Falling US$ and rising oil prices vs. central banks’ cautioning

29 April 2016

Compared to recent weeks, the past week seemed relatively quiet in capital markets.   From our viewpoint however there was plenty going on. In the UK the demise of longstanding high-street retailers BHS and Austin Reed will have been the most widely registered market news. While the repercussions for current and past employees over pension deficits are deeply regrettable, the phenomenon of failing high-street retailers is hardly a surprise for observant investors.   Particularly for those who have long witnessed the increased popularity of online retailers. To our thinking, it is simply another result of changing consumer preferences, with jobs disappearing in what we might view as traditional high street retailers, now reappearing at new retailers like Asos, which younger people regard as their preferred way of purchasing daily goods.

The more relevant market action over the week was driven firstly by relief from a falling US$ exchange rate and further stabilisation of the oil price. Later in the week “tea leave reading” of central bank statements took over once again and pushed more fundamental observations, like surprisingly strong Q1 Eurozone GDP growth and better than expected US company earnings reports, into the background. It is important to observe that Oil, the US$ and company earnings have significant relevance for the economic developments later this year. The central banks news, that they are not inclined to further soften monetary conditions, has much more short term relevance.

The previously very low oil price and high external value of the US$ have been 2 of the major scare factors behind the January stock market correction. The low oil price because it raised fears of wider ripple effects through large scale defaults across the energy sector and the strong US$, because this put stress on Emerging economies US$ debt servicing obligations and drove down US companies’ overseas earnings in US$ terms.  The reversing of these trends has provided relief for many (see charts above).

While the brightening up of the economic outlook gave support to market valuations for the longer term, the announcements by central banks deprived stock markets of the prospect of additional liquidity boosts in the shorter term. This may have well initiated the latest trend reversal in the bond markets which staged their first significant rebound since equities started their recovery in mid-February. We were relieved to have anticipated this market action and had just closed our UK gilts underweight position. It had been the first short term tactical position we had been able to assume through our recently introduced Overlay fund structure and we are pleased that it added the desired value to client portfolios.

We noted throughout the January/February stock market correction that it was driven by sentiment rather than a commensurate deterioration in the economic outlook. We therefore noted with interest an article in New York’s Wall Street Journal which lamented “The seeming obsession with sentiment and positioning continues to get an increased amount of attention“ and the “plunge then surge in commodity prices this year shows investors have spent more time watching each other than fundamentals, which have not changed much.” We are not so sure whether to agree with their assessment that this rally can become more pronounced still as sentiment could become even more positive on the back of the recently improved news-flow.

We suspect that market sentiment improvement was to a large degree also driven by a widely held belief that central banks had turned more permanently towards a once again more loosening bias in March. This came obviously after the first US rate rise in nearly a decade last December which had heralded a turn towards general monetary tightening. Any such expectation was disappointed last week with the Bank of Japan’s refusal to lower rates even further into the negative and the US central bank, the Fed, no longer flagging global economic and financial developments as a source of risk.

This led many to believe that the 2nd rate rise will happen before the end of the summer, rather than having none until next year. This discrepancy between recent market expectations and stated Fed guidance, caused a 1% equity market sell-off on Thursday and Friday around the world. It is this sort of market nervousness which has kept us from wanting to adjusting portfolio allocations more in direction of the improving economic picture. As we have said previously, at Tatton we want to observe market action to adverse news before departing from our more cautious positioning.

The wider news-flow of the past week has reinforced our view that the economic picture continues to brighten up, while at the same time market sentiment remains brittle and therefore unlikely to support much more than a sideways movement until political uncertainties are behind us and the upward economic direction becomes more consensus.