Near-term market sentiment: Still bullish. Third quarter corporate earnings have been strong, particularly for the large U.S tech stocks that have been leading the S&P500 to new highs throughout the year. Brent crude is over $60 a barrel on speculation that Saudi Arabia and Russia are happy to extend their current output caps. Industrial metals are responding to strong demand and supply cut backs in China, as Beijing attempts to limit excess production. There is progress in Washington over President Trump’s plans to reform and cut taxes. In Spain, Prime Minister Rajoy appears to have trumped the Catalan separatists by offering regional elections that may neutralise the recent referendum. Investor confidence in risk assets continues.
As I wrote in the last note, the key arguments that support further stock market gains, and continued demand for higher yielding bonds, are:
Global GDP growth is strong. Last month, the IMF upgraded its estimate of world GDP growth to 3.6% over 2016. It had been 3.2% at the start of the year.
This feeds through into higher corporate profits, which supports stock market valuations and company’s credit ratings.
Bank account cash rates and bond yields look set remain low, because low global inflation means that there is little pressure on central banks to raise interest rates by anything more than token amounts.
Indeed, central banks everywhere remain in a deeply forgiving mode as far as investors are concerned. In the U.S, the Fed’s unwinding of its QE program, due to start this month, will be done at a slow pace in order not to raise bond yields and hurt economic growth. The likely replacement of Janet Yellen as Chair of the Fed is Jerome Powell, a known dove on monetary policy.
In the euro zone, the ECB has announced an extension of Q.E until at least September 2018 (although at a reduced rate from January of EUR 30 bn a month of bond purchases).
The Bank of England looks set to raise interest rates on 2nd November by 25bps, and so reversing the post-E.U referendum cut. But many analysts believe the Bank will hold rates thereafter, in view of the weakening U.K economy and expectations that CPI inflation of 2.9% y/y will fall back over the coming months as the impact of last year’s fall in sterling on import prices works its way out of year-on-year price measurements.
Can this bull market persist? Sooner or later this bull market will end, perhaps prompted by a fall in bond prices if relaxed central bank monetary policy allows a steady upward rift in inflation. But this is not likely to be a problem over the coming 12 months or so, and with no clear trigger in sight to cause a sell-off of bonds that would then undermine equities, it is premature to take risk off the table. Annoyingly, even if one wanted to go into defensive asset classes it is difficult to find any at the moment that will deliver a real return (ie, after inflation is taken into account).
Brexit and sterling. The Brexit negotiations between the U.K and E.U appear to be at an impasse. This, together with the Bank of England’s likely unwillingness to raise interest rates in view of weakening domestic demand, means sterling may again become a ‘big short’. The next test for sterling will be December’s E.U summit meeting. If no agreement is made then to move talks on in order to discuss a transition arrangement, and the final trade deal that the U.K can expect to have with the E.U, sterling will suffer renewed pressure.
At the heart of the impasse is the U.K’s reluctance to agree the divorce bill before the E.U has first outlined what type of trade deal it will offer Britain. Like a game of poker, London clearly sees the amount it offers as a bargaining chip. Perhaps the only one it has of any significance. The E.U wants the bill to be paid first, so it is not linked to discussions on trade. The longer this continues, the more likely there is of a ‘no deal’ outcome to Brexit negotiations, which many economists see as being the most dangerous to the U.K economy.