Summer Reading

07/08/2015 at 11:25 am

Well, here is August. Traditionally, though not always a quiet month, we shall be two thirds of the way through 2015 once it ends. So far the summer period has seen pockets of notable activity in markets rather than outbreaks either of optimism or of panic. For the moment things feel pretty calm – so let us have a look at some areas which have drawn attention over the past month or two as we approach the more active autumn period.

China has preoccupied minds for much of the last few weeks. The stock market is down by about 28% from its peak in June, meeting the technical definition of a crash. A Shanghai-based CIO captured the consensus well when he said a month ago: “The market is now falling on the assumption that both China’s economy and financial markets face systemic risk.”

China’s economic growth has certainly disappointed but despite much commentary the supposed systemic issues are not so clear cut. What is clear is that manufacturing activity has cooled materially since the middle of last year and that export growth has fallen away.

It has attracted little comment that since the bottom 15 months ago the yuan has appreciated by 22% against the euro – very slightly more than what the dollar has done over the same period. Consider at the same time that it is Europe which has seen positive growth surprises over the period and the US where GDP has been sluggish.

We know that there are policy moves afoot in China to reform the economy and that the property market has again hit a bout of serious weakness. But it is also likely that more mundane currency factors, of exactly the kind which have been hobbling reported EPS for the S&P 500, have been playing their part. Chinese exports to Europe have fallen by an average of 16% on the year for the most recent three months where data is available (March to May). That’s the fastest drop since 2009 – and stands against a modest rise in exports to the US.

Elsewhere rate hikes have been attracting attention. (The Bank of England vote on the subject split only yesterday of course.) There has however been very little movement in market expectations for central bank action in the UK and US over the last few months – or to put it another way, continued expectations of a very benign tightening cycle whenever the time finally comes.

This is consistent with the behaviour of oil over the last few weeks. The key Brent and West Texas crude contracts fell during July by 18% and 21% respectively, the sharpest monthly decline in the latter case recorded since October 2008. If prices remain at their current lows it will not be until early 2016 that the base effects of cheaper energy on inflation fall away completely. Through the prism of the short term that looks bullish for rates. But from another perspective it could present markets with more of a shock once the effect finally does unwind.

(As a brief aside let us look at the effects of bargain-barrel crude on oil producers. At one end of the scale it has seen Saudi Arabia return to the debt market for the first time since 2007; at the other, life for 30m Venezuelans gets ever more horrific with farming nationalized and starving people rioting over food. OPEC has raised output by about 2m barrels per day since mid-2014. One begins to wonder whether this whole cheap oil policy was really such a clever idea.)

Back to Britain! While not as dramatic as the oil price the strength of sterling has been a noteworthy feature of the landscape for UK investors, and a seasonable boon for those going abroad. On a trade weighted basis the pound is over 7% stronger so far this year and carries its highest value for more than seven years. On a PPP basis it looks expensive to almost everything except the Swiss franc (though not always significantly so). Nonetheless, this will be causing some creative tension in Threadneedle Street – and it also offers an opportunity for anyone looking to diversify away from sterling.

Finally there was a fascinating story about a possible cyber attack a month ago. On 8 July computer problems grounded all flights at United Airlines, stopped trading at the New York Stock Exchange and knocked over servers at the Wall Street Journal. One theory held that this was the work of Chinese hackers. The logic was that the bankruptcy and euro-exit of Greece, then a live possibility, would open the country up to control by China and / or Russia. Fearful of this, the west used cyber tactics to exacerbate the crash in the Chinese stock market.

This blog would ordinarily have dismissed this as conspiracy prattle – but it was then officially denied. There could not have been a cyber attack, apparently, because United suffered a computer problem whereas NYSE closed because of a technical issue. And at the WSJ it was simply an overload. As CNN summed up:

What ties together all three failures? The companies involved are all business operations that rely on massive computer systems. Automated software is complex, sometimes involving millions of lines of computer code. All it takes is a single error — even misplaced text — to grind it to a halt.

Then there was this wonderful quotation from cybersecurity expert Joshua Corman, who must do contract work for the Department of Administrative Affairs:

“Increased dependence on undependable things allows for cascading failures.”

That offers no explanation whatsoever for what happened on 8 July, but it does underscore the vulnerability of modern society to attacks of this kind. Why only a month earlier the payment systems at RBS collapsed, leaving wages and state benefits for hundreds of thousands of people unpaid. This was attributed to “creaking IT systems” by the British Bankers’ Association, which may well be the case; but what would happen if those creaking systems were to get a concerted external push? We already know that significant black swan events, such as major terror attacks, can occur without state support. Geopolitical conspiracies aside: would it be possible for a real cyber attack against key targets to be perpetrated by non-state actors? And what is implied for the next conflict between developed states?

At this point holiday reading begins to take over from financial analysis so let us leave things there for now.

Markets might have been calm, then, but there has been much of interest to observe. Some of this speaks to future surprises, and some to one or two of the themes identified by this blog at the start of the year. All we can do, as always, is to keep our eyes open and decisions clear as we approach its closing months.


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