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.

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.

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.

Economic Summary for the week ended 17th Dec 2014

Market movements

Last week was a very poor week for equity investors. Around the world, there were signs of slowing growth: weak data from China; multiple downgrades of global oil demand accompanied by further declines in prices; more stringent collateral requirements in China; and renewed angst over European politics. The dichotomy between the US and other countries was sharply represented this week by fund flows, with US exchange-traded funds gathering $2.5 billion of inflows, while those in Europe saw $1.6 billion of outflows. It was a particularly poor week for equity investors in Europe, led by the Greek stock exchange, as there is potential for the Syriza Party to triumph in a series of presidential elections, which start on 17th December. The Greek stock market plunged 18.6% on the week, and Greek bonds sold off. Other equity markets in Europe were also weak as the potential risk to global growth suggested by the declining oil price led to people fleeing those markets in anticipation of earnings downgrades.

In spite of a still-resilient economy, US assets are demonstrating that they’re not immune to the global slowdown. The S&P 500 traded down to a five-week low, with technology and energy leading the way down. Volatility, as measured by the VIX index, rose above the 20 threshold for the first time since October. This increase in volatility was consistent with the further widening of credit spreads, which are now at their highest level since June 2013. The sell-off in high yield has been largely driven by growing concern over energy issuers. Indeed, since the OPEC meeting at the end of November – when no cut in the quota was suggested – we’ve seen the spread on energy stocks rise by 260 basis points. The oil price is the central topic of the moment. Is it the canary in the coal mine, warning us about global growth declining, or is it actually a stimulus to global growth? It’s probably a bit of both in that we’re seeing reductions in energy intensity in a number of countries (China, in particular), but we would expect there to be some activity boost from consumers, who are now finding it cheaper to fill up at the pump. And that is the dilemma that investors find themselves in, because bond markets are rallying strongly: last week, US 10-year Treasuries touched 208, which is the lowest level in over a year, and government bond markets in Europe also rallied.

Another big event of the week was the re-election of Prime Minister Shinzo Abe in Japan; the market will now be looking for an acceleration of institutional and structural reform over the next few months. However, it must be said that investors are a bit nervous as we head into year end. A couple of important things to look out for this week: firstly, as mentioned, there will be a Greek parliamentary vote for a new president, the final round of which will be held on 30 December. If the Syriza Party should prevail, we will need answers to the following questions: will they pull out of the euro? (They’ve said that they will not.) Will they renegotiate or ignore Greece’s International Monetary Fund payments and loans? (In terms of austerity, almost certainly, yes.) And would that be a crack in the eurozone’s recovery? Our view is that while there are some extreme parties in Europe, this is an unusual case, because Greece has suffered more than most in terms of the aftermath of the crash. The decline in European assets has as much to do with the falling oil price and the time of year, but there are concerns that the Greek presidential election will set off a kind of snowball effect. The other thing that spooked people about Europe last week was the relatively small take-up of the European Central Bank (ECB)’s targeted long-term refinancing operations. Investors still hope for quantitative easing involving sovereign-bond purchases by the ECB in the first quarter of 2015. Otherwise, as we head into year-end, Wednesday will be an important day, with the Federal Open Market Committee’s last meeting of the year. All eyes will be on the language of their statements regarding, specifically, whether they remove the reference to not changing rates for a “considerable” amount of time. Also, purchasing managers’ indices across Europe will give us a sense of how flat that economy is.

There is a hangover from this party; it’s being felt in high-yield markets & leveraged-loan markets most of all

It’s important, with regards to economic policy, to look beyond the stream of economic releases and remind ourselves that this is the time of year when markets tend to trade quite thinly. The only major issue that people are having difficulty with is the decline in the oil price. We can see this if we look at stock market indices again, because much of the decline in those indices and the widening in spreads is down to the energy sector. And the question that people want to look into as we move into next year is: has there been a lot of bad lending to energy companies that will impact our capital markets and our banking ratios? The answer is: there probably has been a lot of bad lending, because the oil price has been remarkably stable at a very high level for three years, which set off an increase in global exploration and production. So there is a hangover from this party; it’s being felt in the high-yield markets and the leveraged-loans markets most of all, and in the equity markets in terms of downgrading earnings forecasts for energy companies. But there are bright spots as well: this fall in energy prices is essentially a tax cut for consumers, and as we move into the new year, we feel that investors will start to look at the positive side of the coin as well, and will almost certainly be looking to bargain-hunt in equity markets.

Economic Summary for the week ended 10th Dec 2014

Market movements

As we move toward the end of 2014, the themes that we expect to drive markets in the coming year are really starting to take shape. Foremost among them is the divergence of monetary policy. To that end, the past week has seen two major events that we believe will set the scene for 2015. So far, the divergence theme has been dominated by the easing camp, with action in Asia and talk in Europe. The latest instalment of the European quantitative easing (QE) debate came in the form of the December meeting of the governing council of the European Central Bank (ECB). Expectations for more easing in Europe has risen sharply over the past month, and the collapse in oil prices has, once again, raised the fear of deflation in the Eurozone. In fact, yet more disappointing data has driven the inflation swaps market to price headline inflation dropping below zero for the first time ever in the first quarter of 2015. The hope for more action has been exacerbated, both by the rise in rhetoric from ECB members and by the actions of other central banks. In this regard, the recent easing by both the Bank of Japan (BoJ) and the People’s Bank of China (PBOC) have piled increasing pressure on the ECB to do more.

In line with our expectations, ECB President Mario Draghi stopped short of announcing any new policy tools. However, it was clear from the tone of the Q&A that sovereign QE in Europe remains very much in the cards. With a nod to one of the conditions he laid out last month – i.e. that if existing measures prove too little, they may have to do more – Mr Draghi said that the current policies will be reviewed in early 2015. This, for the first time, helped set a timetable to review the policies, and, if deemed necessary, to move to the next stage of monetary easing. The first sign for that condition will be the announcement of the take-up of the second-tier of targeted long-term refinancing operations (TLTRO) on 11 December. Also notable was the clear message that legal hurdles are surmountable. In fact, according to Mr Draghi, the only illegality is allowing the ECB to move away from its inflation and growth mandate – a clear shot across the bowels of the QE doubters. Market reaction to the announcement (or lack of an announcement) was to price out some of the more exuberant price action of recent weeks, in both peripheral bonds and European equities, on Thursday afternoon. However, the disappointment didn’t last long, with markets bouncing back sharply on Friday – helped by some positive press on the chances for QE in 2015 – most notably in Germany.

On the other side of the Atlantic, the divergence theme has been particularly quiet. In fact, US Treasury yields have been held low, driven by the widening gap in yield with core Europe and the expanding search for income around the world. Behind the scenes, though, the drivers of the tightening camp are starting to pick up. This was confirmed by the latest non-farm payrolls data, which showed the strongest positive surprise since January 2012, coming in at 321,000 versus a survey estimate of 230,000. With October revised upward as well, and hourly earnings beating expectations, it was a strong report all around. Coming on top of the increase in the recent employment cost index – the Federal Reserve (Fed)’s favoured measure of income – the pressure for rising wages is clearly growing. And this is key: the missing link of wages and incomes in the US looks to be appearing fast. As we move into 2015, it is difficult to see the Fed not moving to a more hawkish stance as it prepares for what we believe will be a first hike in the Fed’s funds rate by the middle of next year. That step could come as early as this month, when the Fed may adjust the language regarding timing in a Federal Open Markets Committee meeting.

The strong growth data was taken positively by equity markets, with the S&P 500 creeping up to end on yet another weekly high – its seventh in a row – and the Dow Jones fast approaching 18,000. So far, the good news of an improving labour market is outweighing the bad news of what it might mean for the Fed’s easing stance once they start the hike. This is no small measure, due to the baton change of central-bank QE from the Fed to the BoJ, and possibly the ECB, next year. Even bond markets were relatively sanguine: the 7 basis-point (bps) rise in 10-year yields on Friday took them to 2.31%, still below where they were before September’s Fed meeting.

The winners continued to be Japan & China

While the main news came from Europe and the US, for markets, the winners continued to be Japan and China. Both sustained their positive recent momentum, with A shares up another 9% and the Nikkei up over 2.5% to close at a seven-year high. Rising volumes in A-share markets are encouraging hopes that domestic investors may finally be buying back into their own equity market. The strength of the US dollar also continues to provide strong support to Japan, with the dollar-yen exchange hitting 121.5 on Friday. For emerging markets, the dollar strength remains a significant headwind: broad emerging-market indices were down just shy of 2%. The combination of ongoing European QE hopes and the spectre of the Fed has pushed the euro-dollar exchange below 123, which will continue to help both exporters and Germany. After months of disappointment, tentative signs of a cyclical improvement in the Eurozone economy are appearing, with factory orders in Germany rising strongly. Note that autos helped drive the pick-up in these orders; this is a sector we think should benefit as we move into next year.

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.

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.