Finance and investment wrap - February 2016
The world's central banks have declared their hands.
The Fed has tentatively marked the turn of the US interest rate cycle, although it may have moved too soon. The Bank of Japan has gone 'negative' to join the European Central Bank and the People's Bank of China is trying to engineer a gradual devaluation of the renminbi.
We observe closely for signs of success …or failure.
Markets in brief – the movers and shakers
- Can you trust the word of a central banker? Bank of Japan back flips on its 'no negative interest rates' stance; its stock market rises, its currency falls – but what is the longer term view? Find out more in this commentary
- Is a US recession on the cards? Economic growth for the fourth quarter was a miserly 0.69% and the figures underneath look less than promising. Find out more in this commentary
- Gold is pretty much the only thing to have moved up over the month. Is it on track now for a turnaround towards its US$1,300 short-term target? Find out more in this commentary
What happens in Davos ...
Many of the world’s central bankers, along with some other self-important people, gathered in Davos last month at the World Economic Forum to debate how they would save the world, ignoring the self-evident fact that they were responsible for the problems in the first place, and that further meddling in one of the most complex earthly systems was not going to make things any better.
We are talking about the pseudo-science of economics here.
Haruhiko Kuroda, the governor of the Bank of Japan (BoJ), is probably more aware of this than most of his contemporaries. At the event, Kuroda-san felt it necessary to say that he would not contemplate negative interest rates, but, whilst retaining an air of independence, the BoJ still has its strings pulled and not necessarily by the government either.
And lo, eight days later the BoJ announces a rate cut into negative territory and swings into line behind the European Central Bank (ECB)! You just can’t trust the word of these central bankers can you?
The US central bank (the Fed) now looks to be more out on a limb than ever. US economic growth (GDP) for the last quarter of 2015 was a miserly 0.69% (well the first stab at it anyway – it will be revised ad infinitum) and much of that was “spending” on Obamacare (the name given to Obama's health care reforms) – sounds more like a tax to me.
The question is whether the US economy is headed into a recession or not. Market corrections not accompanied by such an event are usually short lived and the fall, whilst painful at the time, is not catastrophic.
Updating the table to the right shows the S&P 500 to have fallen some 15% since the high and is already 7% off the lows. If there is no technical recession and the Fed persists with its intention of raising rates 4 times in 2016, the consequences for the rest of the world do not look good.
Already the BoJ move has reversed the short term strength in the yen. With such a wide interest rate disparity why would you hold yen and not dollars? And much the same can be said for most emerging currencies, not to mention the euro and sterling.
If a recession is imminent, and the signs of a slowdown are pervasive, then common sense would suggest that the Fed will have to admit that it has made a mistake, but that in itself is an assumption of heroic proportions.
The implications of negative rates are worrying, as are the inevitable unintended consequences. The initial reaction to being charged to hold money with a bank is to withdraw it pronto; in Switzerland it is almost impossible to rent a safety deposit box – they are already full of cash. Investing it elsewhere is fraught with problems too and brings higher risk, which for most people holding cash is an unwelcome consequence.
It may well be part of the cunning plan to do away with cash altogether. It will be sold as a convenience; after all it is becoming much easier to pay by card or touch technology, so why have cash at all? All fiat currencies (those that are legal tender, but not backed by a physical commodity) are ultimately worthless, but that doesn’t give big government the right to take away one of our basic civil liberties: the right to do what we will with our own money.
We will leave the question of gold-backed currencies for another day, other than to say during the markets' decline the only things going up were gold and silver … We will be watching the central bank narrative as closely as ever.
With no signs from the Bank of England that they will follow the Fed in raising rates, sterling has come under pressure, which theoretically helps our exporters and adds to our import bill.
This is usually the sign of a weak economy, but we are currently having a better time of it than the rest of Europe. It does highlight that we can pursue similar economic policies, but with a freely floating exchange rate we are not shackled to a one size fits all policy.
How good would it be if the EU could quietly revert to being a trading zone, and the euro could be consigned to history? The Brexit debate has been shanghaied by the freedom of movement question and, pursued to its logical conclusion, would end the great European experiment in its tracks, but logic, along with common sense, is in short supply, especially in Brussels.
Apart from Obamacare spending, another significant contributor to US GDP are car sales, evidenced by this chart of auto loans which is reaching the frothy stage; half the current quarterly loan totals had a credit score described as “fair” at best.
Other significant loan growth is provided by students. Neither category inspires confidence in long term economic growth.
Another significant area of loan growth is by corporates, in the main using the proceeds to fund share buy backs and thus continue the illusion of earnings per share growth.
Many corporates (NB the fracking industry) have taken advantage of very cheap rates and are now suffering the consequences of $30 oil. A lot more should never have borrowed in the first place, but we are back in a similar environment to the pre-financial crash period where if you aren’t in the club you aren’t a player…
At least the US presidential primary circus is providing some light relief. None of the current favourites looks to be electable on any rational basis. Politicians aren’t much liked; let’s not have any at all and see how we get on!
Data across Europe is improving, but is still a long way off a proper recovery. The banking system in euroland is still in need of fresh capital, especially in the Club Med countries, but even in Germany there are signs that things are not entirely 'Alles klar'.
The price of Deutsche Bank shares is of more than a little concern. They recently railed against Draghi’s “promise” to provide ever more easing by way of lowering negative rates even further. The hidden message was probably more like, “don’t mess around with interest rates, you are playing havoc with our huge book of interest rate derivatives”. They will need a rights issue at the very best.
Last month we said that Japan is beginning to become a case for concern and that was a not inaccurate observation. The yen strengthened on the back of the BoJ seeming reluctant to help out and the market took a tumble.
This was all too much for the powers that be and, as we mentioned earlier, the BoJ had to cut rates into negative territory. The immediate reaction appears decisive, but it may well be a case of short covering that is driving the Nikkei (Japanese stock index) up and the yen back down again.
Despite some concerns, we have not changed our stance here as the underlying market valuations are attractively cheap on a longer term view.
Asia Pacific and Emerging Markets
The People’s Bank of China is also keen to play mind games with the market.
It vehemently denies that a significant devaluation of its currency, the renminbi, is on the cards, which it would love to achieve to re-establish the competitiveness of China’s export economy and thus keep employment high. A devaluation, however, bring about a significant hit to domestic demand as import prices would soar.
As ever, China has an almost impossible juggling act on its hands. They believe that they can “command’ markets to do their bidding, but as they are finding out after much fruitless intervention in the stock market, things are not that easy.
Having telegraphed the forex markets that a gradual devaluation is what they desire, it will almost certainly be a case of being careful about what you wish for as FX traders like to get to places in a hurry.
It seems that everyone wants a weaker currency apart from the Fed. If they change their tune then these sectors will feel the pain again.
Commodities and gold
Last month we thought that the bottom might be in for oil, but the 'catching falling knives' syndrome kicked in and we managed to go sub $30.
With record short positions, there has been a big squeeze and prices have rallied, but production is still way above demand and that is before Iran gets properly on stream again.
Without some serious initiative from an increasingly fractious (a word not to be used in the same sentence as fracking, although that maybe what caused the condition in the first place!) OPEC a retracement back to the falling moving average, currently in the mid $40s, is the best we can hope for.
The battle for supremacy in gold is still raging and the bulls have had a good month. A move above the long-term average, and a breakout above the falling wedge pattern, at around $1,150, which is usually a downtrend ending pattern, is required for progress towards a short term target of $1,300.
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BlackRock Gold & General
Bonds are getting rather “interesting” again. Last month we suggested that the battle line in 30-year US Treasuries was at 3%, with a suggestion that the upside beckoned.
Well, with deflation becoming more of an issue, EM currency devaluations and a seemingly endless supply of cheap oil, the rate actually fell.
If the US does creep towards recession and the Fed has to step off the gas, Treasury yields will continue to head south. Some pundits are even calling for negative yields at the short end of the curve à la Europe!
The fat lady is yet to sing for this part of the bond market.
• Government bonds still look expensive, despite deflation yet again being discussed as the bigger problem. If the Fed has to back track on the rate rise, US Treasury yields are likely to fall.
• Corporate bonds are not cheap either and default risk can only rise from here, making high yield potentially less attractive. Is the yield premium adequate? Defaults in the US (outside the energy sector) in 2015 accounted for more than 50% of the total. There is also significant concern over liquidity risk, despite central bank and regulatory stress testing. High yield might appear more attractive after sharp declines in prices in January, but credit quality is vital from an investor’s perspective.
• Western equity markets appear to have started a long-expected correction, although a new high in the US remains a possibility. Is the reaction to the August lows the start of a new uptrend or a rally in a bear market? The jury is still out.
• Property remains attractive as a real asset offering a higher yield than most fixed interest markets, but not without risk.
• European markets are in a state of flux. Conventional wisdom says that ECB QE should be beneficial for financial assets, but the Greek issue is yet to be fully resolved.
• The Nikkei index has fallen sharply and remains better value than most. Recent BoJ action should help the market regain some poise.
• Emerging and Asia Pacific markets are not overly expensive now, but will continue to be volatile and negatively affected by dollar strength and Chinese economic weakness.
• Central banks are committed to supporting the markets, but their aura of invincibility is beginning to slip. Ultra-loose monetary policy will create inflation eventually, but currently deflation is still an issue and it is getting harder to see where anything other than tepid growth is going to come from; even China is succumbing to the malaise.
• Gold has been pretty much the only thing going up this month and technically is at an important juncture.
• Commodities generally will not see a sustained trend change until the global economy shows more signs of life although in the short term expect geopolitically induced rallies.
Clive Hale, Director - February 2016
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