Breathing easier for the moment

16 February 2018

This week has been quite quiet in the UK. Of note, wages look set to rise more than 3% this year, stronger than 2.6% rise for last year. Subsequently, the Bank of England will probably deliver a rate rise at their March meeting. But we’ll look at the UK in more depth next week.

This week, we take the opportunity to look elsewhere. Today is the start of the new Chinese year. Last year (the year of the Chicken in the 12-year cycle) proved to be pretty good for equity investors. What might this year of the Dog do for equity holders.

For a bit of fun, I’ve looked at the price performance of the Dow Jones Industrial Average since 1930 to see how the years play out. Here’s the table:

Chicken years have done pretty well, beating the average return by almost 7%. Dog years seem to be slightly less beneficial. In overall performance terms, they still beat the average by the small amount of 2.8% but, so far, four out of the seven years have been less than the average.

At least we’re not in the year of the Snake or the Sheep, which both have a history of delivering returns well below the average.

While the exercise is not meant to be taken seriously, it’s interesting that the outlook accords somewhat with our view of how this year might pan out. We expect that the returns of last year will be difficult to repeat.

The global growth in earnings ended 2017 at very strong levels, at the same time as interest rates spent much of the time at historically low levels. Helped by the US tax cuts, analyst expectations of earnings growth were sharply revised higher this January.

The volatility at the start of this month was a reminder that growth is the lifeblood of investment, but it doesn’t necessarily benefit all investments. If you’ve paid up for pretty certain future cashflows, those investments won’t do so well when new opportunities come along which offer better ones.

Here’s the rub. In the “early” stages of a cycle, there tends to be a lot of investor liquidity (aided by loose monetary policy) but few new investment opportunities. As the cycle moves towards its later stages, the business world finds its animal spirits rekindled; entrepreneurs start to offer us new things, soaking up that liquidity through IPOs and bond issues. January saw a lot of business demand for capital, especially for bonds. A bout of indigestion in the new-issue bond market may have been a significant factor in the rise in bond yields.

That brings us to monetary policy. As the chart above shows, the US central bank has been engineering a relative tightening since early 2016. Money supply growth is now only just keeping pace with economic growth, as measured by industrial production. In fact, the chart above doesn’t show the more recent data (which is released weekly by the Fed). Since the beginning of January, M2 growth shows quite a marked slowing. Thus, it’s likely that the Fed has already moved into a tightening phase.

This week’s US inflation data also suggests that the Fed will continue to raise rates. Here’s Goldman Sachs on the subject:

“The January core CPI price index increased by more than expected, with the nearly four-tenths pace the fastest in twelve years. The year-over-year rate remained stable at 1.8%. Over half of the Core CPI acceleration originated in volatile categories such as apparel and household furnishings, but we would not expect a reversal in these price indices next month. As important, the more persistent shelter and medical care categories were also firm. As a result, we now expect Core PCE inflation to end the year at 1.9% (vs. 1.8% previously)…. We left our Fed probabilities unchanged, with subjective odds of a March hike at 95%.”

The Euro, Yen, and Renminbi also show slowing in M2 growth since the beginning of 2017, becoming more marked in Q4. China moved rates higher; while Europe and Japan have ceased extreme easing – tantamount to a tightening policy. And yet it still seems as if money is abundant. We suspect that this is because it has been, in US dollar terms.

When converted into US dollar equivalents, the growth path is much stronger. In other words, the weaker dollar is probably providing a monetary boost to the world, and especially to the US.

Currency markets are always the most complex of all markets in the short-term. Knowing what causes moves is virtually impossible (beware the simple rationalizations one can read in the papers!). Still, the medium-to-long-term reasons are usually to do with relative growth levels. We’ve said for some time that Europe and Japan have solid bases for growth, the Euro and Yen were cheap on a “purchasing-power-parity” basis and that this should lead to stronger currencies. So it has come to pass.

While we remain positive about Europe and Japan in the medium term, market sentiment has moved towards extended US dollar bearishness. We think the Euro parity level is (probably) about $1.30, which means that is no longer very cheap. There are also some signs that near-term economic strength in Japan and Europe is dissipating somewhat. For example, Japanese machinery orders for December were down 11.9% relative to November. Both areas have quite high sensitivity to exports, which are being impacted by the currency strength.

During the last week, it’s been notable that the rally in equity markets has been accompanied by a weak dollar, while the previous week was the reverse. The fall in the dollar during January was quite exceptional and we think it may be due a bounce back, especially if European economic data shows disappointment. The preliminary purchasing manager reports are out next week and will be closely watched.

It may be that any US dollar strength will be “bond-positive”; it might help to relieve some of the inflationary concerns caused by currency weakness. That 10-year treasury yields remained below 2.9% despite the worrying CPI data probably helped US and therefore global equity markets.

As the next article points out, corporate share buy-backs are resuming and that too may provide support. However, we think the signs are that a bout of dollar strength would undermine US equities, as it would increase the perception of tightening monetary conditions.

This week’s bounce-back in equities may be a continuation of recent volatility rather than an end to it. It doesn’t mean the year of the Dog will be a bad one, but it will do well to beat the Chicken.

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