Good riddance January - but will February bring investors relief?

5 February 2016

It's official. January 2016 has been the worst for investors for at least 40 years - and that despite the absence of any notable global catastrophe or major change in the economy. On that basis then, can we expect February to bring investors a relief rally that puts us back to market levels when the year began? Well, it's possible but by no means certain. This is because January's misery was primarily the result of a major negative shift in market sentiment and, while financial markets appear to gradually recognise that the downward move was an overreaction, the souring of market sentiment has had some contagious effect on the confidence of businesses. Given that markets often provide useful guidance by anticipating changes in the future direction of the economy, business leaders can be forgiven to have taken the hint from markets and lowered their own expectations and, therefore, expansion plans. However, while there is clearly the concept of the '˜wisdom of the crowds/markets' there is also the adage that '˜markets have predicted 10 of the past 3 recessions'. In this respect, much of the past week's news-flow has had a healthy counterbalancing effect. Central banks reiterated their determination not to commit a policy error by raising rates prematurely. Indeed, Japan even managed to surprise with a rate cut into negative interest rate territory. Our own Bank of England was no exception and announced that rates would stay unchanged at 0.5%, while further lowering its own forecasts for both the timing of future interest rises (red line in chart on next page) and inflation expectations (second chart). The first chart, to my mind, is showing quite starkly just how much rate rise expectations have had to be scaled back over time, when the economic recovery turned out to be far slower than anticipated and below-average confidence levels have necessitated lower rates for longer and longer. The European Central Bank's Mario Draghi also took every opportunity during the week to warn of the risks of persistent dis-inflation and reiterated that additional monetary policy action was the appropriate counter measure. In the real economy, the media is, as usual, focusing on the negative (which is better at catching attention) and report a significant decline in earnings (profits) by US companies over the past 12 months. However, just like last quarter, excluding the energy and materials sectors completely turns the picture around and actually shows healthy expansion across the rest of the economy. Another important counterpoint to the recent concerns of a potential downturn was the release of the forward looking purchasing manager indices (PMI) across many countries and sectors. These PMI indicators are survey based snapshots of business expectations, with readings above 50 indicating a positive climate where decision makers are expecting an expansionary environment. Readings (bar oil & commodities) were at very similar levels as they were before and therefore indicate that in the '˜real world' not very much has changed and certainly nothing has happened that would justify the market sell-off we witnessed. The most important change, however, may well be the fact that the broader markets appear to start to take serious the central banks' telegraphed resolve to keep the ongoing economic expansion on track. This manifested itself in the currency markets where, in a reversal of previous movements, the US$ fell and the Chinese Yuan appreciated in value. This led to an almost immediate change of direction in the commodity markets, where not only oil but also base metals experienced a notable rally in prices. The importance of these currency moves is that much of the concerns over a potential US economic slowdown emanated from the strength of the US$, whereas much of the concerns over the financial stability of the Chinese credit markets arose from the weakening of the Yuan. In due course, I therefore expect that markets will recognise that 2 of their major growth concerns are now less relevant and adjust their forward valuation assessments accordingly. Over the short term of the past week, stock markets displayed more of a state of confusion and continued to be volatile with bouts of sudden sell offs and bounce backs. At the time of writing on Friday, markets were grappling with lower than expected published job gains in the US, while the unemployment rate had actually declined further to 4.9%. It seems to me that we are witnessing the same old '˜climbing the wall of worry' as we always have, when capital markets are seeking new orientation after the longer running previous outlook has suddenly been challenged. It doesn't help that technical trading indicators are currently not providing strong signals either way. For the next weeks I therefore expect the volatile environment to continue with a lasting trend-reversal only increasing in likelihood once the central bank and economic news of the past week sink in with more market participants and the fear of missing out (the young tech generation call it FOMO) from higher returns overcoming the fear of a (imaginary?) looming global recession or credit crisis.