Markets nervously on watch

Markets are nervous. Confidence that the Fed would probably raise rates at their December meeting and that policy makers in the eurozone, Japan and China would be able to underwrite growth has faded. Many markets spent last week giving back a portion of recent gains. Equities sold off by 2-3% and government bond yields fell back.

Probably the most significant economic news flow this week will be the release of the FOMC minutes from the 27-28th October meeting. Some economists believe that these minutes will reflect more of a balance of opinions than the statement seemed to suggest at the time, giving as it did the impression of a reasonable commitment to raise rates next month. However following that initial anticipation - or relief - when the chance of a rate increase in December rose to over 70%, the market’s pricing of this probability has moderated to 64% and could fall back towards 50% if the minutes of the meeting suggest more of a split on the committee as to whether rates should be increased at all this year.

‘Probability of Fed move in December falls back’

There are a series of important U.S. economic data points due to be published in the week ahead. Market participants will be carefully scrutinizing these releases for clues as to whether the Fed is finally likely to move in December.

The New York Fed industrial confidence survey is expected to show that confidence in the region remains in negative territory for the fourth month in a row. The Philly Fed survey is also expected to still be negative. Similarly, headline and core inflation are expected to remain benign. with expectations for +1.9% and 0.1% respectively.

The next few months should see some important developments for global inflation from a statistical point of view. It was around this time last year that oil prices began to fall sharply, dragging headline inflation lower. It is now beginning to dawn on the market that a significant amount of the disinflation from lower oil prices will, ceteris paribus, start to drop out of the annual inflation rate in the coming months. As Goldman Sachs points out, whereas oil prices are currently 45% lower year-on-year, if the oil price stays at this level for a further two months, oil prices will be down just 10% year-on-year, hence markedly reducing the impact on headline inflation.

One of the near-term challenges to any suggestion that inflation might begin to stabilize is provided by a view of oil’s current fundamentals. Oil markets last week saw a further bout of price weakness. WTI ended the week at $40.74, close to the August lows of $38.24. Part of the reason for the weakness was a report by the International Energy Agency (IEA) that crude oil stockpiles have risen to a massive 3billion barrels. Combined with record inventories of oil products (European diesel inventories, for instance, are at a five-year high), oil prices look likely to remain weak in the near-term, despite apparently improving global oil demand. The IEA continues to argue that they envisage a marked slowdown in non-OPEC supply next year, which would help to bring the market into balance. In the near-term, however, there is a growing fear that the already massive and growing inventories of oil have just about used up any remaining available storage capacity. Huge amounts of oil are in effect ‘stored’ at sea, and any further over-production will immediately hit the spot market.

‘Global inflation on a modestly firmer footing’

U.S. inflation-linked bonds (TIPS) now look good value for investors looking to hedge any risk of a pick-up in inflation. There has been an interesting development in fixed income markets, in that inflation-linked bonds now price-in a greater risk of deflation in the US than in Europe, for the first time since 2011. This is due in part to the greater credibility given to the ECB’s efforts to generate inflation through its quantitative easing, and the recent weakness in the euro.

‘Lower oil price undermines GCC markets’

Weak oil prices are keeping the GCC equity markets on the back foot. Dubai’s DFM Index is having broken key support levels. It now seems likely to trade lower, perhaps as low as the December, 2014, low of 3,033, from which there was previously a sharp rebound. The dividend yield of the market has risen to an attractive-looking 7.6%. Elsewhere in the region, the Saudi Tadawul index is holding at close to the 7,000 level. If that were to fail, the index would then be at risk of downside to the 2012 lows of 6,462.

Chinese financial market news flow remains a mixed bag, although does seem to reflect a gradually stabilizing economy. Economic data releases last week portrayed an economy that is stabilizing, helped by a relatively good performance from the service sector. Inflation data came in below expectations last week, at 1.3%, however retail sales showed their strongest rate of year-on-year growth so far this year. Meanwhile, the authorities are continuing to fight the demons at large in the economy.

For instance, at the close of business on Friday the authorities introduced a new level of collateral requirements to rein-in the use of margin for trading in the ‘A’ share market. Separately, MSCI confirmed the inclusion of 14 China ADRs into its global benchmark, increasing the potential institutional demand for Chinese equities. Also, Goldman Sachs anticipate that the weighting of Chinese equities in the MSCI Emerging Market index could rise by four percentage points in May next year when it is rebalanced.

‘India—bonds preferred for the moment’

In terms of news flow, India didn’t have a good week. The Bihar election results make it more problematic for the government to progress structural changes as quickly as they and the market would have liked. However, we note that local investors are rather more sanguine. Bihar was always going to be a difficult state to carry, given its significant bias to a rural population.

Meanwhile, economic data also came in a little worse than expectations; inflation at 5% is still well below the Reserve Bank of India’s target of 6% for the end of the fiscal year, and industrial production growth was up 3.6%, versus expectations of 4.9% especially after a very strong August when its growth hit 6.3%. The rupee, like all emerging country currencies, has lost value in recent months against the dollar, although has come off the recent highs of 66.50, and currently stands at 66.10. The equity market has given back most of the gains made since late October, and must now form a new base around current levels of 25,600 on the Sensex to make progress. Bonds probably still have the best risk-adjusted return potential amongst Indian asset classes, and to our mind look attractive again after the recent back-up in yields.

At this time, our thoughts with the French nation after the tragic events in Paris over the weekend. Our sincere condolences to all those whose lives have been touched by these terrorists attacks. We all hope and pray that sense and peace will eventually prevail in our current disorderly world.