Weekly Comment on the Markets, Politics and Economics by Alastair Winter,Chief Economist at Daniel Stewart & Co
July into August
Two cheers for the Fundamentalists
Not selling in May
Religious fundamentalists are notorious for inventing authorities to support whatever argument suits them at the time but we Economic Fundamentalists (yes, I am one, in case you had not noticed) are a much more objective bunch, not to mention rational. When it comes to investment, it is really quite simple: any economy able to increase GDP and Employment while avoiding excessive foreign ‘hot’ money, credit creation and inflation will present more opportunities than one that is struggling on one or more of these fronts. Accordingly, the first cheer is due to those of us who have argued for US equities since the start of 2012, for UK equities from last summer and for Japanese equities once the significance of the yen slide became apparent at the end of last year. It would certainly have been a mistake in 2013 to ‘sell in May and go away’.
In Big Ben we trust
The second cheer is due to those of us who have consistently believed what Mr Bernanke says. It starts with accepting that he is the greatest living expert on the Great Pre-War Recession and understands why official actions and inaction went so disastrously wrong then. Whenever he said he would prime the monetary pumps he did just that and now he is clearly intending to reduce the pace. He has been even more explicit on interest rates set by the Fed but has not always been universally believed. As a result, we have cautioned against buying longer-dated bonds unless held to maturity and sounded the alarm when investors, out of greed and/or fear, chased yields to unsustainably low levels in Spring/Summer last year and in April this year.
Missing the punt
The third cheer should be withheld because most other asset classes have become subject, to an unexpected and unprecedented extent, to what can only be described as ‘punting’. It is too easy to blame it all on hedge funds, especially as many of them are reported to be desperate to generate the 20%+ returns that they need to justify themselves. However, many conventional investors have got caught up in the excitement of Emerging Markets (equities, bonds and currencies), Oil and Gold. The huge swings in these asset classes make no sense to economic fundamentalists. Of course, the biggest punt of them all has been on the euro. The solid support of China and other sovereign investors has reduced the risk without eliminating it and a punt it remains, as are the sovereign bonds of many EMU members and their banks.
Yellen to light the taper?
Multi-year visions are of little interest to many yield-hungry investors with quarterly performance reporting on their backs. They would prefer QE to continue indefinitely without being linked to Employment or any other economic indicator and their first reaction has been to sell just about everything except the dollar. The sheer daftness of ‘good (economic) news is bad news (for equities)’ has since become more widely conceded and the more trigger-happy investors have moved on to debating which bits of news are important or, indeed, ‘good’.
So, how good is the good news? Good enough it would seem, to justify the start of tapering in September. The Consumer and Housing sectors have been leading the way for some time and now there are signs that the Business sector is starting to invest in more facilities, higher inventories and hiring more people. There is a growing feeling that many official figures are understated and that too is feeding into greater confidence. The Employment data has been improving month after month, albeit unevenly and with confusing substantial revisions.
Nevertheless, it is possible to argue that tapering might be delayed until December or even after Big Ben steps down. Two clues are the inclusion in the FOMC’s July Statement implying that Inflation was still too low (and certainly no reason to end monetary easing) and also the latest outbreak of fiscal brinkmanship in Washington. Mr Bernanke is likely to remain concerned by all the shenanigans over the debt ceiling, the sequester and higher taxes. It may yet be ‘Chairman’ Yellen who lights the taper.
ECB President Mr Draghi says the worst is over but while he may literally be correct it is hard to see much more than minimal growth for at least another two years. The great hope remains Germany but it needs exports and its main markets in Asia, Eastern Europe and other EMU countries are all in varying states of distress.
The outlook for Italy, however, is bleak where there appears to be no consensus on the economy but only vested interests opposed to change. Some of those interests are non-political but no less determined to protect their corners: state-controlled enterprises, trade and professional associations and, more sinister, the commercial arms of the Mafia. Employers’ organisations, notably Confindustria, try to stay non-political in championing reform but are opposed by the highly politicised trade unions and large-scale co-op enterprises, which are the heirs of the post-war Communist Party. Another key arm of the Left are the magistrates, especially in the North and Centre-North, who seem accountable to nobody while mounting prosecutions and giving judgements that can seem overtly political. The politicians themselves (derisively called La Casta: i.e. a caste of Untouchables) are both a self-serving interest group collectively as well as vicious rivals within and between parties. It is not surprising, therefore, that Italy has been stagnating since well before the current recession and that no relief is in sight. The widespread air of resignation and hopelessness is palpable and it is sad to watch so many people getting poorer. It is no exaggeration to draw parallels with Japan’s lost decade.
Writing today from Italy, there is high political drama following the confirmation of Mr Berlusconi’s conviction for tax fraud. The Magistrates in at last cornering the arch-enemy have set up what they perceive as the final triumph of the Left. President Napolitano, also from the Left and a bitter opponent of Il Cavaliere must be tempted to deliver the knock-out blow. However, not only does the Left-led government need the support of Mr Berlusconi’s PDL party but the PD itself is riven by division and rival ambition. Even worse for the President, the PDL is gaining in the opinion polls and could yet win an election if the government fell. Accordingly, Mr Napolitano will probably try to preserve the government and delay elections as long as possible in the hope that the PDL will splinter over any continuing role for Il Cavaliere and he will take comfort that there is no other figure on the right with the potential of a Thatcher or even of a ‘nice’ reformer like Mr Cameron. In doing so, he will almost certainly have to offer Mr Berlusconi, who has already avoided both jail and expropriation, the chance to return to front-line politics after a period in purdah. This will be very risky as Mr Berlusconi will surely put ever more pressure on the government to pursue not just his own favourite populist policies but to pursue genuine reforms which, to be fair, he attempted before he became cynically inactive in the teeth of opposition from the Left and other vested interests.
Both business and consumer confidence are likely to get another boost on Wednesday when BoE Governor Mark Carney reveals his proposals on forward guidance in monetary policy. Many people in the City are somewhat snootily saying that everyone already knows that interest rates will stay low for many years. Frankly, this is very hard to believe and what is more, even if they did know, most people will be pleased to have the reasons spelt out. There is some speculation that the MPC will follow the FOMC in adopting an employment target but it is more likely to stick to the GDP and CPI parameters that it deploys in the Quarterly Inflation Report (the latest edition will also be released on Wednesday). The most interesting bit could be the extent to which the MPC is willing to tolerate inflation above its central target of 2%. Probably rather a lot for the time being. This is Mr Carney first big moment centre-stage and like George Clooney, whom he is said to resemble, he will put on a very polished performance.
Putting it all together:
* Equities in the US and UK are starting to look expensive and may mark time whilst earnings catch up. However, a relatively new phenomenon is wild swings in the prices of even very large companies, as the punters chase those extra returns. This is best ignored.
* Japanese equities have also been experiencing wild swings, which seem driven by speculative changes in the USD/JPY exchange rate. Conflicting economic data has not helped. The BoJ’s massive QE programme seems largely to be ignored but should provide support for domestic and international share prices.
* It may be a bit early to look at European equities except those likely to benefit from the current government policy mix of cutting current spending and boosting investment. This favours outsourcing and infrastructure.
* Emerging markets seem a lottery at the moment but it is best to assume China is slowing faster than the authorities are admitting, with knock-on effects on its trading partners around the world.
* Bond yields may have settled down again but they can only go one way, even if not for several months in the case of US treasuries, gilts and bunds. Most Southern European bonds still look quite risky but to some extent that is priced into the yields. French government bond yields look far too low considering the economic and political hiatus there.
* Reports of the rise of the dollar have certainly been premature if not yet exaggerated and apparently some punters are getting restless. They should hang on. Most minor currencies have already given ground and the Aussie is still getting regular punishment. It will be the euro and pound’s turn once the Fed’s taper is lit, if not before.
* Gold and Oil should be left to the punters as there is no justification for their recent rallies.
Finally, it is worth looking seriously at microcaps. Shares prices of biotechs are already rocketing in New York. This is surely the next big thing but one must choose carefully as the punters are bound to pile in.