New article from Tatton Investment Management: Trick or treat season

27 October 2017

It’s been a bit of a nervous week in equity markets, and not a brilliant week for bonds. In Europe, the ECB did its best to help EU equities; while UK stocks are lagging for several reasons, mostly associated with all things Brexit in the minds of many city commentators.
Regardless of any general view on our exit from the European monolith, the inability of our lead negotiator to be consistent with the Prime Minister (or even just with himself) suggests degrees of ineptitude. It is a small irony that, Theresa May’s best political ally currently seems to be Angela Merkel. A reasonably warm relationship is emerging, much helped by May’s evolving humility. Merkel, the European leader most able to concentrate on European issues (rather than internal considerations), must be watching the continued rise of anti-immigration sentiment across EU and what it means for the EU negotiating position. Despite the confrontational noises from the negotiators, it may be that the sides are getting closer, not further apart. We’ll have more to say on this in the next couple of weeks.
Whatever the case, the negotiations were probably not at the heart of our stock market’s performance. This week there have been three ‘stand-out’ results on the FTSE 100. First up, - Barclays shares were down 7.4% to their lowest in a year, after the bank missed estimates for the third-quarter, on the back of weak trading performance at its investment banking division. Barclays has been the worst-performing bank on the FTSE 100 this year, down 18.6% year-to-date. The more UK-centric Lloyds Banking Group, owner of the biggest UK mortgage book, saw their shares rose supposedly because of potential rate rises. In the pharmaceutical sector, GlaxoSmithKline shares fell, its biggest daily fall in 9 years, to their lowest level since the Brexit vote. Still, Morgan Stanley estimates UK 2017 earnings growth of more than 20%, against 12.6% in Europe. Unfortunately, a lot of this is on the expectations of a weaker pound.

The CBI’s Distributive Trades Survey published on Thursday, made for depressing reading from the point of view of consumption. The EY Item Club, who conduct the survey for the CBI, said:
“The CBI survey has been particularly volatile over the last few months, and there may have been some corrective elements in October’s sharp drop after a very strong reading in September. Nevertheless, there is no getting away from the fact that this is a very weak report.

…squeezed, cautious consumers are holding back on their spending at the start of Q4. It reinforces our suspicion that the economy is unlikely to see any marked pick-up in activity in the near-term despite GDP growth edging up to 0.4% quarter-on-quarter (q/q) in Q3 from 0.3% in Q2 and Q1.

Retailers will be fervently hoping that the very weak October performance is primarily a consequence of consumers temporarily limiting their spending before the crucial Christmas shopping period gets underway. Consumers look certain to suffer from ongoing negative real income growth through the tail end of 2017 and the start of 2018 as inflation likely hovers at 3% or just above and earnings growth remains limited to slightly above 2%.
The main support to consumer spending is coming from recent strong employment growth.”
 
The squeeze on consumers should progressively ease in 2018 due to inflation falling back markedly (as the impact of sterling’s sharp fall drops out). There will also likely be a gradual pick-up in pay in both the private sector and the public sector (due to an easing of the pay cap). However, employment growth could lose momentum.
The weakened CBI survey is unlikely to deter the BoE pressing ahead with an interest rate hike from 0.25% to 0.50% on 2 November - given the pick-up in GDP growth in Q3, inflation of 3.0% and an unemployment rate down at 4.3%.

Tim Denison, head of retail intelligence at Ipsos Retail Performance, said to the Telegraph: “The state of retail health is in danger of reaching a tipping point not seen since 2012, when the festive ‘shot in the arm’ isn’t enough to counteract the ongoing issues with rising costs and squeezed margins."

In a busy week for EY, they published their half-year report on profit warnings. Retailers, again, were at the heart of despondency.

“The rise in FTSE General Retailers profit warnings isn’t dramatic – 31% have warned in the year to the end of Q3 2017 compared with the year to Q3 2016. But this is against a backdrop of falling earnings expectations.

Thus, it was not surprising to hear renewed dovish noises from one of the Bank of England’s monetary policy committee. Jon Cunliffe said “I am not going to try and anticipate the meeting, but for me the economy has clearly slowed this year. It has slowed because of the squeeze we have seen on real incomes and imported inflation from the depreciation [sterling] that has come in. And pay has remained relatively subdued.”

Expectations of a November rate rise did not change materially though. Indeed, sterling bond yields actually rose dragged higher by rising yields especially in the US.

Away from the UK, data pointed to strong growth. Of note, the US Q3 GDP rose 0.75% in the quarter (a 3% annualised rate and well above expectations): the US and European preliminary Purchasing Manager reports, published by Markit, continued the marked strength of recent months, the US durable goods orders climbed further.

US bond yields are heading back up. And, while quiescent inflation has tended to dominate discussions about central bank policy, it may be that the bond markets are responding to supply and demand rather than expectations of the Fed’s moves.

The process of second-guessing the Fed or any other rate-setting central bank is only possible in the relatively near future – say, about 3 years. After that point (essentially beyond “the cycle”) the market is more likely to focus on the long-term economy’s growth and inflation as a better determinant of rates.

We try to look at what a 5-year bond will yield in 5 years’ time.
You can choose to invest in a 10-year bond or a 5-year bond now and then invest again in a new 5-year when it matures. The current 5 year has a return of 2%. When it matures, what will the next 5-year bond have to return so that you match the 2.5% return on the 10year?
Intuition says 3% - you need the average of the two 5year bonds to equal the return of the 10year. (there are some complications which cause the actual answer to be slightly different but the intuition is basically correct, especially when returns are relatively low).
Using this, we can calculate the “5-year bond yield, 5-years forward” (5>5yr in our shorthand):

This shows that confidence in the ability of economies to generate nominal growth is rising (at least, that’s probably the best interpretation). Indeed, we would be unsurprised to see the US 5>5yr rate heading past the 3% level in the next few weeks.
Supply of bonds seems to be increasing. Having hoarded cash, companies are showing signs of increasing capital expenditure. This comes at the same time as the US government is having to increase its bond issuance (due to lower than expected tax receipts – admittedly a conundrum). All at the same time as the expected “Tax Reform” increases further their budget deficit and the Fed reduces bond holdings.

As for this week’s ECB’s announcement regarding the slowing of their Quantitative Easing program, our guest economist Duncan O’Neill writes in more detail below. Long story short, the markets saw the ECB announcement as determinedly dovish.

  • The retention of the “forward guidance” – i.e. short term rates will not go up until the “outright” bond purchases have ceased
  • outright bond purchases will continue at least until September 2018 and may go on longer
  • maturing bonds, will be reinvested for “an extended period” (well beyond Sep 2018).
For equities, the continued support for corporate credit was especially positive. Credit problems occur when you have to roll over maturing bonds so the ECB’s commitment to use maturing bond proceeds to buy bonds is a big fillip. Credit spreads came in sharply after the announcement and that flowed through to equities.
This is a final (slightly less positive) thing to note. The earlier part of the week looked as if we might be about to see some selling of risk assets. One indicator was in “carry currency” trades.
A favourite trade of leveraged investors is to borrow a low yielding currency and put the proceeds into a high-yielding emerging market short-term deposit such as Turkish Lira.
On October 9th Turkey arrested a Turkish citizen employed by the US embassy, creating a spat with the US. The Turkish Lira fell sharply but subsequently rebounded. However, this week, it has resumed its weakening. Other emerging market currencies have also shifted down, such as the SA Rand.
 
These moves tend to be associated with risk-off episodes and, in particular, equity markets turning weaker. If bond yields head higher, driven by the US, we might find that equity market valuations come under pressure. A strengthening economy means better earnings prospects but can take it away because you have to discount the cash-flows using a higher interest rate.
 

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