Chinese whispers

The tone of 2018 will be set by bond markets, we believe. How they react to the monetary tightening (or not) of the world’s largest central banks will have important consequences for share markets and investor confidence.

A flurry of rumours and announcements sent bond yields wobbling last week. First, the Bank of Japan unexpectedly reduced its bond-buying programme by roughly $180m a month. It is still committing itself to increase its bond holdings by $710.3bn each year in a bid to revive inflation, which sits at just 0.6%. Then the minutes of the latest European Central Bank meeting showed its committee’s discussion was much more hawkish than expected. Finally, news circulated that China was reviewing whether to stop buying US treasuries, a move that would likely push yields higher. This was strenuously denied by Chinese officials, although that is the only course of action to take when you own about 20% of all outstanding US government debt. You’re a bit of a whale with a position that big, capable of setting off a massive wave of selling in your wake.

Over the week, gilt yields rose significantly, with the 10-year jumping 10 basis points to 1.34%. The US 10-year increased 7bps to 2.55%. The German 10-year was up 14bps to 0.58%. This bumpy trend for fixed income didn’t translate to share markets, however, with strong equity market momentum continuing in 2018. Whether this will continue is probably dependent on upbeat American earnings season, which is now underway.

US consumers are riding high, with strong December retail sales. The monthly rise in core retail sales growth (stripping out food, cars, petrol and building materials) was the strongest since 2005. We have been relatively sceptical about the US tax cuts filtering through to wages, but it appears that some companies are passing some of their windfalls to their employees. Walmart, the world’s largest retailer by revenues, is giving its staff a one-off bonus and raising its minimum wage to $11. This shadows similar moves from rivals. This is great news for the US economy, as higher wages for the lower-paid are more likely to be spent, boosting demand and spreading throughout society.

Market tensions will come from how much the strong business climate and buoyant economy influences the Federal Reserve (Fed). US monetary policy is in flux, with a new Chair about to walk in the door and a number of replacements for regional governors due soon after. There is a chance that the new Fed will be more hawkish than we’ve seen over the past decade at a time when the economy is humming. Three 25bps hikes are expected over 2018, with potentially another coming down the pipe if inflation flares up once more. However, what happens if this pace is stepped up even further? That’s probably the reason for last week’s bond market jitters – investors are aware of the risks, but many have been corralled by circumstance into a very crowded sovereign bond trade.

Expect yet more Chinese whispers about the bond market as this year progresses. And the volatility that goes with them.

Index 1 week 3 months 6 months 1 year FTSE All-Share  0.5% 3.6% 7.2% 12.2% FTSE 100 0.7% 3.6% 6.7% 11.0% FTSE 250 -0.3% 3.5% 9.6% 17.1% FTSE SmallCap 0.7% 3.9% 9.0% 17.9% S&P 500 0.7% 5.4% 8.1% 11.1% Euro Stoxx 0.4% 0.9% 5.4% 19.2% Topix 0.6% 7.3% 11.9% 14.1% Shanghai SE 0.4% -0.8% 6.0% 4.7% FTSE Emerging Index 0.0% 4.1% 11.1% 19.7%  Source: Fe Analytics, data sterling total return to 12 January

Yee-haw!

Oil prices have been steadily creeping up over the past six months, with Brent Crude breaking $70 on Thursday.

It finished the week up 3.2% at $69.77 a barrel, but the price is more than 55% higher than its 2017 low of $44.82 in June. This has been driven by a mixture of increased demand from the stronger global economy and supply cuts (some planned, some not). It’s also partly driven by the fall in the dollar (the oil is still worth what it’s worth, so a fall in the currency you value it with simply pushes up the price). The OPEC cartel of emerging market oil exporters has been remarkably disciplined with its production cuts, reporting the lowest output in six months. Meanwhile inclement weather in the US has hit production in some states, and other countries have filled fewer barrels than usual too.

We’re not so sure the oil price can remain this high for long. In particular, US shale producers should be able to make punchy profits at this level. As they expand to take advantage, the extra supply should bring the price down. There are myriad reasons why this may not happen: the wells need to be sunk and they need to be true (rather than duds) and the shale drillers have to be solvent (many are heavily indebted and borrowing costs are rising). Still, shale drillers are an innovative bunch that have been mistakenly written off before, and we think there’s a good chance that OPEC members begin to break ranks as the year progresses too.

One factor investors should keep a close eye on is how much effect higher oil prices have on global inflation. Petrol is stripped out of the inflation gauge used by the Fed, but it will still weigh on the headline number that US consumers will be focused on. They may start pushing even harder for pay rises. And with most companies about to pocket a tremendous gift courtesy of taxpayers, they may be more inclined to give in.

Higher real wages will be great for economies, but the snowball effect on the price level and therefore on monetary policy would mean quite a few more difficult calculations for investors. More difficult calculations usually means more market gyrations.

Bonds

UK 10-Year yield @ 1.34%
US 10-Year yield @ 2.55%
Germany 10-Year yield @ 0.58%
Italy 10-Year yield @ 1.98%
Spain 10-Year yield @ 1.49%

Economic data and companies reporting for week commencing 15 January

Monday 15 January

EU: Trade Balance

Full-year operating results: Rio Tinto
 

Tuesday 16 January

UK: CPI/RPI (Dec), PPI Input/Output (Dec)
US: Empire Manufacturing (Jan)
EU: GER: CPI (Dec)

Trading update: JD Sports, Premier Foods
 

Wednesday 17 January

US: MBA Mortgage Applications (12 Jan), Industrial Production (Dec), Capacity Utilisation (Dec), Manufacturing Production (Jan), NAHB Housing Market Index (Jan), Federal Reserve Releases Beige Book, Total Net TIC Flows (Nov), Net Long-term TIC Flows (Nov)
EU: Construction Output (Nov)

Quarterly operating results: BHP Billiton
Trading update: Burberry Group 
 

Thursday 18 January

US: Housing Starts (Dec), Building Permits (Dec), Initial Jobless Claims (13 Jan)

Full-year results: Chemring Group
Trading update: Associated British Foods, Experian, Halfords Group, Royal Mail
 

Friday 19 January

UK: Retail Sales Ex Auto Fuel (Dec)
US: University of Michigan Sentiment (Jan)
EU: ECB Current Account (Nov); GER: PPI (Dec); ITA: Current Account Balance (Nov)

 

Julian Chillingworth
Chief Investment Officer