The Weekly - No appetite for fear

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14/05/2018
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The ability of these markets to ignore risky scenarios is, quite frankly, staggering.  There are lots of worrying issues bubbling away in the global newswires alongside general agreement that equity and bond markets look expensive, but nobody is selling.  It feels like a winning streak at the casino where a gambler has beaten the house at blackjack on the last five hands but doesn’t want to quit and go home because he believes that his past performance has everything to do with what happens on the next hand.  Greed is wholeheartedly suppressing fear at every turn.

This is probably unsurprising given that risk-averse asset classes continue to give flat real returns at best.  In an extended bull market when investors are looking at positions with significant gains, it is very tempting to believe that those positions are still great to have and any propensity to sell goes against the psychological bias towards those holdings.  We are told to run our winners, taking profit where appropriate but similar to buying a quality product as a consumer, investors tend to think that the quality and performance characteristics of a successful position are likely to continue.  As a consumer, why risk buying something else when the experience to date has been exemplary.

However, the problem with investment exposures is that it often takes a significant reversal of fortunes for that positive bias to evaporate, by which time the profit has gone and may have turned to a loss.  Knowing when you have been shrewd and knowing when luck has been a factor is vital.  Also, if you have been shrewd, most likely a view was taken against the market consensus which turned profitable when the consensus changed and the trade became crowded.  When the herd turns up with their millions or billions, it is time to move on.

This is especially difficult when the alternatives look relatively unattractive and that is the problem right now.  Asset classes outside equities have given significantly inferior real returns since 2015 and in order for bonds and alternatives to be a recipient of profits from Emerging Markets, Asia-Pacific or Technology equity exposure, the investor has to be predicting something seismic.  Whilst there are several possible negative scenarios, none of them are taken too seriously at the moment and so investors refrain from making this switch and equity markets remain supported and expensive through the lack of any selling and anything better to buy.

It is probably sensible to assess those negative scenarios even though we know that the market has no appetite for fear.  The correction we saw in early February is gradually ebbing away and was caused by a wage inflation scare.  This has largely been discounted as the fearsome figure was revised down even though the US employment market has subsequently become even tighter.  There have been a number of sensible explanatory articles on why the Phillips Curve is no longer working which has previously determined that tight labour markets lead to wage inflation and interest rate rises.  The episode was very useful for showing how sensitive the market is to inflationary pressure and anything that may steepen yield curves more than expected.  However, for now, very few believe inflation is about to rear its head.

Trump’s trade war with China, and anybody else who doesn’t buy US goods, has subsequently kept the lid on markets.  However, the market thinking behind this policy has evolved from economic suicide to one of confrontational negotiation using the threat of tariffs where the odds are very much stacked in America’s favour, being the world’s largest consumer.  The negotiations currently taking place behind the scenes, with delegations visiting Beijing and Washington, make the Brexit negotiations look pedestrian.  We believe there is likely to be some grand announcement of a new trade deal with China where their economy is opened up to US corporations like never before, just ahead of the mid-term November elections.  Throw in a dose of showcasing with North Korea and you have a stage set for a good result for Trump in Congress and, to be fair, it will probably be justified from the US perspective.

The other risk has to be the Middle East and what effect the rising oil price could have on the global economy and earnings.  The risk of war has certainly increased and that presents an oil shock risk but Trump is probably banking on nobody having the appetite for outright conflict in the knowledge that ultimately, the US will align behind Israel or Saudi Arabia, regardless of what Iran decides to do.  Also, it shouldn’t be forgotten that the global economy was recently operating quite effectively with an oil price of $120 without inflation or recession. If a conflict does arise, then comparisons with the 1970s Suez crisis are inevitable although that level of supply disruption is very unlikely.

And finally, closer to home, we have Corbyn's risk and Brexit with the former causing many investors to short the UK equity market, even though it has very recently outperformed most developed markets, almost reaching new highs.  The showing in the local council elections revealed that the Labour party has lost momentum as the Tories have regrouped.  It is still a reason to worry but economic analysis of the spending plans of what could be achievable under a Corbyn government reveals that the worst fears are probably misplaced.  Remember that a significant proportion of the Labour party are opposed to his policies but are currently muzzled following his success at the polls.  If they were to gain power, the new government would be as split down the middle as the Tories currently are, and the worst-case scenario would be unlikely to be realised.  Perhaps this is why UK markets and sterling have rallied strongly as that belief is gaining ground.

Whilst real returns from low risk assets remain flat at best, we cannot see anything immediately on the horizon that could cause enough concern to sell equities as we approach the summer doldrums.  Populist politics means leaders that are desperate to be liked by the voters and that is probably a good thing so long as the lunatics and radicals don’t take over by voter disenchantment with the status quo.

Oil rally continues as US pulls out of Iran deal

Oil prices hit their highest level in 3 and a half years last week as President Trump confirmed that the US would be walking away from the Iran nuclear deal. It appears that sanctions are once again set to be imposed on the OPEC member which produces around 4 million barrels per day. Brent rose by +3.0% to just over $77.00 a barrel with WTI rising by +1.5% to $70.50. The former has risen by +22.0% over the course of the last 3 months alone and that has been reflected by strong performance by energy stocks around the world.

Global stock markets had a positive week with each of the major indices delivering gains. The largest gains were seen in the US, the S&P500 which rose by +2.4% with gains seen across the energy sector. With oil prices rising sharply this year, the sector has been the second strongest year-to-date behind Technology. Domestically, the FTSE100 and the midmarket 250 increased by +2.1% and +1.8% respectively whilst in Europe, the STOXX600 advanced for the seventh straight week after a +1.6% gain. The Japanese Nikkei 225 recorded a weekly gain of +1.3%.

On Wednesday, the Bank of England voted to leave interest rates unchanged at 0.5% following a pullback in inflation and weaker performance by the economy. With the news as expected, there was little activity in the domestic gilt markets with the 10-year yield rising by 4 basis points to 1.48%. The US Treasury equivalent rose by an identical amount to 2.98% having briefly pushed beyond the 3.0% barrier earlier in the week.

After a period of weakness, Sterling was back on the front foot with modest gains seen against both the Dollar (+0.3% to $1.36) and the Euro (+0.2% to €1.13). Meanwhile, elsewhere in the Commodity sphere, Gold inched higher with the precious metal rising by +0.8% to $1,321 an ounce.

The Week Ahead

Looking to this week, tomorrow see’s the release of the latest domestic employment figures. Wages are expected to have risen by +2.7% over the 3 months to the end of March, 10 basis points slower than last time. Unemployment is forecast to be unchanged at the 4.2% level seen last time. In the US, retail sales figures are arguably the most important number to keep an eye on with building permits and housing starts also likely to receive plenty of attention as the housing sector comes back into focus. The second readings of Q1 GDP are the stand out numbers in both the Eurozone and Japan with the former also releasing updated CPI inflation numbers on Wednesday. It is a busy week in China with fixed asset investment, industrial production and retail sales all due in the early hours of tomorrow.