The Weekly - The Truth Is Out There

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09/10/2017
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The chorus of chanting from market bears is getting louder by the week, most notably from those who are hurting as equity markets grind higher. Nobody wants to sell but many have cash available waiting for a correction. But corrections only come about through significant selling and that requires a catalyst. Whilst interest rates remain so low and are still at the very early stages of rising, the equity risk premium will continue to look attractive. The catalyst will need to be significant and scary enough for investors to take fright and prefer cash and that remains elusive.

The Truth Is Out There

All eyes are on the US Fed this week which releases the minutes from its September meeting. As US economic data continues to show strength, it is becoming increasingly likely that another interest rate rise is on the cards for November/December. In the UK, Mark Carney has warmed us all up for a rate increase but he will have to justify it on the grounds of reversing the Brexit vote emergency move from last year. The UK economic statistics are weakening and Mr Carney has probably missed his opportunity on economic grounds – business sentiment will be against him unless he blinks and defers the decision. Logic would dictate that the last thing we need is a rate rise during the Brexit negotiating vacuum and especially when our economic growth has fallen to the bottom of the G7 league. However, he has repeatedly delivered a confused and inconsistent message to the markets during his tenure and he will now get criticised whatever he does on 2nd November.

His surprise tightening message delivered in mid-September caused Sterling to rally strongly and this was based on concerns regarding debt and inflation. However, a previous message has been that inflation will peak at around 3% as the effect of the Brexit inspired Sterling weakness washes through the numbers. Cynics might argue that the real purpose was to stop the downward spiral of Sterling against the Euro which was becoming a significant focus of speculators. In this respect, he was certainly successful but Sterling is now weakening again as political stability continues to evade the ruling government party.

We have long argued that some sort of agreement on anything from the Brexit negotiations will be welcomed by all. However, this is now becoming ever more desirable as the pressure builds. Many contrarian investors are finding value in cyclically sensitive UK equities but that requires conviction that a positive outcome will be delivered soon. It doesn’t help that a ‘no deal’ scenario is being worked upon and neither does the endless leadership speculation. We read that the UK equity market is one of the most under-owned regions from the perspective of international investors who are steering a wide berth whilst Brexit grinds on. This suggests the risk is on the upside but patience will be required as it may get worse before it gets better as those on the other side will be well aware how weak Theresa May currently is.

So, when considering equity allocations, if US valuations are too rich for you, the UK too uncertain and the Far East too dangerous as Trump baits Kim Jong-un, what to do? There is still Europe and Emerging Markets but both have been strong and valuations are not as appealing as they were. However, we have been overweight and continue to run with this and in addition we remain generally overweight to equities as they offer the most attractive returns, albeit within a universe where much is looking expensive.

Some will be familiar with the famous quote from Warren Buffet; ‘Be fearful when others are greedy and greedy when others are fearful’. That is fine as a conditioning statement at extremes of market behaviour but where are we on the ‘greed’ scale? Historically, investor greed has been accompanied by unbounded optimism, if not euphoria which are absent from today’s bearish arguments. Perhaps we have evolved from those historical behaviours and we now need to look out for ‘complacent optimism influenced by recent strong returns’. If any investor has sold in the last two years (or more) based on a valuation or record level argument, it would have cost dearly. In the knowledge of this, investors are deciding against this strategy and therefore remain invested and reluctant to sell, despite believing some of the bear arguments.

On the supportive side, it is looking more likely that Trump will get some form of tax reform through Congress and this was the main driver of the reflation trade. In addition, global growth is strong with most purchasing manager indices (PMIs) suggesting confidence which is closely aligned to economic growth. Many are worried about the change in the interest rate cycle and the unwinding of Quantitative Easing. Historically, removal of liquidity and increases in the cost of borrowing have led to economic slowdown and challenges for equity markets. However, the authorities are choreographing their intentions with such transparency, it is unlikely they will do anything that comes as a shock. Also, the reasons for tightening are not to burst a rampant explosion in optimism, speculation, inflation or debt unless the last of these is much worse than we believe.

This could justify higher valuations for longer which would be accompanied by a belief that the authorities will preserve global growth as they reverse their liquidity injections of the last ten years. This requires a high degree of confidence in the competency of our leaders which is something we would judge to be at relative lows. Lessons from the TMT bubble and the GFC have been learnt we hope but we are not in the same environment.

The elephant in the room is never obvious but it always appears at some point, its size determining how severe the market impact. Some believe the room is full of them at the moment whilst others have stopped looking preferring to chase positive returns. There are always opportunities to make money in all market conditions and I guess that is the key. Work harder to find those opportunities but don’t bet the farm just in case something really nasty comes along which no-one has predicted but with hindsight will look obvious.

Payrolls tumble but equity markets remain buoyant

In an otherwise solid week of economic data, the effects of Hurricane Harvey and Irma were felt in the non-farm payrolls data which saw the US labour market contract for the first time in seven years. A severe blow was expected, at least to some extent, but the data subsequently led the S&P 500 to end an eight day winning streak on Friday. The day’s loss was modest though and the US index still closed +1.2% higher on the week. Most other equity markets also extended their gains last week; the FTSE 100 climbed +2.0%.

33,000 US jobs were lost in September following the hurricanes. The unemployment rate was unharmed and in fact dipped to 4.2% as part of a separate dataset whilst average hourly earnings also improved, rising to a rate of 2.9%, but the storms’ impacts on these measures are likely to take a few months to work their way through the data. An unexpected positive effect of the hurricanes was a spike in September car sales as Americans replaced vehicles damaged during the storms.

European equity markets also made positive strides; Germany’s DAX 30 index climbed +1.0% over the course of the week and the French CAC 40 made +0.6%. Spanish stocks meanwhile saw volatility and dedicated Spanish funds faced heavy outflows as the unrest in Catalonia unfolded. An attempt by the Spanish government to suppress an independence referendum lead to ugly scenes in Barcelona. 90% of the ballot was in favour of independence, with those opposed largely boycotting the vote.

Business activity figures from the US and Europe released last week pointed to continued reasonable economic growth. The Purchasing Managers Index (PMI) data is widely seen as a leading indicator of economic growth. European numbers were broadly robust and added to a positive trend seen over the last 18 months on the continent. The UK services sector reading, accounting for almost 80% of the UK economy, was resilient although the far smaller manufacturing and construction sectors disappointed, the latter contracting. US manufacturing and services sectors both showed their strongest readings in more than a decade, but it is unclear to what extent these US survey may have also been distorted by the recent hurricanes.

The Week Ahead

This week is a relatively quiet one by recent standards with US inflation on Friday the standout. An increase on last months annualised +1.8% is expected which may reflect some impact from the recent hurricanes. The release of the minutes from the last FOMC meeting is also likely to get plenty of attention; expectations of another rate rise before the year end stand at around 80.0%. Domestically, the Bank of England releases its quarterly Credit Conditions survey on Wednesday and will include data on secured and unsecured lending to households, small businesses and non-financial corporations. In terms of data, tomorrows manufacturing production figure for September is the main item to keep an eye on in the UK. The main data out of China this week arrives on Friday in the form of trade data for September. Eurozone and Japanese data is in short supply.