Friday, November 7, 2014

Economic Summary for the week ended 7th Nov 2014

Market movements
Last week was a strong one for risk assets, with equity markets leading the way. Most equity markets were up by 2.5%; in fact, the US equity market is back to the year’s highs. The standout performer was Japan, which reached a seven-year high, up 7% on the week. There was also a surprise announcement from Japan, which is increasing its quantitative easing programme substantially and including the purchase of equities within that. The announcement surprised the market, pushing equities higher and weakening the yen. Combined with that, Japan’s Government Pensions Investment Fund announced a significant increase in its weighting to Japanese equities – from 12% to 25%. This fund is at $1.2 trillion – the largest pension fund in the world – giving scope to add significant new exposure to equities. This supported the move by the Bank of Japan (BoJ) on the quantitative easing side, resulting in very strong performance from Japanese equities.
Elsewhere, in bond markets, US Treasuries ended five basis points (bps) higher in yield, at 2.34%; in the gilt market, yields were flat over the week, with 10-year gilts around the 2.25% mark. Corporate bonds were stronger over the week; yield spreads to government bonds were narrower, in line with the rally that we saw in equities.
The stronger dollar theme continued, particularly versus the yen after the aforementioned move by the BoJ, where the dollar strengthened 3.5%. Elsewhere, commodities remained under pressure, particularly oil, which briefly dipped below $80 per barrel during the week. Gold was also weaker by about 5% as investors continued to move away from precious metals.
The future looks bright in the US
So the obvious question is: given the nervousness we’ve seen over the last couple of weeks and during the middle of October, what has changed? Firstly, we think the BoJ’s actions are very positive on the liquidity side for markets – but that happened on Friday, and markets were already rallying before then. So there is clearly something else at play? Turning to the macroeconomic data: it was positive in the US and this clearly benefited markets. We saw third-quarter GDP data coming in better than expected, up 3.5%. The last two quarters of economic data in the US represent the strongest back-to-back GDP gains since 2003. On the employment side, the situation in the US continues to be very supportive, with fewer Americans having filed for unemployment than at any time in more than 14 years. The unemployment rate is now below 6%. So the economic backdrop of the US is currently supportive of markets. Additionally, we are in the middle of the earnings season, and again are seeing some positive surprises. Within the S&P 500, we’ve seen over 70% of companies reporting, and in terms of performance versus expectations, 60% of those companies have beaten sales estimates and 80% have beaten on earnings.
The picture in Europe is less supportive, but you would expect that to be the case. The economic backdrop remains subdued. Markets continued to digest the results of the European Central Bank’s (ECB) asset quality review, where over 130 banks were reviewed in depth and tested against various economic scenarios. Only nine of those were seen as needing to raise further capital, and most of those were quite small banks. So markets seem to be taking some comfort over that. And while there are some questions regarding the toughness of the scenarios that analysis was conducted under – there was no deflation scenario, for example – it seems that markets are taking some reassurance that substantial amounts of capital are not required at this stage in terms of boosting banks’ balance sheets. This it does give considerable clarity about the state of play within the European financial system. In fact, some of the ECB’s data on lending continued to be modestly positive.
All in all, it was a good week for markets. But what happens looking forward? There will be a lot of data out this week: in the US, we will see the ISM survey and employment; within Europe, we have retail sales and an ECB meeting; and in the UK, we have manufacturing purchasing managers’ indexes and Halifax house prices, as well as industrial production and a Bank of England (BoE) meeting.
It’s worth noting is that we do not expect anything from either the ECB or the BoE this week. There will be a continuation of the earnings season in both the US and Europe, and there is scope for positive surprises there. In terms of market outlook, we are seeing significant flows coming back into equities, which do have the potential to continue further. We are now getting into the tail end of the year, so there is a question mark over the extent to which investors are willing to increase any risks they’re taking so late in the year. So the macro and the earnings backdrops should continue to be supportive on funds flowing back in, which could push equity markets higher. But at this stage in the year, it’s difficult to see that going significantly further, given investor sentiment.

Monday, November 3, 2014

Economic Summary for the week ended 1st Nov 2014

Market movements
This week, we focus on how to interpret the last few rather interesting days of market activity. The theme underlying recent weekly reviews has been the market sell-off – in particular, what caused it and whether it will continue. The common view is that the sell-off reflected a genuine slowdown in the global economy, particularly in Europe. However, the market reaction was – not for the first time in the history of financial markets – greater than the macro data in isolation might have warranted. We also stated that we are not expecting a sustained slowdown in global economic conditions. The severity of the sell-off also appeared to reflect technical issues, in particular some widespread long-equity and short-duration positions that were cut as risk assets fell, contributing further to the selling pressure.
So how does this analysis currently stand up? Last week there was a material rebound in risk assets: equity markets rose, spreads over high-quality sovereign bonds fell, and government bond yields themselves rose. As of Monday afternoon, some of this had reversed; there’s nevertheless been some recovery in markets. As a broad rule of thumb, the equity correction has been around 10% on average, and the average rebound up to the end of last week was some 4%. Government bond yields have reversed at a broadly similar proportion to their previous decline.
So what do we know now that we did not know a week ago? First, there has been some good economic data. The European purchasing managers’ index rose in September; Chinese GDP for the third quarter and industrial output for September surprised on the upside; and industrial output also rose strongly in the US last month. It’s also worth pointing out that the current earnings round in developed economies has also been very supportive. US corporate earnings over the year to the third quarter rose at close to a double-digit rate (based on some of the companies that have reported so far) and numbers look similar, if a bit lower, for companies which have reported elsewhere in the world. Finally, in Europe, the recently released results of the European Central Bank’s stress test on bank capital suggest that there is no longer a glaring hole in the heart of the European banking system, even if some individual institutions, particularly in Italy, may have more work to do in that context.
“Perfectly feasible” does not mean “inevitable”
If you add it all up, the soft patch that the global economy hit during the summer does appear to be reversing, although as always, we remain vulnerable to short-term noise in the data. Concerns that the market correction may have reflected some sense of deeper malaise in the global economy have therefore moved a little further offstage. Looking ahead, it does seem perfectly feasible that the global economy will continue to struggle through and that the remainder of 2014 to 2015 will be a period of positive, if less than stellar, growth. After all, global monetary conditions are very loose, global fiscal policy is becoming much less restrictive, financial conditions are easier than a couple of months ago, and there has just been a major fall in the oil price, which will help to put money into consumers’ pockets. And it also seems perfectly feasible that in this environment, inflation will remain low; inflation expectations will remain close to central-bank targets in the long term, and therefore, there will be little or no pressure for central banks to tighten monetary conditions. And if all of this happens, then it’s feasible to expect a diversified portfolio of growth assets to outperform very defensive assets such as cash or high-quality bonds – albeit, at pretty modest absolute returns given the extent to which valuations have normalized. Remember, there are few very cheap asset classes around, and there are some at which the pricing is more aggressive. Still, the correction in high-yield spreads in recent weeks means that some valuation support is now back in that asset class. However, “perfectly feasible” does not mean “inevitable.” The fundamental message behind the market correction is that the feasibility of the scenario just described may no longer be what it was. One month of good data does not, after all, suggest that the Chinese growth model is fixed or that Europe is on the verge of a strong, self-sustaining recovery that will push deflation concerns to one side. Indeed, last week, the good news from the output side of the purchasing managers’ report for the euro area was offset to some extent by a sharp decline in inflation in the services survey for the same area. The recent market correction has also led markets to push out potential monetary tightening from the US Federal Reserve (Fed) and the Bank of England from mid-year to the end of next year.
However, the lower level of bond yield does mean that fixed-income markets remain more vulnerable to a reversal of sentiment. This week, the Fed is likely to announce the end of its asset-purchase program, which over recent months has already been minimized very considerably. The largest casualty of the events of recent weeks is volatility, which had previously been very low across all asset classes for an extended period. This development was not irrational; we were simply in a very low-volatility macro environment. But as the range of possible macro outcomes broadens, so does the potential for markets to flip from pricing one regime to another. It’s difficult to believe that this process is going to stop. Therefore it is highly likely that volatility is not going back to the low average levels that we’ve seen over the past couple of years.