Friday, January 23, 2015

Economic Summary for the week ended 21st Jan 2015

Market movements
The new year is still only a couple of weeks old, but already it is starting to look and feel rather different from the environment that we experienced in much of 2014. There are five key trends which have emerged so far in 2015. First, moderately weak equity markets, although this is more evident in developed than in emerging markets; second, weak commodity prices, with a sharp fall in the copper price last week coming off the back of an oil price that is still declining; third, lower-quality high government bond yields in the US as well as Europe; fourth, wider credit spreads; and finally, a much higher level of volatility in financial markets. These are the patterns that we would expect to see in the event of a material global slowdown in economic activity, or even in a recession.
So the key question for investors at the moment is whether markets are getting it right in appearing to price in much weaker growth expectations. Or is this just some erratic market behaviour, which sometimes happens at this time of year? Now to get this one right, it is important to review some of the recent key market developments which have brought about this shift in behaviour. This includes a number of factors: for example, some weak economic data and corporate reports from the US, in particular falling retail sales and inflation, lower manufacturing business sentiment, rising unemployment claims, and also, importantly, some disappointing financials results in the early stages of the current reporting round. Second, we’ve seen some potential financial dislocations caused by the collapse in oil prices, as in the high-yield market. Third, there have been concerns that the weakness in commodity prices is signalling a frail global economy both at present and going forward. The next factor is the potential for quantitative easing in the eurozone, which is likely to be announced this week. It is a reflection of the inevitability of a period of negative inflation in Europe, and a still less-than-stellar macro background. Another factor is the pending Greek election result, which could lead to additional tensions. And finally, the unpegging of the Swiss franc last week may not have broad global implications, but it is another example of the sort of challenge that markets have had to come to terms with in recent weeks. At the same time, there has been a dearth of unexpectedly good news to provide some welcome relief.
The fall in the oil price has resulted in some very material income transfers
Recently, we suggested that volatility was likely to be more a feature of 2015 than we’ve seen in years past, but this is not to say that all of the themes of the past couple of weeks or so are set to persist. Importantly, we would remain sceptical of the claim that the global economy either has been very weak, or is about to weaken. On the contrary, global economic growth in the second half of last year was the strongest it had been in some time, and we would characterise the more general tone of recent macro data as being quite trendless, rather than indicating material acceleration or deceleration – although the larger emerging economies do continue to struggle. While US financial earnings have indeed been disappointing in the current reporting round, the non-financial companies that have reported so far this quarter have, on average, displayed very robust earnings growth. The oil price is crucial here: the fall in the oil price has resulted in some very material income transfers from oil-producing companies and countries to oil users. To date, the pain being felt by the first group is very visible, and markets have reacted quickly to it. Look at the extreme underperformance of equity markets of commodity-related companies, the underperformance of energy-related high-yield companies, and the drop in the Russian and Brazilian currencies. But ultimately, the fall in oil prices should prove very beneficial for the global economy as energy users react to what is, in effect, quite a substantial increase in their real incomes. That should support spending. And this supportive impact is likely to become increasingly apparent in the coming months. Also, the recent Swiss and Greek challenges to the investment environment in the eurozone should not be seen as inevitably destabilising. In particular, even if Syriza does come to head a new coalition in Greece after the election, their stated policy is for Greece to remain in the eurozone, and some compromise over the degree of austerity is likely to be reached with the Troika even if the negotiations prove difficult for a period.
So recent weeks, for us, do provide a helpful guide to the rest of the year, because they highlight the range of challenges which the markets are having to deal with, and will continue to have to deal with. However, our central case is that these difficult first two weeks of the year will not be a good guide to risk-asset activity going forward. We would expect, on balance, better risk-asset performance than we have seen recently, largely because the weakness in the global economy that is currently being signalled by markets, is, we believe, unlikely to materialise.

Wednesday, January 14, 2015

Economic Summary for the week ended 13th Jan 2015

Market movements
It was a volatile start to 2015. We’ve had six trading sessions so far this year, and in three of those, the European equity market, as measured by the Eurostoxx 50, has moved plus or minus 3% on three occasions. To put that into context, the Eurostoxx 50 moved by that amount only four times in the whole of 2014. As a result of that volatility, most equity markets are now in the red (year-to-date). This is something we expected to happen at some point in 2015; we expected it would be a more volatile year, that we would see periods of sharp moves in equity markets, but even we’ve been surprised that it’s happened so early on. It’s worth looking at the fears that are driving this. Firstly, let’s look at central banks. One of the reasons we expected volatility at some point in 2015 is because we expect central banks to start taking different paths. Up until now, the banks have pointed in the same direction, towards easier monetary policy and more liquidity being injected into the financial system. We expect that to change this year, particularly with the central banks in the UK and the US beginning to tighten monetary policy and perhaps raise interest rates. Meanwhile, we see central banks in Europe and Asia easing monetary policy and continuing to push on with quantitative easing (QE).
But that’s not enough to explain the volatility that we’ve seen so far in markets, because at this stage, those potential rate hikes in the UK and the US are being pushed out much further into 2015 than perhaps we thought. That leads to the second point on what’s driving this climate: the sharp fall in the price of oil is a key driver for financial markets. The delay in rate rises may in part be down to the fall we’ve seen in the price of crude and the knock-on effects in terms of reducing inflation. But from an equity-market perspective, the situation has changed from December, where the fall in the price of oil to around USD$65-70 per barrel was seen as a positive by equity markets because of its impact on consumer demand via the lower prices for petrol. And that is still the case: consumer-led data is beginning to show increased spending on hard goods and soft goods. But in the equity markets, with oil now below $50 per barrel, much closer attention is being paid to the impact on corporate earnings.
A lot of major companies, many of which are energy companies, are starting to hurt from this drop in oil. Currently, people are recognizing that many of the positives from an economic-growth perspective, particularly in the US, have been related to the infrastructure spend going on in oil, for example through fracking and natural gas. Though this has had a positive effect in terms of capital expenditure, a loss of employment has been generated in these industries, leading to concerns that if prices stay where they are today, then perhaps things will reverse, with a negative impact on the US economy.
Where do we think oil prices will stop?
It also leads to the question ‘Where do we think oil prices will stop?’ The most honest answer to give is that we don’t know. But let’s look at both the demand side and the supply side. First, the demand side: one of the drivers of lower commodity prices over the last few years has been the weakness in the Chinese economy, and expectations are for that to continue, notwithstanding the fact that the Chinese authorities have continued to pump money into that system to try and stimulate economic growth. But we don’t think that’s going to be enough to have a meaningful impact on crude-oil demand. It’s difficult to see where there would be an increase in demand sizable enough to mop up the supply. It comes down to when we think supply will start to dwindle. This is a long-run picture, and we are seeing some tentative signs that supply will begin to be curtailed. One of the statistics you can look at is the number of rigs being employed in the US, which has started to fall. We’re also seeing companies beginning to remove money from capex programs designed to investigate new supplies of energy. But that’s a long-term game to be played out. So ultimately, it’s difficult to see oil prices recovering meaningfully anytime soon. We think markets will start to price in oil prices remaining lower for longer. For example, if you look at market expectations going in to 2016-17, expectations are that prices will recover to around $70 per barrel, and that may lead to further pressures on oil price, when people’s long-term expectations start to fall. Elsewhere, we’ve seen speculation about the upcoming Greek election; Syriza still shows a small lead. The challenge here is that we are likely to see a coalition coming out of that election, and it will be a long time before there is any certainty around Greek policy.
So, was there anything that did well over the start of the year? We’ve seen a decent bounce in the price of gold, from $1,185 to $1,224 per ounce. The strength of the US dollar has continued; the euro is now trading below 1.20 versus the dollar. Government bonds also did well; 10-year US Treasuries are trading below 2%, and 10-year gilts are trading at 1.6%. Similar to gold, gilts and Treasuries are a clear beneficiary of sentiment regarding rate rises being pushed farther into 2015. One equity market that has gotten off to a good start is China. This is surprising given the poor economic news coming out of the country, and we suspect growth will slip below the 7% target. But the government is increasing liquidity flows into markets, and equities have been responding to that. As a result, Chinese equities are up 2% on the week. However, we think the Chinese economy is still going to struggle, so that’s an area we’ll avoid. The outlook ahead is all about the European Central Bank meeting on 22 January. Expectations are high that Mario Draghi will introduce some form of QE, so there is scope for volatility and disappointment around that.

Wednesday, January 7, 2015

Economic Summary for the week ended 6th Jan 2015

Market movements
Let’s start with a brief look back at last year: the scoreboard shows that the best-performing major market was Shanghai A-Shares, rising nearly 50%, most of which came in the last three months of the year in response to a weakening economy and central bank policy toward supporting financial assets. This made the point again that financial markets are largely about policy, and that in many cases, bad economics can equal good returns. Italian bonds returned over 24% in 2014, and German bunds did well, with a return of 15%. Both reflected the very sluggish economy in Europe. The S&P 500 in the United States rose almost 15% in the year, and the dollar rose 12.5% against other currencies, particularly the euro. Down at the bottom of the league (so to speak), the honours board was besmirched by the fall in oil, with Brent Crude dropping in price in 2014 by nearly 50%. The major stock market that fell the hardest was Greece, down 30%. The fall in the oil price had an impact on a number of markets with a heavy weighting to energy. For example, the FTSE 100 index was flat on the year. But had oil stocks been excluded, the rise would have been closer to 6% or 7%. The American high-yield market underperformed the stock market and investment grade because of its weighting to energy as well. So you could say the three biggest events of 2014 were the runaway market regarding Chinese equities; the strong dollar (really a reflection of the strong American economy), the declining trade balance, and on the other side, the action of central banks, such as the European Central Bank (ECB), to loosen policy; and the sell-off in oil.
As we enter 2015, most of those trends appear to remain in place. In China, the authorities continue to loosen monetary policy as the economy gets worse and the stock market rises. The dollar has started the year strong against most currencies, in particular the euro. On 5 January, we saw the euro trading below 1.20 for the first time in about eight years. The sell-off in oil continues, with Brent Crude now dropping to around USD$55. These will be important themes as we look at 2015. The fall in the oil price, on the good side, stimulates growth. On the bad side, it impacts the fortunes of the energy sector and the countries that depend heavily on energy for their fiscal revenue. The plus is slightly higher world growth than would have been the case otherwise, maybe by 0.25%. The downside is the material impact on inflation.
The ECB is stepping up preparations to alter the size, speed, and composition of policy in 2015
That brings us to the next point, which is Europe. Just last week, we saw that bank credits in Europe fell in November, which makes 30 consecutive months in a row where there’s been a decline. No wonder ECB governor Mario Draghi made comments last week that the central bank is stepping up preparations to alter the size, speed, and composition of policy in 2015. If you want a large, flashing sign saying, “We’re moving into sovereign QE as soon as we can”, you can hardly beat those comments. Unsurprisingly, this goes along with a weakening euro, but that is a tailwind rather than a headwind for European equities because of the importance of non-European earnings. So whereas 2014 and 2013 started with strong European earnings expectations and declined, it could be the other way around this year. European equities remain on our buying list. The events we’re looking forward to this week, considering the strong dollar, include notes from the Federal Reserve meeting on 16 & 17 December, which was when it changed its language about monetary policy and signalled that it will be raising rates in the first six months of the year. Market participants will pore over those notes. The rise in US rates will be a feature in the first half of 2015. Another feature will be the importance of politics. We are now facing a presidential election in Greece on 25 January; it is likely that the left-wing Syriza party will form part of a governing coalition. It appears at this stage that it will not be strong enough to gain an overall majority. Syriza has scared people quite a lot recently by talking about withdrawing Greece from the euro, but as it has come closer to power, the rhetoric has eased. Alexis Tsipras, the leader of Syriza, made a point last week of saying they’d expect the European Central Bank to include purchasing Greek bonds as part of any sovereign quantitative easing. Politics will have a big year in 2015, not least here in the UK, with the general election on 7 May now impossible to predict.
So where does that leave us from the point of view of near-term opportunity? The picture looks to show the US economy continuing to strengthen, the European economy continuing to be weak, and the Chinese authorities attempting to prop up financial assets. We expect to see earnings expectations for American companies rise. We expect earnings expectations to rise for companies in Japan and Europe, as well, even as their currencies weaken. And although we’ve turned the calendar, our policy remains broadly unchanged: we are pro-equity, pro-high-quality businesses, pro-dividend payers, and, in the fixed-income market, pro-quality in investment grade. And as for oil: it is down now over 50% from its peak, supporting consumption, supporting the airline sector. But it’s hurting others, such as countries heavily reliant on oil revenues for their budget balances. That will be a consistent theme for the first half of 2015, as will be the inevitable cutbacks in production.