Summer blues on the horizon?

29 July 2016

The summer holiday season is kicking off in earnest, and after 5 weeks of the post Brexit ‘Goldilocks’ rally in both stock and bond markets, investment professionals who are still at their desks have begun to scratch their heads. The bond rally has, for years to come, pushed down yields of anything that can be regarded as low risk to levels which will not even compensate for future inflation above 1% p.a. However, if and when yields eventually recover then these ‘safe’ investments are now likely to generate losses if the yield recovery happens at pace, rather than very gradually.

Equities are still looking somewhat better, particularly as ongoing earnings announcements around the world tell us that corporate profits continue to improve, whereas such income upside naturally does not exist for any fixed interest bond one can buy right now. However, the fact that UK stock markets have experienced a very similar step-up in valuations as the rest of the world feels increasingly odd, given economic indicators are beginning to come through which inform us that the outlook for the UK economy has deteriorated, while everybody else is continuing on the upwards trajectory pretty much as before.

Against this backdrop, the market implied expectation of healthy near-term corporate profit growth only makes sense if there is either a significant increase in economic stimulus measures or a disproportional benefit of UK corporates and the economy as a whole from the post-Brexit £-Sterling devaluation. Both are hopes, rather than realities and so UK equities are likely to run out of ‘fuel’ for further upward momentum in the foreseeable future.

While some are therefore wondering whether the UK asset rally of the past weeks is merely a last hurrah, the global news flow is more encouraging.  Corporate earnings announcements from US and Eurozone companies for the 2nd calendar quarter are showing encouraging signs of a return of growth in earnings, particularly when the oil and resources sectors are excluded.

On the central bank policy side, the US central bank’s monthly meeting and announcement came and went without a policy change, but importantly accompanied by language which kept the US$ exchange rate stable and therefore supportive of global growth.

Japan’s central bank, on the other hand, disappointed on Friday what may be regarded excessive expectations that it would essentially bankroll a government spending program the Abe government brought on the way on Wednesday. Markets took it on the chin, which showed that it was more the financial media which had got excited about ‘helicopter money’ rather than the market truly believing in it – yet.

For the time being, markets may have reached a summer truce as, apart from the UK, the world economy and global capital markets have less to fear and worry about than at the same time last year. From a Global perspective the UK’s woes appear to have been put to one side, given this country’s issues do not seem to have caused contagion even amongst our European neighbours and in any case, the UK only makes up approximately 4% of the Global economy. That is at least until the Brexit inflicted activity slowdown in the UK becomes noticeably larger than the £-Sterling devaluation benefits, or it becomes clearer what path the EU/UK Brexit negotiations may actually take and/or when.