Rising uncertainties throw up reasons why markets might consolidate
We have singled out half a dozen factors of uncertainty liable to trigger a bout of consolidation on equity markets. If these were to materialise, we would be likely to see high-yield corporate bond yields climbing while sovereign bonds in major markets would play their allo
Financial markets in their various guises have all experienced mixed fortunes so far this year. This diversity looks set to persist as well on account of economic and monetary-policy cycles in the main economic blocs being at very different stages. This state of affairs is throwing up several factors of uncertainty which could trigger a spell of consolidation on equity markets in the near term. Looking to the longer term, though, stock markets in the developed world retain their attractiveness.
Reasons why markets might consolidate
After rising non-stop by 70% through 2012 and 2013, the S&P 500 is now betraying signs of flagging. We have pinpointed half a dozen stress points that might well spark off a corrective spell. Against this backdrop, we have duly lowered the weighting for equities in portfolios, reverting to neutral.
• Pricing on futures markets is lagging behind the likely timetable for the initial round of hikes in the US Fed funds rate. Share prices might well temporarily fall once this prospect turns into reality as increases in central bank interest rates are often – misguidedly – associated with threats to the upswing in the economic cycle.
• Economic growth in the eurozone has been grinding disconcertingly towards standstill, and deflationary pressures are as potent as ever.
• The dollar’s underlying uptrend against the world’s leading currencies has taken hold over the last three months. This, combined with the prospective hike in the Fed funds rate, is increasing costs for economic agents raising financing in dollars, such as a good many emerging-world economies.
• Carry trade based on emerging-country currencies has collapsed since early September. The positive correlation between carry trade and the S&P 500 historically adds weight to the argument that shares on developed and emerging markets alike will consolidate.
• The slide on yields on investment-grade European corporate bonds stems from the Japan-style tendencies being exhibited by the eurozone economy.
• The subdued volatility of European and US shares looks set to rise as the atmosphere of macroeconomic uncertainty thickens.
Emerging markets on a roller-coaster
Shares in the emerging world overall have been experiencing a switchback ride over the last five years as bull runs have alternated with bear pullbacks; 2014 has proved no exception to that rule. By way of example, the MSCI Emerging Markets benchmark, in dollars, dropped between October 2013 and February 2014 before bouncing back energetically, then consolidating again in September. The MSCI Emerging Markets index, in dollars with dividends reinvested, sank by 7.4% in September whereas the MSCI Developed Markets yardstick proved more resilient, down by just 2.7%.
Performances among the various regional emerging-market indices have also been disparate: Latin America fell steeply in September (-13.3%), the MSCI China index posted a drop of 6.2%, India was more or less flat whereas Eastern Europe managed to edge up 0.6% as the crisis in Ukraine appeared to be subsiding somewhat. That mini-bounce in Eastern Europe needs to be put into context though: the region still ranks as the worst performer in the year to date with a decline of over 6%.
Risk perceptions shifted into negative mode quite quickly as regards emerging markets as tension rose on risk indicators for both currencies and equities. Although emerging-market equities still look attractively valued in both absolute and relative terms, earnings growth trends turned abruptly for the worse in September as current-year profit growth forecasts were downgraded by 2.7%. Analysis of company results released for the second quarter reveals that financials were the ones that beat analyst expectations whereas other sectors overall tended to disappoint. Several flagship large-cap companies in the emerging world reported poor second-quarter figures, with Samsung grabbing the headlines.
Giving portfolios some protection through 10-year US T-bonds
In order to protect portfolios, we had decided to carve out a position in US 10-year Treasury bonds last March. Since then, we have been rewarded by a fall in yields of over 40bp. We decided once again to increase this position in late September, redeploying some of the proceeds from the downsizing of positions in equities and short-dated high-yield corporate bonds. US 10-year T-bonds offer the soundest buffer in the event of any shocks and/or worsening of any one or more of the six factors of uncertainty outlined above. This protectiveness stems from having the best trading liquidity worldwide and the fact that yields on US sovereign debt are higher than on equivalent German Bunds.
US dollar strengthening
In the aftermath of the ECB’s early-September meeting and the decision to lower eurozone interest rates, the US dollar rose significantly, not just against the euro, but also against the whole range of emerging – and developed – nation currencies. Over the month, it gained 4.3% against the euro, 7% against the Australian dollar and almost 9% against the Brazilian real.
Under our scenario, the US dollar’s rise is predicated on two factors. First, the growth gap is still unmistakably angled in favour of the US. Second, the relative sizes of the Fed’s and ECB’s balance sheets over the next six months will still be tilted to the dollar’s advantage. The dollar can, therefore, be expected to stay comparatively strong. Looking ahead 12 months though, that trend might well reverse if the ECB’s initiatives were to bring about an upswing in the eurozone economy.
Commodities penalised by the strong dollar
The firming dollar has exerted downward pressure on commodity prices. Most fell steeply in September, with industrial commodities struggling most. Copper and zinc saw their prices slide by 3% whereas prices for other industrial metals, like aluminium or lead, sank by over 6% in a month. This drop in prices was all the steeper because the economy of the world’s biggest consumer, China, has been delivering some half-hearted economic figures. The PMI for China fell from 50.5 to 50.2 in September – a score below the 50-point threshold pointing towards economic contraction ahead.
The price of a barrel of Brent crude oil slipped below the $100-mark despite the upheavals in the Middle East. We stick firm with our forecast for an oil price averaging $105 for 2015.