Relative calm returns – as does rally scepticism

15 April 2016

Positive market sentiment continued as the quarterly corporate reporting season commenced with ALCOA in the US reporting revenues and earnings for the first quarter of the year (Q1/2016 earnings season). This is good news for investment returns, where the bulk of standard UK portfolio strategies should now be recording 2-3% on the positive return side since the beginning of the year. So far it has played out as we wrote during the sharp correction, that is, in the absence of recessions, bear markets tend to be short lived. The reason why capital markets are now displaying such different sentiment compared to the near panic in January, comes down to a considerable improvement in four areas which the investor community had been concerned about most.  These are:  Falling oil prices, economic slowdown in China and the US , rapidly changing currency valuation parities between the US$ and the Chinese ¥-CNY and most importantly renewed fears that central banks may be running out of monetary policy tools to counter adverse economic developments . Over the past weeks, we have  commented on how the major central banks convincingly demonstrated in March, that they are not about to lose the plot. Over the past week, however, it was oil and China news which buoyed markets. The oil price continued to stabilise around the $40/bbl and Q1 economic figures from China showed that exports, industrial production and fixed investment are all pointing up rather than down. As a result many of the negative feedback loops caused by the above factors have therefore reversed: Credit conditions are easing again, capital outflows from China have reversed as the US$ has weakened, stock markets in the developing world have leaped upwards and general market volatility measures have died down to very low levels. Readers may therefore be forgiven to conclude that markets did indeed get it totally wrong at the beginning of the year and the correction spook is squarely behind us. Unfortunately, as I wrote last week, while this may be the case with the general direction of the economy, there are a significant number of headwinds, which will thoroughly test market sentiment over the coming weeks/months:

The oil price may have stabilised, but the surplus in global oil production (the driver of falling oil revenues), will not balance until much later in the year. True, US oil fracking production is steadily declining, but Iran has just been re-admitted to the global oil market and have more than replaced the US output decline. There are high hopes (and plenty of wishful rumours) that a conference in Doha on 17th of April, will lead to the major oil producing countries agreeing to some form of volume reductions. Unfortunately, I find it hard to believe that they will be united enough to overcome individual nation’s pressures to protect market share and output volumes. I am therefore unconvinced that the oil price will over the shorter term remain above $40/bbl. The best we can hope for from the oil and energy sector, is that the investment spending cuts have already happened and will therefore gradually wash out of the annual growth and activity figures.

The central bank have succeeded in reversing tightening monetary trends, but will their March actions prove a proverbial ‘flash in the pan’ once the US central bank (Fed) will again have to raise US interest rates sometime over the summer?

Corporate profits in the US are another point of worry for the short-term. They are the primary driver of long term stock market valuations, rather than investor sentiment and as it stands at the moment, they won’t be able to contribute positively to a growth perspective over the next quarter. While they declined for most of last year, solely because of the collapse of earnings in the oil and materials sectors, profit declines are now more broadly based across all sectors. Due to the confidence undermining capital market stresses of January and February, the best we can hope for the upcoming Q1/16 earnings season is no further deterioration and that company managements don’t present too cautious an outlook. The consensus that company results should improve once again from the middle of Q2, is encouraging, but for now falling company earnings will (temporarily) make stock markets look even more expensive than they were at the end of 2015.

The UK’s EU referendum in June and the US presidential election in November will additionally make for a fairly uncertain political environment, which is not really what the economy and markets need when company results are unsupportive. Indeed, the International Monetary Fund (IMF) warned this week that even if the UK votes to remain EU member (which is still market consensus), the uncertainty in the run-up to the referendum will delay many business decisions until after 23 June and thereby result in below potential UK growth for 2016. Likewise, if D Trump succeeds in becoming the Republican presidential candidate (poor GOP, but only yourself to blame!), then his chaotic, deeply populist policy rumblings are very likely to slow US investment levels.

Only China’s economy strikes me as unlikely to upset market sentiment again, as all signs point towards renewed expansion of fixed asset investment and consistent economic growth.

Last but not least Greece’s debt issues are raising their ugly head once more, because the IMF is pressing for debt relief by the Eurozone and pension cuts (instead of tax hikes) by the Greek government. This is to make the long term debt consolidation plan more realistic. I wrote last year that this was to be expected, since a near perpetual 3.5% annual budget surplus (the UK’s 2015/2016 budget was still appr. -4.4%!) is incompatible with the also envisaged economic revival. Interestingly Alexis Tsipras Greek government has gone on collision course with this plan, which is probably not because of the debt write downs but because they fear the wrath of the pensioners. Given the Greek economy has turned around markedly and recorded the highest industrial growth rate across the EU in the last quarter of 2015, I am optimistic that politicians and IMF will come to a more sensible solution than the rushed agreements of last year constitute.

We are not normally known to be a ‘glass half empty’ person and as we have said all along, we believe 2016 will be much better than many think, but we fear this will come only later in the year. In the meantime, the combination of relatively highly valued stock markets, nervous investors and plenty to keep them worried (see above), will all make for a volatile stock market for the next months. Another sudden sell-off is therefore quite conceivable, although not inevitable, since the long term picture is looking more positive now and markets sometimes have the ability to look beyond short term issues and anticipate what lies further ahead. For this reason, we are comfortable with the decision of our investment committee last week to stick with the neutral asset allocation stance we have held in portfolios since last September and also the somewhat more cautious fund selection mix which has not always given me joy during the recent rapid market recovery. Those who are more worried than I am about any of the headwinds we discussed above should please remember that markets move very fast and the success in timing a temporary exit and subsequent re-entry to long term investments tends to be very limited and thereby risks missing the strongest return by days/weeks. Who would have guessed that the week of the 12 February, when EU banks came under pressure once more, would be the turning point of markets? We are happy to say, that at Tatton, we had an inkling that it may have gone too far and so our portfolio rebalancing during that and the following week proved fortuitous for our portfolio investors.