Monday 03, April 2017 by Jessica Combes

A market without conviction

The markets still lack any conviction that the pickup in global growth and inflation can be sustained, according to Gary Dugan, CIO, EmiratesNBD.

It was another week where markets largely remained range bound. Equities recovered some of the ground of the previous week’s losses and government bonds remained range bound, but biassed to lower yields. The dollar recovered some of its recent losses but still lacks the conviction seen the rally earlier in the year.

Economic data surprises appear to have peaked, and the market is starting to price lower inflation going forward after the oil price inspired an increase in inflation expectations in the first weeks of 2017. Even the improvement in growth we have seen has yet to ignite a marked improvement in corporate profits forecasts in the developed world. After some upward revisions to analysts’ forecasts in February, the momentum appears to have been lost, and aggregate numbers are staying steady again. We do not see how equity markets can make further sustainable good gains given relatively high valuations and the absence of consistent upgrades to corporate profit forecasts.

Again, in contrast with the economist’s excitement with signs of accelerating global growth, the bond markets remain sceptical. The US 10 year government bond yield continues to trade at lower than recent average yields at just 2.39 per cent.

If there was proof needed that consumers will not tolerate the recent higher inflation it was shown very clearly in Japanese economic data releases this past week. Japanese inflation has picked up recently from deflation through the middle of last year to positive inflation, +0.3 per cent, in the early months of 2017. However, this did not go down well with the consumer who in simple language went on strike to protest at the higher prices. Household spending growth fell 3.7 per cent year-on-year weighed down, in particular, by cut backs in spending by pensioners who remain very price sensitive. Japanese consumer discretionary stocks rose 35 per cent in the second half of 2017 as modest wage growth combined with deflation to increase the spending power of consumers.

However, since inflation rose, the consumer sector has had a modest sell-off and looks unlikely to make much headway in the medium term.

The MENA markets took some heart from the modest recovery in oil prices. Brent oil rose 3.9 per cent on the back of disruption to Libyan supply and hope that OPEC will extend cuts beyond May 25th. The rise in the oil price also helped to ignite a small rally in oil stocks, with the sector up 1.7 per cent for the week against the broad equity market up 0.4 per cent. We believe that energy stocks have further upside. The sector has been a marked underperformer since the start of the year, one of the few sectors to still be showing a negative return year to date. The prospect of the extension of the production cuts, reasonable global growth and some firming of oil prices could lead to a modest rally in oil stocks from oversold levels.

The market still seems sceptical that the recent pickup in inflation will persist. The five-year forward break even in the USA, a market prediction of future inflation, has pulled back from a January high of 2.27 per cent and has slipped to 2.12 per cent. Euro zone inflation last week was below expectations.

Uncertainty about the future is also evident in the comments from Federal Reserve board members and last week’s meeting of the ECB. Fed board members in speeches appear to be bending over backwards to downplay the idea that policy rates could rise quickly and sharply. While three rate rises in total still seems the most likely outcome the bias of the comments seemed inclined to suggest that it would be a maximum of three rate rises overall. Indeed, Evans suggested that the financial markets shouldn’t rule out the possibility that maybe only two rate increases would be needed, given that we are all wondering just what dampening impact monetary tightening this far will have on economic activity.

Last week’s ECB meeting and subsequent speeches by ECB board members gave a slightly confusing message to the markets. Austrian central bank governor Ewald Nowotny argued in a speech for higher rates before the ending of quantitative easing, while the ECB’s chief economist was arguing against such a move. The contrasting arguments about the pace of a tightening of monetary policy came against the backdrop of a worse than expected inflation report that showed both headline and core inflation far below expectations. Despite the noise from the ECB, market expectation for a tightening of monetary policy is virtually unchanged from the start of the year.

In spite of some strong economic data in China, there are signs that growth may be about to moderate. Last week’s sharp fall in iron ore prices on fears that Chinese demand was weakening only calls into question just how robust the recent improvement in the Chinese economy is. Iron ore prices fell from $580 to $556 reversing some of the gains since the start of the year. Year-to-date iron ore prices are up 15 per cent, having been up as much as 32 per cent as at February 21st. Any suspected loss of momentum in the Chinese economy could have negative consequences for the broad basket of metal prices and the Chinese stock market.

However, we would not be overly negative about a mini-cycle in the midst of more consistency in the Chinese economy of late. In a year when there will be a major leadership transition in China, the government is keen to promote good growth and maintain stability. Investors need to keep in mind that the Chinese government’s priority for 2017 is to reduce financial risks of non-performing loans, bond defaults in shadow banking and internet financing. Inevitably bringing in better controls over these new channels of credit growth will hit the economy to some degree.

Metal prices look more vulnerable than the Chinese stock market to downside risk from a moderation in Chinese growth. Chinese equities trade on relatively low multiples (CSI 2018 estimated P/E multiple of 11.4 per cent), with earnings forecasts having remained relatively robust in the year to date. The Chinese equity market has made steady improvement since the start of the year (+3.83 per cent), with the Hong Kong market making more spectacular gains of +9.6 per cent.

British Prime Minister Theresa May formally informed the EU of the UK’s decision to invoke Article 50 beginning the process of exit from the EU. From now, the hard negotiation will begin. There are some key issues that the markets will be focused on, the UK’s access to the single market in the future, the payment the UK will have to make to leave, and the rights of EU individuals living in the UK and UK citizens living in the EU.

The situation will be even more complex over the coming two years as the political landscape in the EU remains very fluid. Incumbent political parties remain under severe pressure from new, often extremist parties often arguing for an EU exit.

UK asset markets have already discounted a good measure of the fallout from the decision to leave the EU. However, it is clear that they will have to ride the wave of newsflow as negotiations progress through the coming years. We believe that with the pound sterling the damage has already been done and hence we suspect that at least in the early days of the negotiation sterling will probably see more volatility, rather than lurching to a new lower level. At current levels, the currency is at a multi-year low on the basis of purchasing power and hence the bias of risk in the coming years is a stronger or stable pound against the euro or dollar, rather than any further profound weakness.

We expect the UK bond market to remain relatively well supported despite the uncertainty of Brexit negotiations. Growth has remained relatively upbeat with industrial confidence improving consistently over the past six months. Although inflation has inevitably spiked, the markets do not perceive it as a serious problem. The 5year-5year forward breakeven inflation rate from a peak of 3.6 per cent has fallen to 3.1 per cent. Meanwhile, the Government’s commitment to prudent fiscal policy is keeping a lid on bond issuance. The UK 10-year bond spread over the US 10-year is at close to one-year low, which probably reflects the view that Brexit is a growth and inflation dampening event over the medium term for the UK economy.

UK equities other than experiencing the volatility seen at the time of the Brexit vote have largely performed in-line with global equity markets over the past year. The weakness of sterling has provided a boost to corporate profits and global competitiveness of many businesses. However, the very international nature of the UK equity market means that the performance of the global economy will be more relevant than developments in the UK.