RMG Investment Bulletins
After a superb run of weekly commentaries, my colleague Stewart Richardson has called time on the treadmill of finding fresh insights every seven days. Let me start by saying that effort is not one I, or my fellow fund manager, Ciaran Mulhall, will try to measure up to. Instead as times change, so do we and recognise that depth of research, in a world of so many opinions, is fighting for too few eyeballs. No, my aim is far more to inspire thought, provoke reaction, and to be brief. I will trouble you but once a month (Ciaran will do likewise on macro themes), but I hope I will also disturb you to.
So, where goes the Pound?
It has become a focus of attention, with the exchange rate being taken by many as a barometer for the future prospects of the UK post Brexit (if indeed Brexit occurs).
"Pound down is bad, Pound up is good" so goes the logic. And on each and every coiffured utterance from Barnier, we get in a frenzy.
Let's face it, Brexit is probably the single most important political issue to face the UK since 1945. You can have a sound economy, you can have revered legal and financial institutions, a dominant international language and favourable time zone, but politics can override it all. Especially if the perception (or reality) is one of institutional paralysis or failure.
The UK has had a current account deficit more or less throughout my adult lifetime. Call it 40 years. Now basic economics tells us, on that basis the exchange rate should adjust downwards, until at least we get somewhere close to an equilibrium level.
The historical effective exchange rate index has traded roughly between 140-90 in that time, and we sit close to the bottom now.
Sterling is weak, and actually it should be. It's been trending that way for decades, with the occasional period of exuberance.
That long term trend is unlikely to change, unless we see a post Brexit supply side revolution.
But there are legitimate reasons to be concerned about a Brexit characterised by UK institutional failings. By that I mean inept government and the inability, or unwillingness, of institutions of government, to do as instructed by the British people.
Wherever you sit on the Brexit debate, no sensible person should want to see the apparatus of government so undermined. Yet that is the real and present danger to Sterling. If that trust is lost, then it will be incredibly hard to re-establish it.
In such circumstances, Sterling will fall hard, and that drop would be sustained.
An organised and visionary Brexit may well also see a fall in Sterling, but I suspect it would be short lived. An open and flexible UK economy, perhaps with significantly lower corporate tax rates, and an immigration policy open to all with the required talents, could be the kind of supply side reform that markets embrace.
But a fudge just won't do. It will lead to increased uncertainty, and prolonged government bickering, further undermining our institutions of government.
One of the eternal conundrums of foreign exchange is after identifying the liability currency, you then have to find the asset currency. In other words, you may think the pound falls, but against what?
In a messy exit lacking vision, Sterling will fall against most things. But let's not kid ourselves that the Euro is some kind of safe haven. The election of Macron was viewed by some as the dawning of a European Renaissance. However, I would suggest that it is more like the apogee, than the start of "more Europe".
Markets adapt to economics in a relatively orderly manner, but when the big picture politics go awry, all bets are off.
And the politics of Europe are changing. This is no localised short-term protest movement, but rather widespread and deep held convictions that somehow Europe or the Euro isn't working for great swathes of people. Both right and left of the political spectrum are seeing a surge in support, and I suspect too many people in Berlin and Brussels are viewing this as just another minor irritant, rather than a groundswell of opposition.
And unlike Greece, Italy is going to be no pushover for either the EU or the ECB this time around. Debt levels are unsustainable, the buyer of last resort that has kept European bond markets so buoyant, will be no longer be present, the demand for infrastructural spending, post the bridge collapse in Genoa and the introductions of minimum incomes and lower taxes, will simply blow the EU budget rules out of the water. And the ECB and Germany are on the hook, big time.
Italians are fed up with internal devaluations forced upon them by Berlin and Brussels.
And the Euro is viewed as the major millstone around their necks.
This has the makings for one heck of a showdown.
So I'd suggest that selling Sterling against the Euro is at best a very short term proposition. An existential threat to the Euro is raising its head, and the beast could easily display hydra like qualities.
The dollar is still the best asset currency to hold against Sterling, although from an historical point of view, anywhere approaching 1.10 dollars to the pound is "cheap".
There is much already priced in to the exchange rate, and some hold the view that markets are already too pessimistic and Sterling offers value. That may be true, but only on a short to medium term economic basis.
The outlook is not dependent on Brexit, but on the
health of our political institutions and the vision or leadership when Brexit
occurs. If the perception grows of institutional ineptness or indeed deliberate
thwarting of long held democratic principles here in the UK, then the pound
will fall hard and deservedly so.
To view a PDF copy of this report, click here.
I have been writing this market commentary since 2010 and it is with mixed emotions that I put pen to paper for the last time under the RMG name. I am moving on to pastures new from where I will continue to write, albeit on a slightly less frequent basis. I truly hope that readers have enjoyed my weekly ramblings.
The post Global Financial Crisis has been an extraordinary period in which to be writing a regular market commentary. Some of my market calls have been good, and some bad. By way of a final sign off from RMG, I thought I would start by 1) articulating what I am trying to learn from past mistakes, 2) share some thoughts on what I see as the current big picture fundamental landscape and 3) what this may mean for future market returns and how to position in what could be a very interesting few years ahead.
First lesson to be learned must be to not fight the trend. No matter what an investor's fundamental view of a particular market, sector or individual security, do NOT fight the dominant trend. For most of the post 2009 period, non-US markets were trending broadly sideways as can be seen in chart 1 below. However, 2017 was a strong year to say the least, and my shift to a more cautious stance in April 2017 was wrong, or at best 9 months early.
Chart 1 - MSCI World Equity Index excluding the United States (price only) in US$
Although I don't feel too stupid for being cautious on non-US markets up until 2017, the US market is a different argument altogether. As I write, the post 2009 bull market in the US has become the longest in history, and my ofttimes cautious fundamental view here has been wrong.
Chart 2 - S&P 500 Index (price only)
So, I have been spending quite a bit of time in looking at momentum studies and other technical strategies in an attempt to keep me on the right side of the market especially when my fundamental view is opposing these. I very much look forward to sharing these with you in the future.
Building on the theme of do not fight the trend, my second lesson to be learned is to admit mistakes as quickly as possible and move on. Every investor/trader makes mistakes (even the best) but the trick is to recognise the mistake as early as possible and to rectify it. I would also phrase this as do not get married to a fundamental investment view, especially when the price action is different from what you see on the fundamental landscape.
There have been many times in the post GFC period when the fundamental landscape appeared to be very worrisome. But the power of investors to look past such troubles and buy into the political rhetoric of the day coupled by tremendous support from central banks has been truly a feature of markets in recent years. Can this be placed under the "do not fight the Fed" banner? Perhaps. Or put another way, central banks have employed the most extraordinary policy tools in order to do whatever it takes to make sure that markets do not go down. Can there really be no unintended consequences to these experimental policies? Only time will tell, but we would suggest that central bankers have not created new tools in this last cycle that have banished economic and market cycles to the dustbin of history, and probably don't fully understand all of the long-term costs that such policies may or may not deliver.
So, if I were to try and place the lessons learned into a single sentence, it would be; maintain a flexible mind to all potential outcomes, be agile in terms of changing market views when the circumstances change and simply do not fight the dominant trend, no matter the strength of conviction held on your fundamental view.
As well as learning lessons from past mistakes, investing is also about risk management and making sensible decisions. When I survey the landscape today, although my momentum work suggests a positive view on the US market, I cannot help but think we are late cycle both economically and market wise (as noted above the US is now in the longest bull market of all time). Assuming that economies and markets remain cyclical and that central bankers have not ascended to the arena of holding Godly powers, investors must expect a bear market (and recession) at some point in the future. Simple risk management and an understanding of past cycles surely dictate that investors should be considering a process of reducing risk in the current time frame rather than increasing risk?
Not only are markets and the economy probably quite late in the cycle, asset valuations in the US are very high. Chart 3 below shows the value of assets held by US households as a per cent of US GDP; this ratio has never been higher and at 505% is about 33% above the average since 1951. This record reading is a result of inflated assets rather than high savings rates, and a further worry is that these assets are concentrated in the hands of a small minority. This inequality is bad both economically and socially and was last witnessed in the 1920s. Either GDP has to start outperforming asset prices or asset prices have to start underperforming the economy, as this chart cannot head upwards forever.
Chart 3 - Value of US Household assets as a % of US GDP
My view is that asset prices will not only begin to underperform the economy at some point, but this process will include a period of falling market values. I have tried to frame this debate since early 2018 as to whether markets are in a multi-month topping phase or not. Regardless of whether we have entered such a topping phase in January or not, surely investors must consider the potential risks here as well as have a view on expected market returns. My personal view is that the potential reward compared to the potential risk is now skewed against an aggressive position in equities (in fact nearly all assets) for buy and hold investors, even though I cannot yet point to my momentum studies showing that risk appetite is rolling over.
What are reasonable assumptions for market returns at this point in the cycle? Well, most reasonable work suggests modest positive real returns over the next 7 to 10 years in the 0% to 4% annualised range. And perhaps the more negative end of the spectrum suggests negative real returns over the next 7 years of so. The team at GMO, who have called markets well in previous cycles (but been too bearish in recent years) have the following return forecasts. All assets are expected to generate returns significantly below their long term averages, and most developed market assets may well see negative returns over their forecast period.
Chart 4 - Real 7 year annualised return forecasts from GMO
It seems to me that the more bullish argument for equities stands on valuation measures based on current strong earnings with price to earnings not too far above long term averages. This is true, but the potential problem with using current earnings is whether they are a true reflection of the long term stream of earnings that shareholders can reasonably expect. Chart 5 below shows that the operating margins currently enjoyed by US companies are at a record high, and are some 40% above the long term average. At some point, is it not reasonable to believe that margins, which have always been mean reverting, will slip back to the 8% level or so? If so, then the bullish view based on future earnings metrics may well be questioned.
Chart 5 - S&P 500 operating margins at a record high
This high level of operating margins is part of the wider debate on the share of the spoils between shareholders and other stakeholders. At heart, we have a position today where shareholders are benefitting more than ever and arguably at the expense of workers in particular. Another way to illustrate the debate is to look at the recent explosion in share buybacks, as shown by the blue line in chart 6 below. I would also stress that it is not simply the fact that shareholders are receiving more reward than ever before, but that these buybacks are almost by nature designed to boost share prices, benefitting not just shareholders but also management.
It would appear that these buybacks are becoming more and more indiscriminate about the price that shares are bought back for, and that they are designed to boost the remuneration of management. Is this increasingly indiscriminate behaviour really enhancing shareholder value? And is the recent frantic activity really sustainable, especially during the next recession?
Chart 6 - US share buybacks and issuance
Coupled with the de-equitisation shown above is the increase in corporate debt since the GFC, shown in chart 7 below. In aggregate, US corporate balance sheets are more heavily geared than ever before, but that masks a distinct division between those really cash rich generally technology companies and a very large rump. The credit quality of the rump has deteriorated since the GFC and the covenants of corporate bonds is significantly worse. Overall, we believe that the US corporate sector is increasingly vulnerable to both rising interest rates and ultimately a fall in earnings that will occur during the next recession.
Chart 7 - US Total Outstanding Corporate Debt
So, overall I believe there is a strong case to say that the corporate sector is more highly leveraged than ever before, that household wealth is higher than ever before and that future returns from financial assets are arguably set to be worse than nearly all previous points in history. These balance sheet analyses seem to oppose the income statements of corporate USA and many households, but with operating margins at record levels and household savings and unemployment at record low levels, the income side of these sectors is vulnerable in the next recession.
We have tried to explain some of our thoughts about leading economic indicators in recent commentaries, and we hope that we have made it quite clear that the US is not about to fall into recession in the next few months. We also pointed out that the equity market itself is a leading indicator, and as it is trading at all time highs, we should not expect an imminent recession. However, it is also wrong to wait for obvious signs of recession before selling, as the peak in the equity market would then be well behind us.
Chart 8 - US equity market, Index of Leading Indicators and Fed Funds Rate with recessions shown
So, with asset prices demonstrably very elevated, and non-earnings based valuation measures near or even at all time high extremes, we continue to believe strongly that the potential reward at this point in the cycle is quite limited, and the risk of yet another devastating bear market is getting higher. Once momentum turns lower (likely after several more Fed rate hikes), the path to said bear market and most likely another recession will be set. For those that believe central banks have the tools to prevent bear markets and recessions, why did they not prevent the 2008 Global Financial Crisis?
What we have tried to illustrate here is that both the financial system (and by extension the economy) are vulnerable to disappointments. Those disappointments could be seen in a future downturn in corporate profitability, a shift in momentum away from ever rising equity prices, a political shift towards rebalancing obvious signs of inequality, a continued shift towards US isolationism, higher interest rates making safe assets an attractive asset class; or just as likely, something that very few are focusing on today.
The main point perhaps is that regardless of the eventual reason/s for a reversal in fortunes, the dye is cast. Buy and hold investors are likely to be disappointed by the overall outcome of the next 7 to 10 years, and are likely to have to suffer a nasty bear market during that period as well. We also believe that the majority of investors would actually like to try and avoid the worst ravages that may befall markets, and that they are not really buy and hold investors at all.
Central banks have pursued policies that not only have encouraged a reach for yield never seen before (remember when over $10 trillion of global debt carried a negative yield?), but their rapid responses to the first signs of trouble in recent years have taught investors that they should look to buy every dip regardless of true fundamentals and potential long term returns. This reach for yield will have inevitably led to a number of poor investment decisions that will ultimately prove costly; just ask those Japanese investors who have bought Turkish Lira denominated bond in the last couple of years, or those investors that bought 100 year Argentinian bonds last year.
Yet at the same time, central banks are now removing the punch bowl, and will seemingly continue to do so until something breaks. It would appear that the Fed will raise rates to between 3% and 3 ½% next year. Is this high enough to cause stress to vulnerable borrowers? Is this enough to cause economic problems at either home or abroad? Will ongoing quantitative tightening coupled with rate rises prove too much for the system?
So, having painted a cautious fundamental picture, I would stress again that momentum (in US markets more so than other developed and emerging markets) remains positive. Bad things are not likely to happen tomorrow so to speak.
But I do believe that everything is very late cycle and that buy and hold investors will be disappointed. Those that wish to avoid such disappointing returns likely coupled with a bear market need a strategy for the period ahead. Two simple strategies could be to either continue to lower risk as markets move higher (and future expected returns shift lower), or to reduce risk once momentum has shifted to a negative bias.
Of course, for those that either disagree with any bearish thesis, or who can/will truly live through the next bear market without any worries, they should simply remain happy with their current portfolio and do nothing; for as long as possible.
And perhaps to sign off on a couple of upbeat notes. Periods of economic and market dislocation can often provide opportunities for those that are willing to entertain trade ideas slightly outside the normal. For instance, prior to the next recession, it is likely that the US yield curve inverts. The next step will then be for the Fed to cut rates as the economy enters recession, and as in every cycle since at least WWII, the yield curve will steepen as the Fed cuts rates to try and boost the economy. So, with the yield curve still positive by 23 basis points, it is too early to put on trades designed to benefit from a steeper curve. But my guess is that curve steepening trades will work well during the next recession when equity markets will be under pressure for a time, and so will be a nice diversifying strategy to have in the portfolio at that time.
Chart 9 - US yield curve and Fed Funds rate
But of much greater importance for the long term, those that survive a future bear market with their capital intact will have the pick of the bunch in terms of buying cheap assets. Will assets become as cheap as they were in either 2009 or 2002, or even the generational buying opportunity in 1982? Only time will tell. But we must look at market and economic dislocations as ultimately great buying opportunities, and I truly believe that such an opportunity lies ahead, and to be prepared to buy at that time will be as difficult as it was at any market low. However, to have the liquid capital available to buy after a significant market decline requires liquidity to be raised (or capital protected) when prices are high. So, it requires fortitude to sell when nobody else does and at the potential cost of missing out on some further (possibly marginal) market gains. But at this late stage in the cycle, I believe that investors of all stripes need to consider the big picture potential reward versus the risks that seem to be growing.
It has been an absolute pleasure writing a regular market commentary on behalf of RMG. I will be returning to writing at some point during the fourth quarter, and I hope to be able to keep in contact with as many of you as possible so please do let me know whether you wish to receive them in the future (my temporary contact email is firstname.lastname@example.org). I wish all my readers and my colleagues at RMG all the very best for the future regardless of what markets may throw at us. I know that RMG will continue to send fortnightly commentaries on Macro themes, written by Ciaran Mulhall, and on Foreign Exchange markets by Howard Jones. Both are hugely experienced investors in their fields and I would encourage you all to continue reading the RMG market commentaries.
To view a PDF copy of this report, click here.
Heading into the bank holiday weekend in the UK, and the end of summer, markets have been extremely quiet. We will keep this week's commentary short as there is not a huge amount new to say. We do, however, plan a longer commentary for next weekend (so please stay tuned in).
Equity markets have bounced a bit in the last week or so; something we allowed for in last week's commentary. From our little perch, we continue to see the US as showing the best momentum with emerging markets the worst and Europe and Japan somewhere in the middle. A closer look shows US indices generally flirting with all time highs whereas the MSCI World excluding the US is down about 12% (in US$ terms) from the high seen in January.
From a technical/momentum perspective, it is difficult to be cautious on a market that is flirting with all time highs. Our multi-month topping thesis has been centred on global equities, but when we split US from the rest of the world, our thesis has a little more weight to it. Even allowing for a little more strength in the weeks ahead, we are cautious on non-US equities here and would view a break of recent lows (on the MSCI World exc. US index) as pretty much confirmation of the bearish thesis.
Chart 1 - US & non-US equities
For the US market, as we suggested a couple of weeks ago, a failure near January's high would leave the impression of a "double top" which would be a bearish pattern if the February and March lows around 2580 were broken on the downside. Chart 2 below shows a few things in more detail. First up, price has obviously been rising since the low in early May, and is above the rising 50 day moving average; this is bullish. However, there has so far been a hesitancy in the last two weeks to break out into new high ground. There is also a rising wedge being form (red lines) which is in technical text book analysis an ending pattern and therefore ultimately bearish.
So, perhaps we were a little premature in a cautious call of a couple of weeks ago, but so far the index has failed to break out to new highs, so our view remains valid. For those that want to remain bullish short term, we would point out the chart support in the 2800 area (green horizontal line) which sits near the 50 day moving average. So long as the 2800 area holds, we have sympathy with the bullish view, however, we are very intrigued by the potential for a double top pattern.
Chart 2 - US S&P 500 with 50 day moving average (in blue)
We are regularly asked what it would take to change our cautious view. Well, from a pure price perspective, if US equities break high ground, then we would move back to at least a neutral position. For Non US equity markets, we would need to see price start to 1) trend higher, 2) start trading above medium and long term moving averages and 3) trade above obvious resistance levels. Either that, or become so oversold that a mean reversion rally were likely.
As an example, let's look at the German equity market. Chart 3 below shows the Dax index, which bounced nicely off support a week or so ago. This has us on watch for a more constructive view, but to actually adopt such a view, we would want to see price start to trade above the 50 day moving average and for the moving average to start trending higher as well. A move above the declining trend line (in red) would bolster a bullish view as would price trading above the May and June highs in the 13170/13200 area.
Chart 3 - Dax Index with 50 day moving average (in blue)
From a fundamental perspective, a shift to a more dovish stance by the Federal Reserve would cause us to sit up. On this point, this weekend will see comments and speeches from central bankers at the annual Jackson Hole symposium, but of much greater interest to us will be the FOMC meeting at the end of September. President Trump is increasing the verbal pressure on Chair Powell, and it will be interesting to see both the outcome of the September meeting and also the press conference. At the moment, we don't expect the Fed to be swayed by political interference, but we shall know more in a few weeks time.
So until we see signs of real price improvement in markets, or a demonstrable shift by central banks back to very dovish policies, we will maintain our current equity market views. Overall, we are cautious, with our main working thesis being that global equity markets are in a multi-month topping pattern. Short term, the US remains the strongest and emerging markets the weakest. We will have to become more constructive on the US if price breaks to new high ground, which is really not far away. For global markets excluding the US, a lot more work needs to be done before we would become bullish.
So that's it for this week; nice and short for a long weekend. As noted at the beginning, we will be writing a longer update.
To view a PDF copy of this report, click here.
For quite a few weeks now, our position on equity markets was modestly constructive with a preference for the US over Europe/Japan and with Emerging Markets our least favourite. Then last week, we expressed a more cautious position on equities overall. Generally speaking, we have been happy with how these views have panned out and we believe that the price action in recent months fits the picture we have drawn as a multi-month topping process.
As we sit here this weekend, we have to admit that our level of conviction for the weeks ahead is suddenly rather low. We can make a bullish short term case and a bearish case. When we find ourselves in this position, we just have to accept that this dilemma can happen quite often when attempting to predict the direction of markets. The best thing to do when conviction levels are low is to risk less capital and focus on the big picture. So, we remain of the view that central banks will continue tightening policy until something breaks, and that equity markets may very well be in a multi-month topping phase. In the short term, what is holding our attention more than usual is some extreme positions held by the speculative community; something that is often seen around time of market reversals.
First, let's look at the positions of speculators in the US Government bond market. As can be seen in chart 1, speculators have been adding aggressively to their short positions recently and their net position is now the largest short position on record. Historically, this group of investors are wrong at market turning points, and we are intrigued by the current set up, wondering whether this group may again be wrong with their current bearish position. Are US 10 year notes about to move sharply higher in price (yields lower)?
Chart 1 - US 10 year Treasury Yield and Speculative Positioning
We have written a number of times about the US Dollar in recent months (either bullish or neutral), and positioning here is also becoming a bit lop-sided, with speculators holding mostly bullish Dollar positions against a number of currencies. One good example is the Australian Dollar which has been performing quite poorly and now speculators hold a substantial net short position. If something were to happen to the Dollar, or put another way, if something bullish were to be seen on the macro front, there is plenty of room for speculators to have to sell Dollars and buy back their short currency positions. Could this coincide with lower US bond yields? Quite possibly so.
Chart 2 - The Australian Dollar and Net Speculative Positioning
One more chart on positioning, this time in Gold, where speculators have been aggressively selling in recent months and now hold a net short position for the first time in about 17 years. Gold is definitely oversold now and is on many investors most hated list.
Chart 3 - Gold and Net Speculative Positioning
We'll keep this really simple here. If the Chinese Yuan reverses direction and begins to appreciate against the US Dollar, then Gold should rally quite a lot. Chart 4 below shows the very tight correlation between Gold and the Chinese offshore currency. We all know that China manages the Yuan closely, and after a significant move and at a time when tariff negotiations are being resurrected, we think that the Yuan could rally quite smartly on any positive news.
Chart 4 - Gold and the Chinese offshore currency
Although we have highlighted the above market positions, we would also add here that there has clearly been a whiff of panic in the air as Emerging Market assets have been buffeted around by several factors, not least the collapse of the Turkish Lira. But nothing moves in a straight line forever, and although we have not changed our big picture view, we do see the capacity for a rally in risk assets which would most likely coincide with a weaker Dollar.
That's the good news. The bad? Well, if global equity markets do rally in the weeks ahead, we suggest that policy makers will see this as a signal that their policies are working and so they will continue to tighten policy (until something breaks).
To view a PDF copy of this report, click here.
Having been plodding along seemingly quite comfortably until early last week, all of a sudden Emerging Market concerns (amongst others) did in fact matter. Although we had been expecting a pretty quiet period over the remaining weeks of Summer, we had suggested keeping an eye on the potential downside risks; these risks are close to front and centre now.
Let's start with Emerging Markets. The problem last week was Turkey which, unless Erdogan changes direction quickly, will blow up financially speaking. We suspect that being a high yielding country, quite a bit of money has flowed into Turkey in the last two years or so, and some of those investors have clearly been hitting the panic button. Interestingly, contagion has spread to other countries, like South Africa, mainly in the Foreign Exchange markets. Chart 1 below shows an index of Emerging Market currencies, which as well as being way down from the highs seen several years ago, has now plummeted to new lows.
Chart 1 - JP Morgan index of emerging market currencies
Not surprisingly, emerging market bonds and equities are being sold down too. Chart 2 below shows the main emerging market equity ETF traded in New York. The recent rally that started in late June has the look of a bear market rally that failed below the previously broken support zone.
Chart 2 - Emerging Market equity ETF
As well as rising tensions in emerging markets, headlines on the simmering trade conflict keep niggling away at confidence. And just to keep everyone on their toes, the current Brexit position and an upcoming Italian skirmish with the EU on their budget are very much in the background. Individually, these concerns may not matter too much to a market that seems capable of ignoring bad news very easily. However, the fact that markets have suddenly paid attention leaves them at an interesting juncture in our opinion.
What really caught our attention last week was the performance of EM debt and specifically EM debt denominated in US Dollars. Chart 3 plots the yield spread of the JP Morgan USD EM Sovereign Bond Index in Red, and as can be seen, yield spreads blew out to the upside. When we get the trio of Emerging Market assets (FX, Bond and Equities) under pressure as they are now, this is a much stronger signal than just an isolated EM incident that affects just one country or say the currency of one country.
So, we think we have a very strong signal from Emerging market assets here. Currencies and Bonds are under significant pressure and EM equities are underperforming. We therefore have to be very attentive to this performance spreading to developed markets. So far, this has not really happened. This lack of contagion is evident in chart 3 by looking at the performance of US High Yield Bonds alongside Emerging Market USD Sovereign bonds. High Yield bonds have actually been performing reasonably well.
Chart 3 - JPM Emerging Market USD Sovereign Bond Spread and US High Yield Bond Spread
At this point, we have to say that, although the headlines are all around EM and tariffs, we think that the underlying cause of market wobbles is the continuing Federal Reserve policy tightening. Yes, perhaps investors like to have a fundamental excuse to sell, and the headlines are currently providing plenty of excuses. But for months now, markets have been going generally sideways as we have pointed out before, and simplistically speaking, this sideways pattern is either a high level consolidation within an ongoing bull market, or a multi-month topping pattern that will eventually break down into a cyclical bear market.
Liquidity is the lifeblood of markets. If central banks flood the system with liquidity, this will eventually boost prices as shown by the QE exercises seen in recent years. The Fed is tightening by both raising interest rates and draining liquidity as it allows its balance sheet to decline. We know that the ECB will end QE by the end of 2018, the Bank of Japan has been tapering its QE and there is clearly a debate going on about how they can exit their current policy stance.
Global monetary policy, which has been so supportive of asset prices since the last crisis, is slowly becoming more and more of a headwind, and it is this we believe that is beginning to impact markets. We stick with our theory that this steady tightening in global policies is impacting the most speculative areas of global finance first (crypto and volatility strategies in January), and will creep ever inwards towards the core (developed markets and specifically the US). The creeping is currently manifesting itself in sideways price action in developed markets (with the US being the best of the bunch), and with Emerging Markets more at risk of already being in the process of rolling over.
We have said before that we think the Fed will keep on tightening until something breaks. It therefore suggests that if the Fed suddenly reverses course because of declining financial markets, we will have to turn bullish. This is basically just saying that watching the central bank's reaction function is important. So far, the Fed is sticking to its tightening programme; it looks like rates will be raised in September and December, with more next year, and the balance sheet will decline by $50 billion per month from October onwards. Chair Powell seems to be ignoring Trump for the time being, and with inflation still rising (Fridays inflation release shows CPI excluding Food & Energy at nearly a 10 year high and likely heading a bit higher still) and unemployment below 4%, the risk is that the Fed is behind the curve so must keep going unless something breaks.
So, what of the developed markets? Let's start with the US and the S&P 500. Last week, the index traded within 0.50% of the high seen in January, and then proceed to peel away and actually closed down for the week. This leaves the impression that the market is not keen on proceeding immediately to new highs. In the worst case scenario, a failure here would leave in place a double top formation, which would be confirmed by a close below the 2600 area.
So, for those of a bearish disposition, we think that last week's high of 2858 is important, and that the 2873 high can be used as a line in the sand. Bearish traders can sell using the all time high as a stop. Investors can hedge or reduce exposure and remain that way unless the 2873 high is breached.
Chart 4 - S&P 500
In Europe, the position looks a bit messier to us. First, Europe has been underperforming the US year to date, and so the index has not traded near the January high and is much more rangebound than the US. There is no clear cut line in the sand looking at last week's price action, and all we can say is that Europe will most likely track the trend seen in the US.
Chart 5 - EuroStoxx 600 Index
Looking ahead, we think that the performance of High Yield Bonds in the US will be an important indicator for US equities (and by extension developed markets in general). Prior to the China inspired equity sell off that bottomed in early 2016, High Yield bond spreads has been widening for some time. In fact, history show that the performance of high yield bonds can be a very useful indicator of brewing trouble for equities. As indicated in the chart below, we believe there is a line in the sand for high yield bond spreads; if the widen past 370 basis points, this could well spell trouble for US equities.
Chart 6 - US Equities with High Yield Bond Spreads
So it's time to wrap up this week's commentary. We may well have erred in our view that financial markets would see out the summer in quiet fashion. The troubles in Emerging Markets, along with tariff worries, Brexit and Italy have suddenly coalesced into a headwind for markets. More importantly, central banks - with the Fed at the vanguard - are also increasingly a headwind, and this is all catching up with markets. Our theory that the pain will first be seen in the most far flung and speculative areas before creeping inwards to the core appears to be holding true as Emerging Markets come under pressure.
So far, the contagion from the worst Emerging Markets has been contained, but the performance late last week is not encouraging. The risk is that developed market assets begin to buckle and central banks ignore this and continue to tighten because they are already behind the curve.
As to how this relates to our multi-month topping pattern, we think this fits in really well. The January peak was either the momentum and/or price peak and we have traded mostly sideways since. The US market has tested the January high and may be peeling away. Performance has been less good in Europe and Japan and worse still in Emerging Markets. If price chooses to go down immediately from here, this will add weight to our thesis but the ultimate break of support in Europe and the US lies ahead of us.
For those that want to play the markets in the summer weeks remaining, traders may want to be short with stops above last week's highs. Investors may choose to buy some hedges or reduce exposure.
To view a PDF copy of this report, click here.
At the Federal Reserve Open Market Committee meeting last week, the Fed may have left rates unchanged (as expected), but they did give the impression that they thought the US economy was performing well. With nominal GDP growth now at its highest since 2006, it's easier to talk about the Fed being behind the curve, thereby risking a period of overheating. Furthermore, with Government spending on the up and tax cuts still fresh in our minds, we can certainly see why the Fed may be keen to keep tightening policy regardless of what Trump says. Our view remains that they will raise rates at each calendar quarter end and let their balance sheet run down until something bad happens.
Chart 1 - US nominal GDP growth and Fed Funds Rate
In terms of what we learned this week; we know that the employment data remains strong, but what piqued our interest was the decline in business confidence in both the manufacturing and services sectors. When discussing the big picture, we have recently focused on some of the leading indicators that will most likely deteriorate before stock prices and the economy do. Two that we have been monitoring are the US Manufacturing PMI and the Leading indicators index. These are plotted in chart 2 and it appears to us that both could be in the early stages of rolling over.
Chart 2 - US Manufacturing ISM and Leading indicators Y/Y % change
The main question is whether tighter US monetary policies with the prospect of further tightening to come is beginning to weigh on business confidence. Also, is it not a worry to the bulls that, considering business was the biggest beneficiary of the recent tax cuts, confidence is no higher than it was before the tax cuts were announced?
Along with tighter monetary policy, we have a stronger US Dollar and trade issues that could crimp growth in the quarters ahead, but it is important to note that the US economy is not about to go from boom to bust overnight. The key point is that, well ahead of the onset of recession business confidence, along with other leading indicators, is going to peak and rollover. We believe that the chances of a peak having already occurred are high.
Chart 3 - US GDP Growth and US Manufacturing PMI
But this is still early days, and we need more confirmation. For example, the Manufacturing PMI shown above only covers large companies. Small companies are very important within the overall economy, and within this group, confidence remains at very high levels.
Chart 4 - US GDP and NFIB Small Business Confidence Index
So in the months ahead, we are going to be watching business confidence very closely. Despite the best economy in over a decade and the best earnings performance (as measured by EPS) pretty much ever (outside of the early stages of an economic recovery), business confidence may have peaked in Q2 2018.
We would also note that stock prices themselves are one of the 10 components of the leading indicators index and the trend is still higher. The S&P bounced off the 2800 area last week and price is near record highs and comfortably above the rising 50 day moving average. From a trend perspective, we are constructive on the broad US index in the short term, especially as long as the 2800 level holds. Longer term, it would require a break of the 2600 area for us to move to a much more defensive posture.
Chart 5 - S&P 500 daily chart
From an equity perspective, our concerns lie in non-US markets which appear to be struggling (in US$ terms). Price appears to be at risk of rolling over, is below the 40-week moving average which is in the process of rolling over, and price appears to have just failed at resistance.
We think we have seen this play before. As US monetary policy becomes restrictive, capital retreats to the core, which in this case means US equities, whilst global markets begin to underperform. Our roadmap is that, as global equities continue to struggle, at some point this will spill over into US equities.
Chart 6 - MSCI World exc. US weekly chart
We don't know when this will happen, but as we have discussed before, if we are correct that the Fed keeps raising rates until something breaks, then investors need to be watching leading indicators very closely point. And as noted above, stock prices themselves are a leading indicator, and we are very open to the idea that global markets in this cycle will lead US stock prices.
So, as we see it, it appears that some of the leading indicators peaked in Q2, perhaps alongside year on year GDP growth as well. This thesis is in its early stages but needs watching closely. If we are right, and business confidence begins to deteriorate, we would look for consumer confidence to rollover (from very elevated levels), alongside housing data which may well have begun this process already. Last to deteriorate will probably be employment data with stock prices peaking somewhere in between.
This series of events should play out over a number of months; we would suggest the next 6 to 12 months. We will of course report on key changes as and when they happen.
- Where Goes the Pound?
- The End of an Era
- A Short Update on Our Equity Market View
- Some Extremes Held by Speculators Could Force Change
- Emerging Markets Challenging Our View of a Quiet Summer
- Has US Business Confidence Peaked?
- Central Banks
- Fixed Income
- FT Special Report
- General Update
- Show all