The Lowdown on Markets to 22nd July 2016
World Markets at a Glance
In this week’s issue
- Global equity markets are starting to show some signs of fatigue but the trend is still up.
- The driving force behind the markets rests with Wall Street as the S&P hits new high.
- The European Central Bank decides to keep interest rates on hold for the time being.
- In the UK the latest PMI figures shows a distinct deterioration in the economy.
- Both the G20 and the IMF voice concerns over Brexit and downgrade growth forecasts.
- Whilst central bankers stay accommodative equity markets are likely to remain robust.
“Short term concerns affect global equity markets sentiment”
Global equity markets are beginning to suffer from short term concerns over central bank support, a weaker crude oil price, and some mixed corporate earnings data. Nonetheless, this has not deterred Wall Street’s S&P 500 Index from setting several new highs. Unfortunately, many other benchmarks around the world still remain well below their all-time peaks indicating that this is undoubtedly a US market driven rally.
However by the same token when you take a look at Wall Street the story so far has been very much a sector driven rally but not across all sectors. Indeed, sectors such as telecom services and utilities have led the way, both gaining something like 20 per cent so far this year, whilst the likes of the Real estate investment trusts have added more than 10 percent. Conversely, other important sectors such as energy and financials have barely risen, if not marginally down for the year. But nevertheless we have seen the wider S&P 500 Index rise by +6.41% so far in 2016, which is important when looking on a global perspective.
And so why is the United States so important from an investment perspective, well it’s the largest economy in the world, it owns the world’s reserve currency, the US dollar, its weighting in the MSCI World Index is just under 60 per cent, with nine out of the top ten constituents within the index being US companies. These are all meaningful numbers when viewed from a global performance perspective, for instance this year the MSCI World Index is up +2.66 per cent, but if you strip out the United States, its down -2.33 per cent.
“Are we moving into bubble territory?”
Arguably, you then need to ask the question is this year’s rise of +6.41 per cent in the S&P 500 Index justified, or are we moving into bubble territory? Well undoubtedly, some of the US economic data has been displaying some signs of recovery, but it has been very mixed at times, hence the possible reason behind why the Federal Reserve Bank have been sitting on their hands in respect to further monetary tightening, obviously, alongside external issues such as Brexit, China, and anguish about creating a stronger US dollar by raising rates too soon which could be harmful to corporate America.
Therefore, what can we expect going forward from the US market, we don’t think it’s in bubble territory, but neither do we think it’s cheap. The problems are that real GDP is only growing at 2 per cent, whilst companies have no pricing power, and revenue expansion is slow, consequently, we are seeing a margin squeeze. Indeed, if you just look at this year’s second quarters corporate earnings season you will see that whilst 63 per cent of the companies have beaten their corporate earnings expectations, this figure is below the historic average, admittedly, only 20 per cent of the companies have reported so far, and so this statistic will change over the coming weeks.
The real conundrum that now faces US investor’s is the weight of money that is inactive, and on the sidelines, given its extraction from the market earlier in the year, as uncertainties built up about the direction of crude oil prices, China’s slowing economy, the Feds unclear stance on interest rates, and fears surrounding the result of the European referendum. All of these issues have weighed heavily on investor’s minds leading to a significant increase in their cash deposits and bond holdings.
“50 per cent of the stocks in the S&P 500 Index are now yielding more than the US 10-Treasury note”
Consequently, this has now led to a situation where 50 per cent of the stocks in the S&P 500 Index are now yielding more than the US 10-Treasury note, which is unusual, and probably means that for many income seekers the equity market is the only game in town, regardless of valuations. However, this could turn out to be a risky strategy given that we are now in the second longest bull market in history, and therefore, likely to become much more reliant on the earnings outlook going forward, and of course, any further economic shocks, or indeed, geo-political dilemma’s along the way could discourage global equity markets from moving up much further, perhaps even creating a flash crash or short-term correction.
Clearly, we are now seeing heightened risks in the UK and Eurozone from the Brexit vote, and the ensuing deterioration in the recent flash, or preliminary, UK Markit’s purchasing managers Index seems to support that, given it has fallen the most in its 20 year history. However, export orders were up on the back of a weaker pound which must be good news for many of those multi-national companies within the FTSE 100 Index.
“The European Central Bank decided to keep their interest rates on hold for the time being”
Interestingly, the European Central Bank decided to keep their interest rates on hold for the time being, but that maybe a precautionary decision whilst they decide what to do next. Indeed, their monthly bond buying programme might become less effective over the coming months given the shortage of eligible bonds that may be available after the collapse in European bond yields that has seen the likes of German 10-year government bond yields move into negative territory.
Understandably, the G20 and the IMF have both spoken out over their concerns about the possible fallout from Brexit, and its implications for the wider global economy, which subsequently has led to the IMF downgrading its UK economic growth forecast from 1.9% to 1.7% for 2016 and for the wider global economy from 3.2% to 3.1%. Clearly, there will be a measure of uncertainty until a resolution can be found between the EU, and the eventual departure of the UK from the European Union, but this will take some years to conclude, and is likely to include some eventual benefits for all parties.
However, in the meantime it is likely that we will see the ECB, and the Bank of England, being forced into an additional period of monetary policy easing, with the probability that the UK will cut interest rates in August, given the dramatic deterioration in the economy in July. Similarly, in Japan the July Markit “flash” purchasing managers index has shown that their manufacturing sector had tumbled below 50 signifying contraction within their economy. Equally, international demand has fallen at its sharpest rate in more than three-and-a half years, which is probably due to the appreciation of the yen, therefore, the Bank of Japan governor, Haruhiko Kuroda, will need to address this situation in the not too distant future.
“It could be said that the pound is now significantly undervalued against the dollar and euro on a trade weighted basis”
And so moving on to last week’s market moves, government bonds were relatively steady, whilst equity markets moved marginally higher, but lacked any real direction, as they pondered the next moves from the leading central banks around the world. In respect to the foreign exchange market, the pound began to fall again, prompted by the latest PMI figures and the impact of Brexit on the UK economy. And although we might see further sterling weakness over the coming weeks it could be said that the pound is now significantly undervalued against the dollar and euro on a trade weighted basis.
Finally, in the commodity markets base metal prices were mixed, whilst in the energy sector, Brent crude oil fell back towards the US$45.00 a barrel level, as investors continuously worry about the oil excesses in oil production over demand. Certainly, this is worth keeping a mindful eye on especially if the price were to dip below USS$40.0 a barrel as concerns would rise again over reduced US capex and possibly solvency for the US oil shale sector. Also the imminent direction of the U.S.dollars might signal which direction global equities might take, given that in a strong dollar environment equities tend to suffer. And to conclude, the all empowering language of central bankers is likely to continue to be the most significant driver for financial assets over the second half of the year.
Peter Lowman Chief Investment Officer
Peter Lowman has been in investment management for over forty years and prior to becoming Chief Investment Officer for Investment Quorum, he worked within a larger asset managers, primarily as an Investment Director with Cazenove’s. He is responsible for the overall investment strategy for Investment Quorum clients and sits on the Investment Quorum Committee.
This article does not constitute specific advice and investors should bear in mind capital invested is not guaranteed. Investment Quorum is authorised and regulated by the Financial Conduct Authority .