Archive for October, 2015
In these uncertain times, let us refresh ourselves by beginning with what was again proved this week to be an indisputable fact: Mario Draghi is the most significant and successful central banker in the world.
The announcement three years ago that the ECB was assuming the power to intervene in bond markets, when he was not even 12 months into the job, put the sovereign debt crisis to bed, restored market confidence across the world and helped turn the creaking hull of the eurozone supertanker away from recession. Two years later his €400bn bank liquidity programme and adoption of a negative policy rate had analysts calling him a rock star. Another €700bn splurge and surprise rate cut followed. And at the beginning of this year Mr Draghi announced a €1.1trn programme of quantitative easing.
So yesterday’s announcement that the ECB was ready to modify the “size, composition and duration” of its QE exercise was part of a pattern. Draghi and team are being seen to do whatever it takes to re-normalise the eurozone economy. Indeed, as he put it at a speech he gave in London on 26 July 2012:
The ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.
Everybody believes you now, Mr Draghi.
Market reaction yesterday and overnight was, in a word, electric. The euro plunged by 1% against the dollar in the space of half an hour to close the day 2% weaker overall. (That is a more significant one day fall than the planned devaluation of the Chinese yuan that caused such consternation back in August.) The Euro Stoxx 50, which had been trading flat throughout the morning, rocketed up in the afternoon to post a +2.5% close. European bond yields hit new record lows: the 2-year bund was pricing at -0.35% in the opening hours of this morning while the 2-year Italian buono hit negative yield territory for the first time.
There is a good, detailed overview of the global impact of Mr Draghi’s latest star performance from Reuters here: Global Stocks Hit Two-Month High On Dovish Dragi Message. But it is the quotes from market observers which we will focus on before leaving this subject:
“Investors and traders are buying the idea of expected action out of the Bank of Japan and the ECB,” said Ben Le Brun, market analyst at trading platform provider optionsXpress.
The Chinese central bank’s injection of 105.5 billion yuan into 11 banks via its medium-term lending facility this week, combined with possible additional stimulus from the ECB, “may give the Fed more reason to raise rates by year end,” said Chris Brankin, chief executive officer of online trading platform TR Ameritrade Asia in Singapore.
“Draghi has come out and kitchen-sinked the whole thing, everything is now on the table,” said Gavin Friend, a strategist at National Australia Bank in London. “You combine what the ECB is now saying with (the fact) that the Fed is not going to be going aggressively and that the Bank of Japan is going to want to get involved, then you say ‘Blimey!'”
Mr Draghi has played his role exceptionally well, but the dominance of central bank rhetoric and activity over market behaviour is unhealthy. When the People’s Bank of China devalued over the summer for example it was treated as a disaster – a desperate act to prop up a seriously weak economy. The falling stock market in China had helped unsettle the world and the markets’ interpretation of events took place against a background of gloom. This week, however – thanks to the ECB – we inhabit an era of sunshine and optimism. So when the PBOC announced further monetary loosening today it was seen not as desperate but as a sign of “the government’s determination” which has now lit “a fire under global stocks” as “US equity futures jump”, to quote some of this afternoon’s commentary. Markets hated Chinese policy over the summer and loosening by the PBOC was taken badly; today it’s just what was needed to cement the rally in place.
If there is a cloud to go with this week’s silver lining, therefore, it is the now familiar truth that reliance on central banks has become a major source of volatility. “Money Markets Primed for Draghi as Bets Jump on Deposit-Rate Cut”, says Bloomberg’s headline today. And what if there is no cut on 3 December? Or if there is, but this is seen as bowing to market pressure – the kind of pressure which appears now to govern decision-making at the Fed? One day markets are given a boost by “Super Mario”, the next, they start looking for more – and pricing it in.
Volatility is the textbook definition of financial market risk. Mario Draghi is, to say the least, an impressive figure. He has given investors much to be very grateful for. But he and his confreres around the world, counter-intuitive though it might seem, have actually helped to make investing today a riskier proposition. To put it another way, we have become used to looking to central banks to underpin market stability; and by relying on them to the extent that we now do, ensured the exact opposite.
Economically speaking there has been little drama or excitement in the UK over recent months. While markets agonized over Greece, and then China, and subsequently the Fed, the British economy quietly kept on going. There have been no growth surprises in either direction; no change to the Bank of England’s guidance or rhetoric on interest rates; no unexpected outcomes in the labour market, or price indices, or activity indicators. The PMI survey for September showed a bit of weakening in output. And Mark Carney did have some diverting things to say about topics other than monetary policy (climate change for instance). But all in all, it has been an uneventful time.
Nonetheless the UK markets are of key importance to British investors and do not always reflect goings on in the economy, to say the least. So while the economy might not invite too much scrutiny just at the moment, here is a summary of conditions across the major UK asset classes.
Starting with property, the residential market rally that took off in 2013-14 continued into this year but has abated somewhat. Government data showed a 5% increase in house prices in the twelve months to August, down from a 12% annual rate in the early autumn of last year. Valuations are mixed: the simple average earnings to average house price measure suggests the market is red hot but on this measure that has been true since 2004. Using a measure of mortgage affordability (which takes account of interest rates) the market is priced fairly: the ratio of average mortgage payments to average earnings is almost exactly in line with the average since 1976.
The commercial property market has been having a jollier time of things, with the Investment Property Databank All Property total return index up 15% over the twelve months to September. Again, the valuation picture is mixed. Rental yields have fallen sharply over the last couple of years and are about as low as they were at the peak of the late 1980s boom (though still a little way off the lows seen before the Great Recession). On the other hand, the rate of capital growth has not been as aggressive as in previous rallies and there is some distance before the market surpasses its 2007 peak.
Staying at the riskier end of the spectrum the equity market has been picking up nicely in recent days. The FTSE 100 has risen by 5% so far this month and is now 8% above the low it marked towards the end of August – though remains 10% below the record set back in April. There has been pressure on earnings from currency and commodity effects this year so the improvement in valuation since then has actually been rather muted: the forward p/e ratio has risen from 14x to 16x, which looks toppy against a ten year average of 12x. At the same time, however, the dividend yield has risen from 3.5% at the end of last year to 3.9% today (the ten year average is 3.6%).
Talking of yields, the gilt market has barely shifted from where it began the year. All the key maturities – two year, five year, ten year, thirty year – as well as the ultra longs are within 10bp of where they ended 2014. There is one exception: the ultra long end of the index-linked market has rallied, with the yield on the 0 3/8% 2068 linker down 16bp to an uncompelling -0.8% in real terms. The ten year conventional gilt yield stands at 1.8%.
Corporate bonds have similarly had a dull time of things, at least in the investment grade arena where widening spreads have seen total returns of about 0.5% according to the Bank of America Merrill Lynch family of indices. High yield has done better: spreads are about where they were at the start of 2015 so there has been relatively little capital impact on income return (the total return on the sterling high yield index stands at 4% for the year to date). In valuation terms credit spreads are much higher than they were in the years preceding the 2007 crunch but not very compelling against average levels given the scale of the collapse at that time. Using the Markit iTraxx Europe index as a benchmark the price of investment grade credit is just over 80bp today, up from a pre-crisis low of 20bp but somewhat below a ten year average of 90bp.
There is nothing much to say about cash with base rate stuck at 0.5% for the last six and a half years, though the worst performing assets of all are to be found in the commodity space. The near Brent crude oil future has rallied from the new bottom it reached in August (by some 14% in fact), but is still worth less than half what it was before the crash last year. The economic and market consensus is for very limited improvement over the coming months and with supply still materially stronger than demand there seems little reason to argue with this. There would also appear to be the will in some important quarters for oil to stay cheap: Saudi Arabia alone increased daily production by just over one million barrels during the first seven months of this year.
Precious metals have had a better time of things too lately and both gold and silver are trading very near the levels at which they began the year. Still, gold at $1183 an ounce remains expensive relative to inflation-adjusted 30 and 40 year averages of $793 and $825, even though that price is almost 40% below the $1900 reached at the peak of the bubble.
At this point we have departed from strictly British assets of course but that, at least, is all the key bases covered!
It has not been the easiest of years for UK investors and readers will have noted that this blog sees continued volatility ahead. But there are always opportunities amid uncertainty. Time will tell if we are able to find them out.