The Lowdown on Markets to 26th August 2016
World Markets at a Glance
In this week’s issue
- Fed chair, Janet Yellen, says there is a case for an increase in short-term interest rates.
- The customary caveat is that any decision would depend on further positive data.
- When the interest rate trigger is pulled then treasury yields are likely to react.
- There will be ramifications for the US dollar and more so the equity markets.
- In the UK overseas tourists are splashing the cash and helping retail sales figures.
- Whilst we could see a pull-back in markets, equities are still better value than bonds.
“The Federal Reserve Bank paves the way for possible rate hike this year”
Clearly, the markets became fixated by the words spoken by the US Federal Reserve Bank chair, Janet Yellen, in her address at the annual meeting of the leading central bankers at Jackson Hole Wyoming. In her carefully worded statement she said that the case for an increase in short-term interest rates had strengthened over recent months, given steadier jobs growth, a moderate US outlook for growth, and the probability that US inflation would reach the Fed’s target of 2 per cent within the next few years. Also US new home sales have hit a near 9-year high whilst interest rates have remained low.
But of course, she then went on to her customary caveat by saying that the committees penultimate decision would depend on further positive incoming data, to confirm the Feds outlook, and perhaps more importantly, the external forces that have obviously plagued the FOMC in raising interest rates further since their last hike back in December 2015. Arguably, pulling the interest rate trigger on the next available date, the 21st September 2016, is likely to be heavily debated amongst the committee members, and in particular, those that are counselling a word of caution about acting too quickly on the recent better news.
“The markets became fixated by the words spoken by the US Federal Reserve Bank chair, Janet Yellen”
Unquestionably, the next US jobs report, that is due out before the next Federal Reserve Meeting, might be the determining factor given that they are nearing their statutory objectives of maximum employment and price stability. Then of course, we do have the US presidential election in the first week of November, therefore, they could hold off until their final Fed meeting of the year and then announce a further interest rate hike. Either way, they really need to get on with it, whilst reassuring the markets of their intentions, so as not to create a flash crash in either equity or bond markets.
Regrettably, one of the real problems that many of the central banks have now created through their monetary policies, and quantitative easing programmes, has been the engineering of historical low interest rates, and bond yields. Indeed, the demand for government bonds has skyrocketed over the recent years; in fact, it has been calculated by the Bank of America Merrill Lynch and EPFR that the latest buying takes the QE era flows into bond funds to near US$1.0 trillion, which in turn, could be very dangerous if investors then decide to liquidate positions rapidly on any expectations that the Fed will need to raise interest rates far quicker in 2017 than perhaps the market is expecting.
Astonishingly, global bonds have produced an annualised return of 20 per cent so far this year, the second highest return over the last 30 years, this in itself is unusual, and re-affirms that there is a high expectation that the bond rally is intact and that near-zero interest rates will remain in place for the foreseeable future. Conversely, any future inflationary shocks, perhaps from wage inflation, could create an uncertain time for the bond markets and subsequently generate a bond tantrum as fixed interest investors become nervous.
“Global bonds have produced an annualised return of 20 per cent so far this year, the second highest return over the last 30 years”
By the same token, if you look at the UK government bond market this is likely to remain in high demand over the next decade, given that both the Bank of England, through their bond buying programmes, and the pension fund and insurers chase down “safe assets” such as sovereign bonds. Regrettably however, the collapse in bond yields has meant that deficits for many of the plans has increased, and therefore both insurers and pension fund schemes are likely to need a further £300 billion of extra gilt issuance over the next decade. Remarkably, like global bonds, the total return so far this year for long-dated gilts has been nearer 30 per cent, fuelled by aggressive buying.
Another asset class that has once again begun to affect market sentiment has been the direction of crude oil. Indeed, it was the movement in the oil price and the Yellen speech that were the two main influences on the markets last week. Clearly, since the crude oil price bottomed out in January of this year it has risen by over 80 per cent. However, since breaking through the US$50.0 a barrel level it has been anguishing from very mixed signals, in respect to what the various OPEC counties might be thinking about future oil production, and the differing outlooks from each of the nation states.
Clearly, next month’s producer meeting is going to be very important, given that one of the OPEC members, Iran, has said that it would attend the industry conference in Algeria, setting the scene for some serious debate, however, Bijan Zanganeh, a serving oil minister for Iran has already stressed that Iran’s production cannot be restricted, given that it has raised its output in an effort to recover some of its customers after being affected by the western sanctions in previous years.
Unquestionably, the oil price and the market has improved, which in turn, has led to a pick-up in the worlds demand, this in turn, has led to the Saudi’s indicating earlier this month that they might be willing to co-operate with OPEC and the larger non-OPEC nations, but of course, as always there are delicate matters involved when the member states meet, and of course, with Janet Yellen starting to talk about a backdrop of US moderate growth, and a stronger case for interest rate hikes, the stance for most asset classes will undoubtedly begin to change direction.
“The oil price and the market has improved, which in turn, has led to a pick-up in the worlds demand”
Certainly here in Britain sentiment seems to have already changed post Brexit, indeed, in the run up to the EU referendum we saw an acceleration of economic growth, helped by a rise in consumer spending, and a rebound in business investment. Since the EU vote we have seen the Bank of England cut interest rates, and sterling fall to levels not seen in a very long time, this in turn, has led to a pick-up in tourism, as overseas tourists flock into the UK to take advantage of the weaker pound. Also the retail sales figures have risen recently, despite predictions that the consumer would begin to tighten their belts given the uncertainties surrounding Britain’s future relationship with the EU.
Conceivably this economic boost might be short lived, as we still have very little idea as to the long-term ramifications for Britain’s exit from the European Union. However, with the UK government having yet to invoke Article 50, and with the prime minister, Theresa May, only just beginning to draw up the blue print for Britain’s exit we could still see further economic improvements over the coming months.
And so to conclude, with the rising expectations that the Federal Reserve Bank will announce at least one interest rate hike before the end of the year, and a decoupling of US monetary policy from the rest of the west, it is likely that we will see a period of rising bond yields, and perhaps more volatile currency markets.
This in turn, might have some consequences for the global equity markets, given that they have undoubtedly got ahead of themselves over the summer months. Therefore, the likelihood of an autumn correction could begin to gain some momentum, as traders and fund managers return back to their desks from their summer vacations, and begin to ponder over what has happened in recent weeks, which is likely to have some consequences for future asset allocations.
Other factors that need to be carefully watched over the coming weeks will be what actions the European Central Bank and Bank of Japan might take over the coming weeks, and whether the Peoples Republic of China take a different direction, also last but not least, be wary on the direction of the crude oil price which has a tendency to affect market sentiment. Finally, whilst global equities do not look cheap they are still better value than bonds; therefore, any meaningful pull-back in the markets is likely to be seen as a buying opportunity by global investors.
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 .