Albemarle Market Commentary – September 1st 2016

“I and others, have, for several years now, suggested that the primary problem lies with zero/negative interest rates; that not only do they fail to provide an “easing cushion” should recession come knocking at the door, but they destroy capitalism’s business models – those dependent on a yield curve spread or an interest rate that permits a legitimate return on saving, as opposed to an incentive for spending. They also keep zombie corporations alive and inhibit Schumpeter’s “creative destruction” which many argue is the hallmark of capitalism. Capitalism, almost “commonsensically”, cannot function well at the zero bound or with a minus sign as a yield.” Bill Gross – Janus Capital Group

Not always the most consistent of commentators, but there is no denying that his latest epistle carries more than a hint of truth. Markets are broken and trying to divine an investment strategy is more akin to going through the card at Newmarket; the odds at the race course will be a lot fairer than the ones currently on offer in bond world. Savers in search of income are being forced into areas which from a risk perspective they wouldn’t normally touch; high yield bonds, emerging market debt, equities and property all of which stand close to all-time highs and are seriously “expensive”, beset with liquidity issues or provide little or no downside cushion.

Worse still, the pensions industry still clings to heroic assumptions about growth rates in all manner of markets. Underfunding has been an issue for many a year but if realistic growth rates were factored in the shortfall would be catastrophic for insurance companies and pension fund trustees alike. In the US the American Academy of Actuaries and the Society of Actuaries has scrapped its long time joint Pension Task Force and banned the dissemination of its paper highlighting this dilemma, under threat of legal action against would be transgressors. As one pensions expert put it, “an inferno in the making, but without the benefit of Dante’s poetry.”

In the UK, Carney has said that he won’t go as far negative rates, but with the 30 year gilt yielding circa 1% he’s pretty much there already and providing actuaries here with a very similar headache. ZIRP didn’t work and NIRP is destined to fail even more spectacularly. Faced with minus rates savers are not spending; they are saving more! Markets are beginning to wake up to the fact that the central bankers are running naked. A number of fund managers that we speak to regularly would genuinely like to see markets significantly lower as they are struggling to find anything resembling value. Be careful what you wish for is an epithet that immediately springs to mind. The markets certainly seem keen to test the central bankers’ metal; will the Fed raise rates in September or will they flinch again?

As we continue to observe, the common narrative that the central banks are minding the store is beginning to wear a little thin. We are approaching the “witching” month of October so we are maintaining our cautious stance in terms of our risk budget. There is a possibility that the major US equity indices may make further highs, if the Fed manage to provide some balm at their next meeting on September 21st, but that would be an opportunity to take some more chips off the table. The other major concerns, pre-referendum, were the Chinese “devaluation”, which has been proceeding stealthily, while attention has been drawn elsewhere, and concerns over the European banks where stealth too is being applied; in Italy thus far, but open warfare could erupt at any moment, so we must remain ever vigilant.

UK

House prices in the UK remain firm dispelling yet another Brexit fear story. Our PM has told her civil servants that Brexit must be delivered, but we would rather see some action. Triggering Article 50 would do it, but her reluctance in this matter suggests there is another strategy in play. The number of influential Remaindeers clamouring for a re-run is growing apace including the unholy Virgin, the disgraced former Labour leader and one, but not both, of the candidates for the current post. If by some perversion of democracy they succeed, then ComeWhatMay can say well I told them to deliver, it wasn’t my fault….

Carney has cut rates despite any indications that the economy needed a flu jab. He has said he won’t contemplate negative rates and bond markets around the world seem to have taken that message on board with government bond prices here and around the world, notably Japan, ticking upwards again.

US

In the US, consumer sentiment is up, most likely on the back of rising house prices. This, despite the fact that year on year house sales are falling again. In the US you can find a statistic to prove, or disprove, almost anything! The serious electioneering is about to start but don’t expect the debate to be “serious”. Rather like the Brexit episode over here, expect Project Fear to be used by both sides, but mostly by the main stream media at the behest of the vested interests including, but not exclusively, the military, big business, big egos and the small minded.

If the Fed raise rates at their next meeting it will be the first time in their history they will have done so this close to an election. Barney Frank, a staunch supporter of Clinton and one of the co-sponsors of the Dodd/Frank Wall Street Reform and Consumer Protection Act (a curiously named piece of legislation given that Wall Street doesn’t appear reformed by any stretch of the imagination and the consumer is still on the ropes) has already told Yellen that it would be a mistake to risk destabilising markets and perhaps the broader economy a few weeks before Election Day. He is obviously only too aware that falling stock markets are a reliable indicator of change of party allegiance at the White House.

Europe

The EU has not yet fully woken up to the fact that Brexit is more of a problem for them than for the UK, and they are in no mood to see Article 50 invoked either. We are a significant trading partner and the already fragile European economies would suffer further if we were to source more of our imports elsewhere. Despite all the ECB’s attempts, inflation remains stubbornly low and, as of now, are heading lower; that wouldn’t have anything to do with negative interest rates would it?!

Japan

With the odds on a September rate rise improving, the US dollar has strengthened and as a corollary the yen has weakened, which is just what the policy wonks in Japan have been striving towards. The Nikkei is back testing the 17,000 level again.

Abe is still struggling to get the third arrow out of his quiver and the cynics are saying that he has in fact shot the first arrow (massive QE) three times! Unless the yen continues to weaken from here the outlook for the equity market has weakened considerably although on a relative valuation basis parts of the market are seriously cheap.

Asia Pacific and Emerging Markets

China’s slowdown is still a concern as is the ongoing devaluation that is exporting deflation to the rest of the world. The Chinese market is still being propped up by the government, but other Asia and Emerging markets have generally done a lot better; India has been especially strong.

Another market that has been surprisingly resilient has been Brazil, which in local currency terms is up 50% since January. Dilma Rouseff has now been impeached for election rigging, and whilst the new president, Michael Temer, “has a lot of wood to cut” the Brazilian economy is showing signs of improving.

Commodities

The oil price continues to struggle to get back above $50 on any consistent basis and despite pumping for all its worth, the Saudis are finding their economy under considerable pressure. Non-oil GDP is now falling on a year on year basis. Their cost of production is sub $20. In the North Sea oil doesn’t make a penny under $52 a barrel; a message there for the SNP perhaps…

The precious metals have had a stupendous run since January, despite being the most hated asset class back then. We are now seeing a consolidation phase and prices may retrench below $1300 for gold and $18 for silver. They are still one of the best insurance policies against central bank induced currency debasement.

And last but not least…Bonds

The yield on the 10 year JGB (Japanese Government Bond) is still negative, but we have a seen an upward surge over the last month following the BoJ’s tacit admission that maybe, just maybe, QE doesn’t work. The implication being that the JGB buying programme will cease. They own more than 50% of the market anyway so it would have had to have stopped at some stage! Other markets around the world have followed suit, but in a much more tentative fashion.

The key bell weather to watch is the 30 year US Treasury. A move back above 3.2% would herald a change in a very long running trend.

Summary

The central banks have, as expected, stepped up to the plate. Whether they can keep the plates spinning longer term remains to be seen and we can be sure that the UK’s Brexit saga has many more twists and turns to keep the markets preoccupied. Chinese yuan devaluation and the outcome of the US elections all add to the uncertainty.

We observe closely for signs of success…or failure.

  • Government bonds still look expensive despite deflation yet again being discussed as the bigger problem. Short term the trend in rates is upwards.
  • Spreads on corporate bonds are still tight. They are not cheap either and default risk can only rise from here, making high yield potentially less attractive. Is the yield premium adequate? There is also significant concern over liquidity risk despite central bank and regulatory stress testing.
  • Western equity markets may be about to start a long expected correction although a new high in the S&P remains a possibility, but it could be the last roll of the dice.
  • Property remains attractive as a real asset offering a higher spread against most fixed interest markets, but the UK market is effectively closed for the time being as many funds have been gated due to large redemptions.
  • European markets are in a state of flux. Conventional wisdom says that ECB QE should be beneficial for financial assets, but the Greek issue is yet to be fully resolved and Spain is still struggling to form a government. The elephants in the room are now the banks. However, it is unlikely that the ECB would allow a full blown crisis. The Nikkei index has risen as the yen weakens, but needs a new high above 17-18,000 to remain viable. Emerging and Asia Pacific markets are not overly expensive now, but will continue to be volatile and affected by dollar strength and Chinese economic weakness.
  • Central banks are committed to supporting the markets, but their aura of invincibility is beginning to slip. Ultra-loose monetary policy will create inflation eventually, but currently deflation is still an issue and it is getting harder to see where anything other than tepid growth is going to come from; even China is succumbing to the malaise.
  • Gold should continue to rise but is currently overbought and a correction is underway.
  • Commodities generally will not see a sustained trend change until the global economy shows more signs of life although in the short term expect geopolitically induced rallies. Oil at $50 means shale producers will start turning on the pumps again which will increase supply and keep the upside price in check.

Clive Hale – September 1st 2016

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