Summer low or summer lull?

25 August 2017

The past week brought a stabilisation of stock markets, as buyers returned to buy the latest dip. It would seem that despite the looming announcement of the reversal of QE by the US Fed (probably September) investors worldwide continue to have confidence that markets will not collapse as a result. Macro-economic data releases provided support for such a view with the latest readings confirming that global economic growth remains firmly on track. Forward looking activity indicators in the form of the purchasing manager indices (PMIs) reported healthy levels of activity growth, with further acceleration still observable in the Eurozone, which is clearly taking over the growth baton from the US where waning business exuberance for Trump policy potential is leading to a first slight deceleration in the manufacturing sector. On the back of this, Bloomberg, the global financial data, research and news provider expects 2017 global growth to accelerate to 3.4%, following the 3.1% reading for 2016. The proverbial fly in the ointment for domestic UK assets was that £-Sterling hit a new low in its external value to other leading currencies (see chart above against the €-Euro), which can be interpreted as a no confidence vote of markets for the near-term future of the UK's economic progress relative to the rest of the world. We look at this in more detail in a separate article and note that this latest decline may be no more and no less than a wider realisation that the UK's economic progress has begun to diverge from the rest of Europe because of uncertainty over our future trade relationship with the rest of the block. While we are currently likewise not the greatest fans of the UK stock market relative to the Eurozone and other global regions, we wonder whether this sudden renewed focus on the UK's currency actually marks the end of this currency depreciation round, rather than the beginning of another. While thoroughly unwelcome by all holiday makers from the UK, the lower value of £-Sterling also has its benefits for the economy, particularly in respect to export competitiveness and foreign investment. This latest decline that started in April/May now amounts to roughly 10% and brings the total fall of the UK's currency since the Brexit vote to around 25%. At this level UK business and other fixed assets are looking far more attractive to foreign buyers than those in the Eurozone and elsewhere, even with the looming Brexit uncertainty. Export growth on the back of the improved pricing position has so far disappointed, but the recent pick up in industrial production and manufacturing PMI readings suggest that there may have been a longer lag in this coming through than initially expected. We therefore anticipate that we may well have reached the trough of the 2017 UK activity decline and that it is more likely to get better from here to the end of the year, than worse. The bigger concern for investment portfolio returns between now and year end is how capital markets will react to the aforementioned reduction of QE asset volumes by the US central bank, the Fed. It would be reasonable to expect that if QE had a positive impact on the development of asset values when it was in full swing, that it's reduction will constitute a headwind to further upside in asset values. This is broadly our expectation, although as we have commented on these pages in the past at length, this is likely to affect fixed interest bonds far more than equities. While rising yields rob bonds almost entirely of medium term upside potential to their capital value, growing company earnings can continue to provide valuation support for equities. However, for the near-term the more imminent question is whether markets will experience a repeat of the 2013 taper tantrum, when both bond and equity values fell, when the Fed first announced that the time had come to gradually reduce any additional QE asset purchases. We got a timely reminder of this scenario back in June, however, it was quite brief and not very severe. It is therefore quite possible that history will not repeat and instead equity markets simply trade sideways until the economic impact becomes clear. The economic impact is what will really count and here, from my vantage point three schools of thought are being most discussed. The first suggests that as long as central banks proceed with caution and plenty of pre-warning, broader financial condition should not tighten unduly because the improving economic environment, which necessitates the QE reduction in the first place, accelerates the turnover of money enough to compensate for the overall volume reduction of liquidity through the QE unwind. Thus, economic conditions should not deteriorate, but further asset price inflation beyond reasonable valuation levels should find less (liquidity) fuel. The second view is even more straight forward and suggests, that since QE never really improved economic conditions in the first place and only inflated asset price, its gradual withdrawal will have equally nil impact on the economy and only reign in runaway valuations. While we beg to differ somewhat, the outcome would be the same than if we followed the first argument. The third is the view of the doom and gloom mongers, who predict a collapse of bond markets, which triggers the second global financial crisis in just 10 years. We see this as highly unlikely, given the recent, very cautious track record of central bankers and would be concerned that on the opposite, interest rate and yield curve normalisation progress might prove too slow, opening up more substantial pressures to general price inflation further down the line. As usual our view at Tatton is somewhere in the middle. We don't expect major negative impacts on the global economy, but anticipate increased short term market volatility. This could be heightened to more disruptive levels through the unfortunate coinciding of any major geo-political crisis, be that from the side of the North Korea tensions or any rash global trade suppression from an increasingly ineffective US president Trump. Undoubtedly equity investors are on edge (despite low general volatility readings) as three UK FTSE100 companies found out quite painfully this week. Profit warnings by international advertising agency WPP Plc led to their share price plummeting 12.5%, while Dixon Carphone warehouse Plc lost a staggering 32% on theirs, citing less consumer appetite for the latest mobile phone. Truly exceptional was the up to 75% share price collapse of subprime lender Provident Financial Plc, who were hapless enough to be able to combine every bit of current investor concern in one single company update. That the FTSE nevertheless closed up for the week underpins our medium term central case of a resilient overall economy and stock market. Clearly, however, investors have also begun to apply far more scrutiny to individual company fortunes, now that with higher cost of capital on the horizon, plastering over poor performance or even the survival of '˜zombie' companies will be so much harder than during the era of '˜easy money'. This may provide a much needed boost to lagging productivity levels through better allocation of capital but could potentially lead to disappointment for purely passive equity market investors. For the full weekly, please click here.