Too much of a good thing?

In the fullness of time, markets are a finely-tuned valuation machine. Risk and reward is weighed in countless transactions allocating capital to the places where it does the most good for society. But in the short-term it looks a bit like a dog’s breakfast. 

After a week of near panic and doom, equity markets have since returned to their prior ebullience. Volatility has calmed down from its extreme highs and is at its long-term average of 20. During February, there have been eight trading days resulting in a move (up or down) of more than 1% in the S&P 500. That’s the same number as during the whole of 2017.

The minutes of last month’s US Federal Reserve (Fed) meeting will be released on Wednesday. Fed funds futures suggest a 25-basis-point hike next month is a certainty, no doubt driven by the recent fears about accelerating inflation. Last week’s US inflation print came in higher than expected at 2.1%, driving the 10-year treasury to 2.9% (a four-year high), before it settled lower. This was coupled with the University of Michigan US Consumer Sentiment survey hitting 99.9, up from 95.7 and easily beating the 95.5 expected. And then there’s the quickening momentum in housing construction.

We’ve been confident about the strength of the US economy for some time now. Expansion here should provide a strong base for global commerce; improvements in the eurozone and continued demand form China’s ever-growing middle class will only help this too. Whether this environment will be good for the American stock markets is a tough thing to predict. Corporate earnings – which are already a larger proportion of GDP than they have been on average over the longer term – will have to go even higher to offset higher interest rates and the more aggressive discounting that accompanies monetary tightening. US public companies have certainly delivered the goods this quarter. According to FactSet, three-quarters of S&P 500 stocks reported higher earnings than analysts had hoped for. Even more beat sales forecasts. About 80% of the index has reported so far; if the 78% of companies surprising on sales numbers holds it will be the highest proportion since FactSet started measuring. Similarly, if the blended earnings growth stays at 15.2%, it will be the best quarter since late 2011. 

The effects of the Trump tax cut will be complicated for some firms, but in the main it should be a tailwind for US businesses. Whether that will foster a strident response from the Fed is an unknown. This risk is hanging over markets right now. At a time when earnings are looking strong, the economy is humming and cash is plentiful, the forward P/E of the S&P 500 is 17.1x. That’s only slightly higher than the long-term average of roughly 16x. We believe there is a risk that the Fed will make a monetary policy blunder. Its long-term interest rate forecasts are noticeably above those of the market and at a level that would suggest dampening the business cycle. However, these forecasts (the once-revered Fed dot plot), may yet be revised down, and the effects of overly quick tightening would take 18 months to feed through to the real economy. In short, we see storm clouds in the distance, but the next year or so should yield blue skies.

 

Index 1 week 3 months 6 months 1 year FTSE All-Share 3.1% -0.5% -0.2% 5.1% FTSE 100 3.2% -0.7% -0.5% 4.2% FTSE 250 2.7% -0.2% 0.5% 8.4% FTSE SmallCap 2.3% 0.8% 2.3% 10.8% S&P 500 2.6% -0.4% 2.2% 5.1% Euro Stoxx 3.2% -2.0% -1.2% 14.8% Topix 1.1% -1.3% 4.0% 8.8% Shanghai SE 0.4% -7.0% -4.1% -4.1% FTSE Emerging Index 3.1% 2.8% 4.4% 12.9%

Source: FE Analytics, data sterling total return to 16 February; *to 14 February due to Chinese New Year

Dilemma on Threadneedle Street

Global equity markets were strong last week, while the dollar remained weak. This weighed mostly on the Topix, which rose only 0.3% in yen terms. Investors preferred cyclical industries to the more defensive firms.

The weak dollar will help the Bank of England (BoE), which has found itself in a bit of a bind lately. A stronger pound should take the edge off higher prices on imported goods. Inflation was flat at 3% last week, a level it has remained at or above for five months now. It is eating into real wages at a time when economic growth has been softening. The dilemma for the BoE is does it continue waiting for the price level to fall of its own accord, or does it tighten interest rates and risk snuffing out what meagre growth is left in the UK. At the moment, the UK swap market suggests the bank could start to raise interest rates to 0.75% in May or June, and almost definitely by summer’s end.

The UK unemployment rate and average weekly earnings will be released on Wednesday. The BoE will want to see some good news for employees here, as it would make a rate hike more palatable. But then, higher wages coupled with continued disappointments in productivity growth may simply fuel inflation …

 

Bonds

UK 10-Year yield @ 1.58%
US 10-Year yield @ 2.87%
Germany 10-Year yield @ 0.70%
Italy 10-Year yield @ 1.98%
Spain 10-Year yield @ 1.46%

Economic data and companies reporting for week commencing 19 February

Monday 19 February

EU: ECB Current Account (Dec), Construction Output (Dec)

Full-year results: Reckitt Benckiser, Spectris
Preliminary results: Fidessa

Tuesday 20 February

EU: Consumer Confidence (Feb); GER: PPI (Jan), ZEW Survey Current Situation/Survey Expectations (Feb)

Full-year results: HSBC, Novolipetsk Steel
Preliminary results: Intercontinental Hotels
Quarterly results: BHP Billiton

Wednesday 21 February

UK: Average Weekly Earnings (Dec), ILO Unemployment Rate (Dec), PSNCR/PSNB (Jan)
US: MBA Mortgage Applications (16 Feb), PMI Manufacturing/Services/Composite (Feb), Existing Home Sales (Jan), FOMC Meeting Minutes
EU: PMI Manufacturing/Services/Composite (Feb); FRA: PMI Manufacturing/Services/Composite (Feb); GER: PMI Manufacturing/Services/Composite (Feb)

Full-year results: Capital & Counties Properties, Lloyds Banking Group, Rosneft
Preliminary results: Glencore
Half-year results: Barratt Developments
Trading update: FirstGroup

Thursday 22 February

UK: GDP (Q4)
US: Initial Jobless Claims (17 Feb), Leading Index (Jan)
EU: FRA: Business Confidence (Feb), Manufacturing Confidence (Feb), Own-Company Production Outlook (Feb), CPI (Jan); GER: IFO Business Climate/Expectations/Current Assessment (Feb)

Preliminary results: Anglo American, British American Tobacco, Centrica
Full-year results: BAE Systems, Barclays, INTU Properties, KAZ Minerals, Moneysupermarket.com, NOVATEK, Playtech, RSA Insurance Group, Serco
Half-year results: Hays
Quarterly results: Go Ahead Group

Friday 23 February

EU: CI (Jan); GER: Exports/Imports (Q4), SPA: PPI (Jan)

Full-year results: Aberdeen, International Airlines Group, Pearson, Rightmove, Royal Bank of Scotland

 

Julian Chillingworth
Chief Investment Officer