The reaction in the markets to the sad events in Paris has been stoic and full of resolve. At one level, there has been shock and horror that, for instance, the terrorists responsible for last weekend’s outrage had been operating under the noses of Europe’s security services, yet during and immediately after the events they effected some successful raids against the perpetrators. Markets and strategists are attempting to get their heads around how to make allowances for such risks, to whatever extent they are able to. It might seem illogical (or cynical), but the reality seems to be that the inexperienced heads in the market initially sell, or mark prices much lower, and then seasoned veterans step in and buy, usually for a short-term trade. Eurozone equities closed up 3.2% over the week.
The U.S. Federal Reserve in reality continues to be in a very tight spot, between the proverbial ‘rock and a hard place’. The FOMC postponed hiking when the U.S. economy was running at annualized growth of 3.9% growth, due to the perceived threat to Europe from the Greek situation, then because of economic weakness in the world economy, and specifically because of the Chinese stock market debacle. As a result the Fed is well and truly ‘behind the curve’, not a comfortable place for central bankers. The publication last week of the FOMC minutes from the October meeting all but confirmed the Fed is very likely to raise rates next month, “provided that unanticipated shocks do not adversely affect the economic outlook". Rather like a fund manager who has had a poor third quarter (and who tries to ‘catch up’ in the final quarter), the mere existence of being behind the curve increases the likelihood of a problematic outcome; as we and others have said, U.S. rates need to come off the floor, as possibly substantial misallocations of resources and fund flows have already resulted, one of the costs inherent in saving the financial system after the Great Recession.
Assuming the Fed raises next month, and given they are now under significant pressure to do so, markets could well correct badly if for some reason they don’t. In short, market participants now need that rate rise. U.S. equities had a very good week, closing 3.3% ahead, following some bad weeks, and following Europe’s lead. Any judgement by investors that a rate rise will have little adverse impact on the market could be correct, but only in the very short-term - the testing period will come afterwards, moving into 2016. Fed funds futures currently indicate a 70% probability of a move by the Fed at the December meeting.
At the same time, investors and strategists are now beginning to talk about a normal cyclical downturn in the U.S. economy, and no longer in such hushed tones. Earnings forecasts on the S&P500 have turned downwards, partially due to dollar strength harming export revenues, plus the effect of foreign earnings upon translation. Seasoned investors know that the probability is that it only gets worse from here. In market terms a perfect storm could be brewing, and not just due to an earnings downturn; rates coming off the bottom will reduce the present value of future earnings and cashflows, and that is before one factors in the political uncertainty going into next year related to the U.S. Presidential Election. Of course political uncertainty is a prime enemy of P/E multiples. Meanwhile, we note that U.S. junk bond yield spreads have recently risen sharply, with S&P apparently expecting junk bond defaults in the U.S. to rise to 3.3% by autumn next year (up from 1.4% in 2014), and only partly due to the energy sector.
The U.S. dollar remained firm last week, attributed mainly to the divergent monetary policies of the Fed with most other central banks, with the greenback back to within 1% of the 12-year high reached last March on a trade-weighted basis. The yield on the policy-sensitive 2-year Treasury Note closed at 0.92% last week, up 6 basis points on the week, and close to a four and a half year closing high, helping to sustain dollar strength. The 10-year yield was 2 basis points lower over the week. However, according to the recent Merrill Lynch fund survey, the most vulnerable trade heading into the December Fed hiking season is the ‘long dollar’ position, which still looks like a very crowded trade. If you had asked us much earlier this year which individual factor could begin to turn around the mighty dollar, we would have said the inclusion of the Chinese renminbi in the IMF’s Special Drawing Rights - basically the official confirmation by the IMF that the renminbi is a bona fide reserve currency. This will result in the gradual accumulation of renminbi by the largest global central banks, and diversification out of dollars. The decision to include the currency was deferred in the aftermath of the Chinese markets debacle - but early last week it was confirmed as having been approved by the IMF in principle, with the details needing to be worked out. We are not saying this will happen overnight; rather, we think this move will be highly significant in the medium-term.
Further monetary stimulus
Late last week Mario Draghi, the ECB president, said they “will do what we must to raise inflation as quickly as possible”. The ‘account’ of the ECB’s October policy meeting released last week reinforced the likelihood of further monetary stimulus at its next meeting on 3rd December, with market commentators expecting an increase in monthly asset purchases from €60bn, to perhaps €80bn or more. Anything less than this would likely disappoint. It is also generally expected that the (already negative) bank deposit rate will be increased by 10 basis points, to minus 30 basis points.
The People's Bank of China announced fresh stimulus measures on Thursday, cutting the rates charged when it provides liquidity to commercial lenders. The move, which came into effect last Friday, lowered the overnight lending rate from 4.5%, to 2.75%, and the seven-day lending rate to 3.25%, down from 5.5%. We need to better understand whether this move equates to blind panic, which would cause great concern, or whether it is a prudent move to enable the central bank to get ahead of the curve! - or somewhere between the two points.
Lastly, we detect heightened discussion of the increasing possibility - after a long period of time - that inflation could rebound. Some of this results from a statistical comparison in the event oil prices firm after the anniversary of their weakening, but it would only take firmness in a few basic commodities - and/or tightening (U.S.) labour markets - to put the deflation arguments to bed. A famous strategist in the UK once said, “Invest in bull markets, and trade in bear markets”. This of course pre-supposes we know which we are in. We were at an investment conference early last week, listening to some of our peers, and all they really did was to preach diversification across asset classes. We are rarely comfortable following the consensus, but for the moment feel we have to do so. There are only sporadic pockets of real value, e.g. Chinese equities via Hong Kong. Overall, markets are likely to remain choppy and nervous.