Archives for October 2015

Listening to the markets

Markets are commonly understood to be leading indicators of economic activity, despite the fact that most investment manager’s reports to their investors focus on how actual economic developments have caused market movements! Market prospects are not divined from economic developments; rather economic prospects are more likely to be divined from market developments.

So what are markets saying today?

  • Fed fund futures – ever since QE came to an end twelve months ago, the market expectation for the date of the first increase in the Fed Funds rate has been six months into the future. This has reflected the Fed’s professed data-dependency, the market’s perpetual optimism that the US economy has always been about to accelerate but also the steady stream of slightly disappointing economic news. Until August’s market turmoil, the market, aided by strong hints from Yellen, had priced in a first rate hike by now, but current expectations are once again for a hike in about six months’ time.
  • US high-yield bonds – the US high-yield market peaked in May 2014. The most damage over the ensuing eighteen months has been in the energy sector, where much of the financing of the investment in the US shale oil fields was from the high yield market. However yields have also been rising across the rest of the high yield market over that period. This reflects economic growth disappointing expectations over that period, and the fact that in order to meet analysts’ earnings per share expectations, companies have accelerated their share buybacks, and funded this through corporate debt issues. The high yield market has thus been signalling deteriorating creditworthiness amongst US companies, which is typically a leading indicator of an equity market top and economic downturn.
  • US equities – through 2015 the US equity fund has lost the momentum that had sustained its long bull move since March 2009 (the S&P 500 gained over 200% in this period), trading sideways and in August it broke the uptrends from both the 2009 and 2011 lows. This fading price momentum was also accompanied by deteriorating breadth as fewer and fewer stocks made new highs as market leadership became concentrated in a few key technology and biotechnology names, and market volumes disappointed. These internal market signals, are very typical leading indicators of a developing market top., and the August breakdown below 2,080 was a market statement that the bull market since 2009 was complete and a bear market, or at best a long sideways correction, had begun. In addition the daily market action of the last two years, whereby the market tended to rise on weak economic data, since it implied an easier monetary policy for longer, and tended to fall on strong economic data, implying a nearer, tighter monetary policy, suggested a market that was valuation-driven as long as QE was still on the table, rather than an market led by stronger corporate performance.
  • Chinese equities – in the summer of 2014, just as the US high-yield market was peaking, the Shanghai Composite index broke out of its long bear market, having formed a year-long base around the 2,000 points level (having fallen from almost 6,000 in 2007, and started to move upwards. This coincided with a change of Chinese monetary policy, which had previously been kept tight to bear down on inflationary pressures in the economy and also to slow house price inflation. Typically the first phase of a new bull market starts slowly and only moves sharply after several phases and years of grinding higher – China between July 2014 and June 2015 rose by 150%. It has subsequently corrected to below 3,000 before stabilising. In stark contrast to the US which has enjoyed a 5 year bull market which is now over, China has endured a 7 year bear market which was ended by an explosive new bull market. Recent activity was likely just the first phase of a new bull market, which has also now been through a severe correction, but has settled well above the 2,000 level it saw in October 2014. A second phase will start soon and lead the Chinese market higher.

Market price action is telling us that the US economy will struggle to grow over the next few years, in contrast to the general optimism amongst the world’s economists and investors, while the Chinese economy will continue to perform well, in contrast to the fears and pessimism amongst those same classes. This remains the Asian century and investors should use the current setback to ensure their portfolios reflect that fact.

Reasons to be fearful… The German economy

Since the onset of the eurozone crisis in 2011, and the ensuing austerity across the Mediterranean, the health of the eurozone economy has been dependent on Germany and the desire of the German consumer to buy goods and services from the rest of Europe. Given the German cautious savings mentality and aversion to spend this has rarely been a winning economic strategy, but in fact the strength of the German labour market has given some succour to the eurozone economy in recent years.

This strength came from the jobs and pay from the German capital goods and autos sectors, demand for which held up due to strength from two key export markets, China and the Middle East. Over the last eighteen months, however, both of these economies have seen significant weakness. The Chinese government has reversed course on the massive public infrastructure investment programme it undertook from 2009 onwards and is now looking to rebalance its economic demand away from exports and investment and towards domestic consumption, where apart from autos, German industry is not well represented. While the oil price was comfortably above $100, then the oil exporting nations of the Middle East had lots of money to finance investment spending in their economies, but now that oil is trading below $50, this spending has dried up.

So these cyclical trends were already pointing to a slowing in demand for German goods and a consequent impact on German consumer confidence. In recent weeks there have two further hits to the German economy.

First, the extraordinary response of the country, led by Angela Merkel, to the refugee crisis, which will see 800,000, or 1%, of the population, immigrants allowed into the country in the near future. In the long term, as these people find jobs and pay taxes, this will be seen as supporting the German economy that was beginning to worry about its ageing population, but in the short term the economic impact is more likely to be a burden to the German government, since it will widen the budget deficit and this will likely lead to a tightening of fiscal policy elsewhere to remain with the balanced budget rule that Germany has now put in place.

Second is the Volkswagen scandal which erupted last week over the software coding in VW’s diesel cars that was designed to deceive regulators testing the emissions of these cars. This appears to drive a stake through a core German industrial USP, that of reliability, trustworthiness and quality. VW is the country’s largest employer and embodied much that the Germans felt good about themselves. It is too early to judge the effects of this scandal but they could be very significant not just on export demand for VW cars, but all German cars and possibly other German products too. Aside from this is the neagtie impact on the psyche of the German worker and consumer, who has never needed much excuse to feel they must save more now and spend less.

The new balanced budget rule means that a weaker German economy now leads directly to German austerity, and a further hit to the outlook for the eurozone economy.

The world economy needs more German spending not less. The German and Chinese economies are the two major creditor economies left in the world today – with the other major world economies running trade deficits, new demand in the global economy needs to come from consumers in these creditor economies. Without it, as is now looking increasingly likely, the global economy will remain very weak, and policy makers have few policy levers left to pull to boost it.