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., 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.