The Weekly - Economic Gods & Their Mysterious Ways

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12/02/2018
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Last week certainly broke the monotony of ever-rising markets.  If you had been a cautious investor sat in cash for the last two years, then finally you had your reward.  Timing markets in the short-term is a mugs game and predicting precisely when investors will take fright is equally impossible to predict – the madness of crowds and all that.  What is especially bizarre about last week is that the data point that triggered it was precisely that which many critics had said was so sadly lacking, namely wage growth.  Just as we get some evidence, which should be good news for consumer spending, the markets decide that this could trigger inflation and therefore interest rate increases which are more than expected.  Shock and awe of an entirely different variety.

The markets have been shown to still be very sensitive to unexpected inflation.  This illustrates the festering underlying subliminal fears that all the money-printing may still deliver.  Nobody really understands why wage growth and inflation have been so subdued whilst QE has been in operation.  It therefore logically follows that there is a risk that if inflation really does start to move, then either we still don’t understand why and there is only one way to combat it – we need to put the brakes on big time.  Or, we will understand it as the delayed reaction to all that liquidity which we always knew was likely to trigger rampant inflation in the end, as the textbooks have said – and we need to put the brakes on big time.  Both lead to the same conclusion, a forced slowdown in the economy from a policy change implemented by the Central Banks as they attempt to tame resurgent inflation.

We all know that the QE style of money-printing that we have endured is different and has only inflated asset prices and not the spending power of the consumer, the principle reason being to recapitalise the banks and keep the global economy functioning.  This has been remarkably successful but the fear is that if and when inflation does emerge, it could be like an elastic band and get out of control very quickly and we could then be in a whole load of trouble.  That’s probably the worst case scenario and unlikely but whatever transpires over the next few weeks and months, we know that volatility has risen dramatically from the lows, the complacency that we saw over the last six months is gone and everyone is looking at everyone else for some insights as to what happens next.  This is why markets are whip-sawing around with more volatility in terms of wild swings than any period since the credit crisis of 2008.  To be accurate, last week the fear index or VIX measure hit the highest level since September 2011 which was when Europe was feared bust or more specifically the PIIGS being Portugal, Italy, Ireland, Greece and Spain.  Is this development really of that magnitude?

This week sees a CPI (consumer prices) data release in the US as well as PPI (producer prices) and both will be watched keenly against forecasts.  If there is any further evidence of building pricing pressure then expect more volatility.  Even if there is no evidence, the markets are now on inflation watch and what had previously been shrugged at will now be scrutinised and that is a permanent change in market psychology which will remain for the weeks and months ahead. 

The silver lining to this newly arrived dark cloud is the new Fed Chairman Jerome Powell.  He is expected to be similar in outlook to the outgoing Janet Yellen and very much on message.  A cynic might suggest that as he is Trump’s appointment, the last thing he is likely to do is upset the markets further and burst Trump’s market miracle, unless he wants to join his growing list of fired apprentices.  On the contrary, he will probably want to calm nerves regarding rate rises, which after all, were expected to occur several times this year anyway and the markets were comfortable with that.

More of a surprise comment during the turmoil came from Bank of England Governor Mark Carney who for some reason seemed to think it was a good time to potentially bring UK rate rises forward on the basis of stronger UK growth which everyone thought was under pressure.  This has created forward confusion rather than guidance as so much regarding growth in the UK is dependent on confidence, uncertainty and the outcome of the Brexit negotiations.  Companies are delaying investment due to Brexit.  Facing the prospect of potential early interest rate rises as well is the last thing they need.  Our Bank of England Governor moves in mysterious ways which often appear at odds with market thinking.  However, reassuringly, the markets didn’t really flinch, taking the view that if the MPC moves it will only be because growth has surprised on the upside not ahead of that outcome.

Whatever lies within the thinking of the Fed and the BoE, there would now appear to be a determination to normalise interest rates with far less regard to the impact this causes within the investment markets.  And that is a shift in policy.  The ‘Fed Put’ as it has been known whereby the Central Bank blinked every time markets became worried about the US economy is probably no longer there.  What we don’t know is just how far they would be prepared to ignore market volatility and how bad it would need to get before they would suspend liquidity tightening.  Let’s hope we don’t have to test it because if benchmark bond yields rise above 3% in the short-term, following an inflationary scare, all markets, bonds and equities, will be lower than where they are today, even after the recent sell-off.

Our advice would be to focus on longer term goals and don’t try to time this market.  Luck will determine most of the outcome until more certainty prevails.  We know that global economic growth is strong and synchronised, which is a rare phenomenon.  If emergent wage growth is modest and broad-based then that is a good thing.  Also, we know that few businesses have any pricing power due to the consumer having better market knowledge via the internet – the old economic adage of suppliers being able to raise prices without affecting demand in an inflationary environment no longer applies in the same way.  Most retailers and manufacturers are under constant pricing and margin pressure and if they dare to raise prices, their revenue plummets.  That said, in a tight labour market, if employers are having to pay up to attract new staff as their business expands, then this will hit profit margins and that affects earnings and share prices.  Mark Carney made reference to there being limited capacity in the UK economy, some of which has resulted from the departure of labour back to the EU as Brexit has evolved.  This could be a feature that is specific to the UK economy but this has already translated into weaker profits and weaker stock market performance on a relative basis when compared to other developed economies.

For now, we remain fully invested, overweight to equities and underweight to fixed interest with a focus on real assets, which have an element of inflation proofing such as property.  Overseas diversification is also attractive as the challenges of the US and UK interest rate setters are less of an issue in other developed and developing economies.  The elders of our Investment Committee see parallels with 1987 when the Fed dramatically changed tack after a booming stock market and a strong recovery from the earlier recession.  This came as a complete shock and caused the October crash of that year.  Central Banks are no longer in the game of shocking the markets and sitting back.  On the contrary, forward guidance is the mantra as evidenced by the first US interest rate rise having been talked about for about 3 years such that if it hadn’t happened when it did, the markets would probably have been disapproving.

The economic recovery from the credit crisis has been long, arduous and somewhat anaemic which is why the stimulus has been maintained.  Economic temperature is notoriously difficult to measure as is the perceived economic spare capacity which could lead to upward pricing pressure.  These days, if it moves, it gets measured and analysed, more than ever before.  Maybe that is a justification for higher valuations as investors have greater confidence that the economic gods within the Central Banks can achieve absolute control, even if they do move in mysterious ways along the way.

Global Equity Markets Fall on Inflation & Rate Rise Fears

Global stocks endured their worst week for 2 years as investors concerns over the future path of both inflation and interest rates pushed all of the major indices into correction territory. Unsurprisingly, the spark came from the US where higher than expected wage growth sparked inflation fears and concerns that the Fed will hike rates even quicker than the market currently anticipates. This was followed by the Bank of England, which, at last week’s Monetary Policy Committee meeting also struck a more hawkish tone based around upgraded economic forecasts and inflation staying above target for longer than expected.

The phrase that when America sneezes, the rest of the world catches a cold ran true last week as a -5.2% drop in the S&P500 sparked a global sell off. Domestically, the FTSE100 fell by -4.7% after a turbulent week as it spiralled down below the 7,200 mark. European bourses followed suit with the French CAC40 and German DAX30 both declining by around -5.3%. However, the greatest decline was seen in Japan where the Nikkei 225 was effectively in freefall, shedding -8.1% by the close of play on Friday.

After a mini revival in its fortunes, Sterling was on the back foot last week. Against the Dollar, it dropped back below the $1.40 level to $1.38 after a -2.2% weekly decline. This follows a 3 month period where it had appreciated by +5.3% although it is worth noting that has been more do with Dollar weakness as opposed to real Sterling strength. The fall against the Euro was much less profound, declining by -0.7% to €1.13.

Positive US crude production data put significant pressure on global oil prices. Having hit a 3 year high just as couple of weeks ago, Brent slumped by more than -8.0% last week to $62.79 a barrel. Gold was also decline with the precious metal seeing its value decline by -1.3%to $1,313 an ounce.

Finally, looking at the sovereign debt markets and after briefly touching a 4 year high of 2.853%, 10-year US Treasury yields ultimately closed the week just 1 basis point lower at 2.845%. Meanwhile, the 10-year equivalent gilt yield was 2bps higher at 1.607%.

The Week Ahead

Inflation data comes to the fore this week as the latest Consumer Price Index (CPI) readings and Retail Sales data is due, both in the US and the UK.  The data in the States, due Wednesday, is expected to show a modest pick-up in both measures on a month-on-month basis. On home soil, the consensus forecast for Tuesday’s CPI reading is a slight drop from the 3.0% headline rate recorded a month ago, though Friday’s Retail Sales are anticipated to recover from a far weaker than expected number last month.  In Europe, a second estimate of Q4 economic growth is due on Wednesday. Currently, no change is forecast to the 0.6% quarterly rate.