will be impacted by this slowdown we’re seeing.
Where do we go from here?
The obvious question raised by the dollar strength is “where do we go from here?” The strength of the dollar last week suggests that there are still many people tempted to jump onto this trend; but we have moved a long way and I would expect that, while that trend of dollar strength will continue, price action isn’t likely to be much more two-way going forward.
The third of last week’s themes was the resumption of a topic that dominated markets earlier in the year. Emerging markets started 2014 very weak – they outperformed over the summer, but there are a couple of things now driving that re-emergence of weakness. The first relates to the broader volatility in equity markets and concern around growth, but also the dollar strength. Historically, it’s worth noting that, in periods of dollar strength, emerging markets have generally underperformed or been weak. I would caution against reading too much into this: if the dollar is strong due to some positive momentum from an economic perspective, that could be an environment that is broadly more supportive for emerging markets, particularly those in Asia. We continue to see some idiosyncratic issues at play in emerging markets.
Russian assets were very weak last week. Democratic demonstrations in Hong Kong are putting pressure on all things Chinese. From a perspective of growth, we remain very confident about the outlook for the US; any slowdown in data should be examined in context with what is actually a robust growth picture for the country. There are some challenges around the Eurozone, particularly for some of the larger economies: some of those are starting to weaken quite markedly. Linked to this is an important point about deflation. Central banks will do all they can to avoid deflation, but the market is getting more and more concerned about it.

The economic background of being broadly positive should continue to be supportive for equity markets, but I think the question marks that are coming through in terms of that pattern of growth and the uncertainly around rates means that we can expect higher volatility as we head toward the end of the year. The message is one of being reasonably constructive about equities, but we shouldn’t expect the very low levels of volatility and risk that we’ve seen over the summer to continue into the end of the year – it’s going to be a bumpier ride.