Monthly commentary - September 2016

No room for complacency

We are now three months into a post-referendum world – not post-Brexit, as some people have slipped into thinking. 

11 October 2016

The becalmed state of the UK economy is akin to the ‘phoney war’ in 1939-40. This will probably continue until there is clarification on the terms of the UK’s exit from the EU and, potentially, the single market. This could take two to three years, although there are likely to be bursts of volatility along the way.

As a result of this uncertainty, economic growth may slow, but we do not anticipate a recession. The latest leading indicators appear to confirm this. Since the Brexit vote, UK economic data have held up much better than Mr Carney, the Treasury and most commentators expected.

The UK Citi Economic Surprise Index ebbed away from its multi-year high throughout September, but rocketed back up to a new peak in early October. This was driven by another round of rebounding PMIs: construction jumped 3.1 to 52.3 and manufacturing increased by 2 to 55.4. Services slipped by 0.3 to 52.6, but it still beat expectations. With these measures, a number greater than 50 signals growth, while less means business is contracting.

As for equity markets, they have been relatively solid since the referendum. However, there is a bifurcation between companies with overseas-earnings (particularly pharmaceuticals and the giants of consumer products and beverages) and UK-focused retailers and leisure companies. This month, however, the gap has been closed somewhat by outperformance from the more cyclical areas of the British market. Over the month, UK 10-year gilt yields rose to 0.75% from 0.64%.

In November, Chancellor Philip Hammond will outline a new path for fiscal spending at the first Autumn Statement of both his tenure and Theresa May’s government. A flow of long-coming projects have leaked out again recently: the Hinkley Point nuclear reactor, a new London runway and another high-speed rail link with the north. This policy turn would be welcomed. It is illogical to focus on reducing a public deficit while surrounded by decaying infrastructure when borrowing costs are lower than ever before.


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Source: FE Analytics, data sterling total return to 30 September 2016

Battle of the (disliked) titans

On 8 November, the US will go to the polls to pick a president after one of the ugliest presidential elections in living memory.

Both Republican Donald Trump and Democrat Hillary Clinton are widely unpopular among Americans, and it is interesting to watch President Barack Obama’s approval rating steadily rising as his term winds down.

Strangely, the candidates’ doom-laden rhetoric bouncing around convention halls and cyberspace is at complete odds with the reality: unemployment is near multi-year lows, stock markets have hit new highs and social measures show America is safer and wealthier than ever before. There are fair concerns that some of that is lopsided and the average household income has stagnated, but that is far from the US crumbling beneath the waves – or Chinese competition, for that matter.

The US services PMI exceeded expectations, rising to 52.3, which has assuaged some concerns that the American economy is rolling over. This has led investors to believe that the Fed may indeed raise interest rates in December. For our part, we believe it is likely the Fed will move at the end of the year, barring any extreme market volatility or poor data.

The Bank of Japan announced it will ‘twist’ its QE programme by buying fewer long-dated bonds and purchasing more short-dated issues. The plan is to increase long-term yields so the curve steepens – so that yields are higher for longer maturities than for short-term lend. Because banks tend to borrow short-term and make loans for the longer term, this should improve the profitability of banks.

Japanese lenders have been hurting since domestic lending slowed sharply in August last year. A move to negative rates in January compounded the pain. The Topix Banks Index has slumped more than 23% in the year to date. This yield contortion has helped somewhat, with banks gaining almost 5% over the week. The move does raise questions about just how much more the BoJ can throw at its economy, however. Predictions of a spike in Japanese government bond yields are multiplying. Yields have already risen noticeably across the curve over the past couple of months.

How the mighty fall

Once the European upstart taking the fight to the titans of Wall Street, Deutsche Bank has now well and truly hit the rocks.

Hot on the heels of the EU ruling that Apple received illegal state aid from Ireland to the tune of €13bn plus interest, the US Department of Justice has told Deutsche Bank to pay $14bn for its role in mis-selling mortgage-backed securities in the 2000s. That led many commentators to posit that the tough stance could be retaliation.

On average, US banks have paid 4.5% of the total amount of mis-sold securities issued, according to JPMorgan analysis. On that measure, Deutsche’s $71bn of issues would mean a $3.2bn settlement. According to reported rumours, negotiations are now for a penalty of around $5bn – the level that Deutsche has provisioned.

However, the episode has focused investors’ attention on the parlous state of Continental banks. And it has reiterated that it is not just the shakier southern states sporting frail banking ecosystems. German media have reported – from unidentified sources – that German chancellor Angela Merkel has ruled out a rescue of the country’s largest national bank, but that seems hollow to us.

Could Germany really allow such a pivotal part of its financial infrastructure to crumble? We think not.