The Weekly - Listening to the bond markets


The summer season is well and truly under way with Ascot, Glastonbury, Wimbledon, Henley and a plethora of music events in full swing – a booming sector for those that provide hospitality.  We are still waiting for the consistently good weather to arrive, but I suppose you can always cower in a Marquee if it rains and drink more Pimm’s!

Invariably, during this period, investors can become distracted, hence the popular adage for investors to sell in May and go away until the autumn. Statistically, there is some evidence in favour of this, but it should never form the only basis behind an investment strategy. Take this year, for example - since 31st May the main global indices of the S&P 500, Hang Seng, Euro Stoxx, MSCI Emerging Markets, Nikkei 225 and FTSE All Share have risen by 6.6%, 6.0%, 5.8%, 5.1%, 4.4% & 3.5% respectively (Source: FE Analytics in £). If you had followed the adage, you would be now questioning the decision.

The catalyst for these increases has been a significant change in the stance of the global central banks. This started with the Federal Reserve Bank who have hinted that interest rates may be cut at the July meeting and that there could be further cuts ahead. We believe this was prompted by a slowdown in global economic growth and forward-looking indicators which suggest there is some weakness ahead. Whether or not the Federal Reserve is operating completely independently of the White House remains to be seen. For now, the market seems to be buying it. Suspicions arise from the accompanying statement from Jerome Powell when he first raised the prospect of cutting rates on 4th June. In this he stated that ‘interest rates could be cut if trade tensions (with China) damage the economic outlook’. The mandate of the Fed is to target inflation at 2% and to promote economic stability via the use of interest rates.

The statement specifically said that policy makers would ‘act as appropriate to sustain the expansion with a strong labour market and inflation near our symmetric 2% objective.’ Sustaining the economic expansion is not within the remit and talking up the bond markets by dangling the carrot of a rate cut at the earliest signs of economic slowdown suggests political tampering to us. Talk of interest rate cuts has persistently boosted the equity markets ever since the credit crunch, in the belief that cheap and freely available capital to borrow boosts economic expansion. This has occurred without any further evidence of economic slowdown – it is as though the equity markets are taking the Fed at its word and believe that the so called ‘Fed Put Option’ is alive and well - whether or not Trump is pulling strings behind the scenes.

It was noticeable how Trump played the ‘record breaking markets’ line at his recent Florida hustings where he launched his presidential campaign for next year’s re-election. Pump-priming the markets via the Fed would be an irresistible strategy and he knows the impact of doing this publicly. As we saw last Christmas, the markets had a temporary wobble over his pressure tweeting the current Chair of the Fed, Jerome Powell, suggesting his appointment may be a mistake and that he may not be fit for the job if he didn’t stop raising rates. There is a minor media frenzy right now as to whether Trump has threatened to demote Powell in order to gain influence over him, suggesting interference, all vehemently denied of course.

So, we have a situation where the bond markets remain correlated with the equity markets, as they have been ever since the credit crisis. As soon as an economic cloud appears on the horizon, the central banks talk up a pre-emptive rate cut, and investors buy both bonds and equities - the so-called ‘bad news is good news’ trade. The risk with this strategic assumption is that we now have a President who is measuring himself against the performance of the markets and is also quite capable of manipulating the supposedly independent policy makers. That is fine so long as the world doesn’t actually experience a significant slowdown. The problem lies in the fact that, as equity markets set new highs, they have skipped the stage where they are supposed to experience weakness when the first signs of an economic slowdown occur, leading to earnings downgrades. The Fed is controlling the levers, investors believe they will do whatever it takes, and the US economic expansion will continue unabated - no need to worry about the bull market coming to an end. This was fine (up to a point) whilst the White House was disconnected from the Fed, but we now have a President who will use any influence he can to get re-elected.

Equity and bond markets are pricing in further rate cuts with an unquestionable belief that any slowdown will be brief and mild. There is therefore no need to question earnings valuations. Even news of the resumption of talks with the Chinese at the G20 meeting in Osaka has further boosted markets on the assumption that an agreement will be reached. The reality is that both sides are deeply entrenched with significant differences. Perhaps Trump will relent on some of his red lines, deliver it as a triumph and the markets will continue to believe Trump’s messages.

One of the seven deadly sins of investment is the theory of confirmation bias, the others being herding, loss aversion, anchoring, the endowment effect, conservatism and overreaction. Confirmation bias occurs when investors focus on data that merely confirms previous beliefs which have yielded profits. This is more prevalent today than ever before due to the volume of available information which leads to investors unconsciously filtering out data that would contradict a highly desirable outcome which suits both clients and businesses alike. We can now add the President of the United States to that list. Whether you believe him or not is currently irrelevant, markets are hitting highs so that is confirmation enough.

We would therefore suggest that as the US markets attain new highs and even the Brexit downtrodden FTSE-100 shows some strength, be cautious ahead of the second quarter US results season that starts in early July and onwards over the summer. There are some ominous signs in the data, partly the result of trade tariffs, partly the result of normal trade cycles which suggest there could be some earnings disappointments ahead. Dovish comments from the world’s central bankers will not be enough and especially as there is only one major central bank that can meaningfully cut rates with all the others still trying to recover from the quantitatively eased era.

 Ten-year benchmark government bond yields have moved decisively ever since the Fed changed tack with those in Germany, Sweden, Holland, Switzerland and Japan now slightly negative, implying significant economic weakening ahead. In our experience, when there appears to be an apparent conflict between bond market pessimism and equity market optimism, it is usually the former that ends up winning the day as there is less speculation involved. However, ever since the credit crisis, central bankers have been rigging the bond markets and what appears like a severely negative scenario has actually been artificial stimulation rather than a true reflection of investor fear.

Nothing has really changed but we now feel nervous that we could have a compromised Federal Reserve Bank adopting interest rate policy, potentially influenced by the White House. The one thing no-one can control is the behaviour of consumers and businesses. There is a slowdown approaching but it is the degree and extent of this which will drive the direction of equity markets over the next few months – the bond markets are already pricing in something quite significant whilst the equity markets believe all will be well and that the economy will get a boost from the loosening liquidity. Disbelieving Trump’s rhetoric and economic competency has not been a profitable investment strategy ever since he gained power. Having been proved wrong for two and a half years, the equity markets now seem to be no longer treating his statements and strategy as incompatible. Many must be keeping their fingers crossed because if the data continues to deteriorate, earnings expectations will be too high, and markets will need to price that in.

Oil rallies on raised US/Iran tensions

The price of oil was the big mover last week as geopolitical concerns in the Middle East continued to grow. Alleged Iranian attacks on oil tankers in the Strait of Hormuz had amplified tensions between the US and Iran over the past month. This was escalated further by the downing of a US surveillance drone off the Iranian coast last Thursday. Given the Strait’s importance in the transport of oil and gas around the world, the threat of supply disruption led energy prices higher with Brent crude jumping by +5.1% over the week to $65.20 a barrel.

Global equity markets enjoyed another strong week with all of the major indices concluding Friday in positive territory. In the US, the Federal Reserve left interest rates unchanged at its latest policy meeting but dovish tones in its post meeting statement were enough to send the S&P500 up +2.2%. At home the FTSE100 rose by +0.8% with the mid-cap focused FTSE250 climbing by +1.1% whilst European stocks ended the week up +2.0%. In Japan, the Nikkei 225 ended the week +0.7% higher.

10-year Gilt yields held firm at just 0.0% with the Treasury equivalent in the US falling by 3 basis points to 2.07%. Meanwhile in the Eurozone, the 10-year German Bund yield fell to a new all-time low of -0.315% whilst the French 10-year dropped to 0.0% for the first time. Last week, ECB President Mario Draghi signalled that the Bank is also prepared to offer more stimulus if economic growth continues to slow, leading yields on the Continent lower across the board.

Elsewhere in the commodity markets, Gold continued its resurgence, boosted by the lower bond yields being seen around the world. The precious metal rose by more +3.0% and had briefly pushed beyond the $1,400 mark for the first time since 2013 before closing the week at $1,393 an ounce. It has risen by almost +9.0% over the course of the last month.


The week ahead

The final revision of Q4’19 GDP is the main data from the UK this week with quarterly growth of +0.5% likely to be confirmed. Tomorrow, Bank of England Governor Mark Carney and several other MPC members are presenting their latest economic and inflation projections before Parliament. Comments made during the hearings are likely to come under heavy scrutiny for any clues regarding the future path of interest rates.

In the US, revised economic growth is also the standout data release although no change to the previously calculated +3.1% Q1 figure is expected. Other US related numbers to keep an eye include durable goods orders (leading production indicator) and new home sales, both for May. The main release from the Eurozone this week arrives on Friday with headline CPI inflation forecast to have remained at just 1.2% during May.

It’s a busy week for Japanese data with several significant releases due including retail sales, unemployment, industrial production and inflation. Chinese data is in short supply on this occasion.



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