April fool or permanent market truce as global economy '˜refuses' to change course?

1 April 2016

Anybody who last looked at capital market returns in mid-February would assume reports of positive investment returns for Q1 2016 is a rather cruel April Fool's joke on investors. However, the first quarter of 2016 will go down in market history as the most pronounced V-shaped recovery ever recorded in the first quarter of a year. Fears over slowing global economic growth and that central banks may have run out of policy tools to stem a renewed economic slowdown had caused the worst early in the year stock market sell off recorded for decades. By February 11th developed world stock markets had lost between 10 and 20% in value and where thus hovering in the territory between severe correction (-10%) and full blown bear market (-20%). Then the wind turned positive almost as suddenly as the downdraft had started and as oil and commodity prices gradually recovered ground, the US$ stopped rising and the Chinese Yuan likewise stopped falling, those fears over a looming global recession abated. Central banks contributed their part, by either proving that they had by no means run out of monetary policy tools (Eurozone's ECB) or at least would act sensibly and slow their path of normalising interest rates upwards (US Fed). Together with economic data flow evidence showing that Global economic development is by no means falling off a cliff and in the instance of the commodity impaired manufacturing sectors even re-accelerating, suddenly changed the sentiment from relentless doom and gloom messaging to a renewed focus on a resilient, albeit slow economic growth scenario. As the first quarter ended, western equity markets were firmly on course for a full recovery, while from the perspective of a weakened £-Sterling, Global stock markets as represented by the MSCI World index even recorded a slight gain. Best performers of the quarter were commodities, although that was more as a counter-reaction to their haemorrhaging declines previously, rather than a fundamental change in direction. The biggest return surprise perhaps was the strong performance of the repeatedly written-off government bond asset class. Their already desperately overvalued prices were first pushed up further by investors seeking their relative safety after stock markets began to crumble and then when equities began to recover they didn't fall back as a consequence of the continued monetary easing support of central banks. This led some to suggest that the equity recovery would be short-lived, because the more sanguine bond markets did not '˜believe' in the improved economic outlook. At Tatton we had all along commented that the Jan/Feb market correction was unjustified from the perspective of a fairly resilient global economic development, but that the correction came not entirely unexpected, as such market upheavals have historically often accompanied the change towards monetary policy tightening as initiated in late December by the US Feds first interest rise in a decade. We also said that much of the market unease was around fears that rapid changes in currency values between the US$ and the Chinese Yuan (RMB) during 2016 could seriously disrupt flows of capital. This, so the widely held view would create a '˜perfect storm' scenario as capital markets were already just about grappling with the reversal of the previous over-investment in commodity exploration and capital repatriation from slowing developing market economies. For us, therefore, the most reassuring observation of the outcomes of the first quarter of 2016 is not that equities have broadly recovered, but that the US$ has stopped and reversed its 3 year uptrend and equally that the Chinese Yuan is no longer depreciating. This has the potential to put some of the more serious market concerns to rest and should lead to a less tumultuous Q2. However, as we have also warned in the last few weeks, the general market nervousness has not gone away and for all those who believe that the V-shaped market recovery was merely a reaction to the stabilising oil and commodity prices, a renewed sell-off is absolutely possible and plausible if and once commodity prices decline again. This could happen as there remains a commodity supply surplus over demand for the near term, which attracts much speculative trading interest. Together with once again relatively high equity valuations relative to now reduced corporate earnings expectations and technical signals of overbought markets this has the potential of a market consolidation in the coming weeks, before the macroeconomic fundamentals of 2016 eventually take hold of market direction thereafter. In the meantime, our focus will be on the government bond/gilt markets, whose valuations are now once again much at odds with an improved economic outlook. A longer term revaluation of their levels is far more likely and concerning for investors' long term returns than short term equity market fluctuation. The past week's market action of stable to rising equity markets, while oil prices have fallen around 10%, is an indication that recent history may not immediately repeat itself, but, to use Mark Twain's words, there is still a fair chance that while not repeating itself, the present still rhymes with history.