Posts tagged ‘equities’

Hitting The Doldrums

Day after day, day after day,
We stuck, nor breath nor motion;
As idle as a painted ship
Upon a painted ocean.

Thus Coleridge, in his celebrated “Rime of the British Stock Market”.

In 2014 the FTSE 100 index returned +0.7%, a year later -1.3% and over the course of 2016 to date it has delivered -0.8%. One can point to several reasons for this lacklustre performance, notably the commodity markets, the pound and their effect on reported earnings. These are admittedly forecast to pick up this year (though even forward-looking valuations do not look especially cheap on an absolute basis). In any event, to say that it has been a frustrating period for equity investors is to make something of an understatement.

Of course two and a half years barely amounts to a medium term horizon. Like all investors, we know that equities are a long term asset class. They will outperform other types of asset, especially if we remember to reinvest our dividends whenever possible, but will deliver bouts of short term volatility. Hang on in there and those long run returns will begin to come through.

There are, however, some issues with this analysis. Short term bouts of equity market losses have been a recurrent feature of life in the twenty-first century. It started out with the end of the dot-com bubble (three consecutive years of negative returns to the Footsie over 2000-2002). Then there was a peak-to-trough loss of 45%, again on a total returns basis, from October 2007 to March 2009 amid the credit crunch and the Great Recession. The recovery from that low point was soon derailed by the carnage of the sovereign debt crisis in 2011 (total return for the year: -2.2%). There was some brief strength in 2013, and now we are where we are.

Another way of looking at this is to say that from the 31st of December 1999 to the end of March this year, the FTSE 100 index had returned an annualized +2.8%. Uncannily enough, this is exactly the annualized change in value of the Retail Price Index over the same period. Which is to say that over the century to date, the key UK market benchmark has returned exactly zero in real terms.

Is it really the correct response to this fact to dismiss it as a short term effect, and put our faith in long run real returns of 5% – as calculated by the Barclays Equity Gilt Study team – from 1899-2015? (As an aside at this point it is worth noting that Barclays used to cite the arithmetic rather than the geometric mean for forecasting on the grounds that, for various statistical reasons, it provides “the better unbiased estimate”. The arithmetic mean real return to equity is closer to 7% than 5%. While the methodological explanation remains in the 2016 study, however, that 7% “unbiased estimate” is nowhere to be found any more.)

1899-2015. The Long Run. There is something compelling, something authoritative, about this. Nonetheless, a 16-year period of zero real returns is not to be scoffed at either. And that 116-year databank is marked by it too: the real return to UK equity from 1899-1999 was 5.7%. The new century has already wiped almost 1% off the entire long run average.

Look at the 16 years heading into 1999 and the story is very different: stocks averaged a return of +12.6%. Ex out that stellar period from the series and the real return to the asset class (from 1899 to 1983) diminishes to 4.4%. Over the first half of the twentieth century it averaged only a little more than 3%.

In defence of the equity market the FTSE 100 is not at the high-growth end of the spectrum. Since 1999 the mid-cap FTSE 250 has put on over 9% annualized, and so has delivered a real return of +6.2%, which is about what the historic data conditions us to think of as our due.

And yet the 250 is only a fifth the size of the 100 in terms of market capitalization, so it is much less genuinely representative of UK equity as an asset class. Other asset markets do not have to resort to this kind of selectiveness: the IPD UK All [Commercial] Property index shows an annualized total return of +8% for December 1999 to March 2016, the Nationwide index of house prices managed +6.2% (and that ignores rental yield), the gilt market delivered +5.9% and sterling non-government bonds +6.3%. UK investors could have put their pounds to work in any other major asset class – with the single exception of cash – and made a creditable real return. Equity has been, quite simply, appalling.

Past performance is not a guide to future returns . . . and even the Ancient Mariner makes it home in the end. Should the FTSE 100 perk up and hit 7,000 at some point over the next few months things would be feeling very different. But there are sound reasons when looking at expected returns for regarding the 1980s and 90s as the truly anomalous period: the Cold War is not going to end again, nor the internet be invented a second time. Looking further forward one might also note the impact of (developed) world demographics on aggregate demand, and observe that Japan’s stock market has returned an annualized +0.2% over the past 30 years.

The aim of this piece, however, is to raise questions, not to pontificate about any supposed cult of equity. Perhaps, like the Mariner, we should conclude simply by recommending the embrace of diversification.

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13/05/2016 at 4:38 pm

Crash! Panic! Doom!

So this week London entered a bear market. Some commentators discern echoes of the “2008 financial crash”. Sage market participants – who have been warning us about China* / Emerging Markets* / the Euro* / QE* / Commodities* / Debt* / Deflation* / Monetary Tightening* [*delete as appropriate] – for several years have finally been proved right. Several of them caution, sagely, that we should remain cautious as it could have further to go.

Yes, this week, the FTSE 100 Index entered a “bear market”, as defined by a fall in value from its closing peak (7,103.98 on 27 April 2015) of at least 20% – 20.14%, to be precise, reached on Wednesday with a closing price of 5,673.58. It should be obvious that this signifies nothing whatsoever more than a fall of 18% or 19% but there we are. Markets have their conventions. This is now, technically, a “crash” rather than a “correction” (a fall of between ten and twenty percent). And some would have us believe it’s 1929 all over again.

Such, however, it cannot be. Global equity (as measured by the MSCI World Index) has not entered a bear market – it has fallen by 17.62% from its peak – and this is entirely due to Wall Street. The S&P 500 has shed a mere 12.74% from its heady peak last May. Since the US market makes up a little under 60% of the developed world’s total market cap this more than makes up for the fact that Tokyo and … erm … Brussels? … have entered bear markets alongside London with the TOPIX and Euro Stoxx 50 indices down 23% and 25% respectively.

Even here in the UK the crash is not that clear cut. The mid cap FTSE 250 Index has shed only 14%, with the small cap index having done slightly better. Considering the fundamentals this is understandable. There are few oil supermajors bestriding this particular corner of the marketplace, or mineral colossi. The much vaunted overseas exposure of the large cap index has been, at best, an equivocal strength with the UK economy doing as well as it has (not to mention the distorting effects of all that foreign exchange exposure). So the current infestation of bears has been locally as well as globally selective.

Still, who needs “fundamentals” with all that lovely panic to go around! Surely it can only be a matter of time before those other columns tumble? After all, it’s 2008 all over again!

Except, of course – it isn’t. Not even remotely so. Back in 2007, to refresh our memories, there was a massive over-extension of credit via packaged structures that were as poorly valued and understood as they were widely held. A few mortgage arrears in the US later and the world’s financial system suffered cumulative capital losses just shy of $2trn and would have collapsed without the $1.5trn of capital that then had to be pumped into it, mostly by governments. Then in the autumn of 2011 it looked as though the bond market might close to Italy. Since the Italian economy is rather large, with a commensurate burden of sovereign debt, it was certain that neither the IMF nor its sponsoring governments would have been able to afford a bailout. At that point we could have seen governments across the developed world plunged into default.

Now that would have been a disaster.

And what is behind the doomsaying today? The rate of GDP growth in China down by 0.1%! Oil falling – which is admittedly more dramatic – but unlike the financial crisis will prove an economic benefit on average (and perhaps delay the need for monetary tightening in Britain and elsewhere). Or perhaps it is simply the case that the bull market run since 2009 got ahead of itself and equities are anticipating the forthcoming change of cycle.

On that last point there is something further to be said about all those crashes and corrections. Amid the justifiable fear of 2011 the S&P 500 had a peak-to-trough fall of 19.4%. Admittedly, this is a whole 0.6% short of a full-blown bear market, or “official” crash. But it was not much fun for investors at the time. And away from the US, stock markets have had a much more equivocal rally. While the S&P raced ahead during 2013 and 2014 for instance, returning 50% over those two years, the FTSE 100 returned only 20%. In Japan, suffering from the earthquake and tsunami of 2011 and their aftermath, the market did not even start to climb until the tail end of 2012. The years since the credit crunch and Great Recession have seen healthy equity market returns – at times, in some places, and in fits and starts. But it has not been any sort of eye-watering, valuation-busting rocket trip.

We are where we are. But the crash has been as partial as the bull run, the panic is hard to justify – in some respects, even, absurd – and it may yet prove that all the doomsaying is being listened to just a little too closely.

22/01/2016 at 6:26 pm

Another Year Over

Well so much for 2015. It was a curious year for the major asset classes and a frustrating one for many investors, including those in the UK. Still, now it has passed we can look at the numbers, identify the winners and losers and remind ourselves that the only reliably immovable feature of the financial landscape is uncertainty.

Starting with UK equity an initially record-breaking year unwound to deliver a disappointing total return of -1% to the FTSE 100 Index. It was a very different story for the mid- and small-cap indices, however, which are less exposed to energy price and currency effects and posted numbers of +11.4% and +9.5% respectively.

On the fixed income front it was a tough year for gilts. Markets which might have been expected to benefit from “risk off” nervousness struggled in the face of the anticipated gradual unwinding of emergency monetary conditions both here and across the Atlantic. The Bank of America Merrill Lynch conventional gilt index managed to return only +0.5% last year with the index-linked index actually losing 1.2%.

Corporate bonds did a little better, with the BoA ML sterling non-gilt benchmark delivering +0.7%. The sterling high yield bond market is tiny (with a face value of £48bn, about the size of Diageo’s market cap), but for what it is worth returned a creditable 5.4%. High yield returns in Europe (+0.8%) and the US (-4.6%) give a more representative idea of what might have been secured by UK-based investors in this asset class, however, and the combined $1.7trn market here was dented by the collapse of borrowers in the US energy sector.

Away from smaller-cap equity and high yield the really bright spot was the property market. Commercial property continued its strong recovery, with price growth underpinning a 19.1% return to the IPD All Property Index (over the year to November, the most recent month for which data is available). And though the residential market lost a little heat last year it was up by 9% on the year to November in price terms using the smoothed HBOS house price series.

Cash rates hardly moved in 2015 as one would expect with the Bank rate frozen at 0.5%: the NS&I Income Bond rate stood at 1.25% with term fixes from the banking sector available a few bp higher. Key exchange rate moves were (as one would also expect) rather more exciting: the pound fell by 5.4% against the dollar, 5.0% against the yen and 4.9% against the Swiss franc while managing to put on 5.4% against the euro.

The most significant market move of all came from commodities with the price of oil down by more than 31% in sterling terms over the course of the year. Gold also fell, the GBP price losing 5.3%.

Finally a brief look at some of the other key international markets (all in local currency terms).

  • It was a disappointing year for US equity with the S&P 500 returning only 1.4%.
  • Europe did better, paying investors 7.4%, while Japan was best of the major markets with a total return of just over 12%.
  • Major government bond markets did very slightly better than gilts with the BoA ML US Treasury Index returning 0.8% and the Euro Government Index 1.6%.
  • More interestingly, the top performers in the eurozone were the weaker peripheral countries with the Italy index returning nearly 5% and Greece – recovering from price depression into the start of the year – delivering over 20%.
  • During the year Greek politics were usurped by the Chinese stock market as the financial world’s bête noire. So it is interesting that the Shanghai Composite Index, despite all its intra-year turmoil, posted a return of +11.2% across 2015 as a whole.

It was a year of turbulence and surprises, though one or two of these numbers did turn out roughly as the consensus had expected at the start of the year. How the consensus, along with the rest of us, will do during 2016 we will all discover in due course …

04/01/2016 at 5:02 pm

Best (And Worst) Of British

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.

16/10/2015 at 4:49 pm

Sins Of The Policymakers

This morning’s leading headline on Bloomberg News read as follows: “Stocks Advance in Europe, Asia Amid China Holiday … ”

Without the peril of the Chinese stock market to contend with, European bourses were up by 1-2% early in the day and are higher at the time of writing. This certainly fits the narrative of those who see the collapse of the supposed equity bubble in China as the source of all the summer’s ills.

(Before moving on, a brief comment on that “supposed”. The Shanghai Composite Index rose by 58% from the start of this year to its peak on 12 June, having risen by 53% in 2014. It hit a p/e of 23.5x in the process – then began to fall. By the bottom on 26 August the drop had reached 43%. If that isn’t a bubble … ?

On the other hand that p/e was well below the 45.5x reached at the market peak of 2007 – a peak which has yet to be exceeded. And it is miles short of the 60-70x levels seen during the twilight of the go-go 1990s tech boom, and below the average level so far this century. In addition, +53% is only the fourth-highest calendar year price return for the index in the last ten years, the highest having been seen in 2006 when the market much more than doubled. Finally, the market was valued at under 10x earnings for long stretches of 2013-14 before the rally began, well below the 14x and 12x reached at the market bottoms in 2005 and 2008.

This is a febrile market which has undergone rapid change but to interpret its rally from the depressed point of mid-2014 as an egregious bubble episode is to make a glaring analytical mistake.)

Some of the actions of the Chinese government have been woefully unhelpful. Direct interventions in the stock market have exacerbated falls and sharpened investor concerns, as tends to be the way of these things. At the same time, special interests in the corporate sector have sought to manipulate the government’s response to their advantage.

Other parts of the world were in exactly the same place very recently. The SEC banned short selling of financial stocks on Wall Street from Friday 19 September 2008 – the week of the Lehmans bankruptcy – in an effort to “protect the integrity and quality of the securities market and strengthen investor confidence.” By the time the ban ended after the close on Wednesday 8 October the S&P 500 Diversified Banks index had fallen by another 22%. Christopher Cox, then Chairman of the SEC, gave an interview to Reuters after Christmas that year which contained the following little nugget:

Cox said the chief executive of one major U.S. investment bank even urged suspension of normal trading rules across the entire U.S. market, likening the situation to how Abraham Lincoln suspended habeas corpus during the Civil War and Franklin Roosevelt sent Japanese-Americans to internment camps during World War Two.

The chief executive said, “that is how America made it through such crises, and we couldn’t be too focused on maintaining the rule of law,” Cox said.

Now that is panic. When it hits markets it is perhaps understandable that policymakers are not immune.

At the same time as the SEC was floundering around trying to put the clock back, however, the US Treasury began to implement measures under the newly-enacted Troubled Asset Relief Program, including the purchase of mortgage-backed securities to assist in the repair of bank balance sheets. On 8 October 2008 the Fed cut its target rate for the first time since April of that year from 2% to 1.5% in a concerted move with the ECB, Bank of England and the central banks of Canada, Sweden and Switzerland. A month later it began its first tranche of bond purchases under QE.

The speed of the banking sector recovery in the US – as opposed to Europe or the UK – has been one of the great relative strengths of the American economy. While some actions of the American government were woefully unhelpful, therefore, others were more constructive.

Exactly the same is true of the situation in China today.

As this blog remarked over the summer, it had been ignored amid all the attention on stock markets that China’s exporters were being hobbled by the quite sudden strength of her currency against the euro (and, for that matter, the yen). Only a few days after that post was published the People’s Bank of China devalued the yuan by 1.9%, its most significant depreciation since the epoch-making 50% shift engineered in January 1994. By the end of the week the yuan was down all of 2.9% at 6.39 and has stayed close to that level ever since. A few days later the 12-month benchmark lending rate was cut, for the fourth time this year, and a further reduction in the required deposit reserve ratio announced for major banks. At this point the PBOC had fired all three monetary weapons in its arsenal in a single month.

Back in the 1990s China came to dominate production in certain low-technology sectors, such as toy manufacture, and remained a relatively small economy (still smaller than Italy by the end of the century). Through continued competitiveness, investment, innovation, and broadening into higher-tech areas such as computers and mobile phones, Chinese exports overtook those of the US in 2007 and of Germany two years later. Today China is the world’s largest exporter by a mile, with the annual pace running at $2.4trn versus $1.6trn for the US; fifteen years ago China exported about a quarter as much as the US did.

So exports matter to the Chinese economy, devaluation ought to help exporters, and monetary softening elsewhere ought to ease some of the pain in the property market and contribute to lending growth. All this is fundamentally supportive. Nonetheless, the devaluation in particular – arguably the least contentious policy response of all – was interpreted as a sign of panic and the stock market continued to fall. In other words the actual direction of monetary policy was ignored in favour of the presumed context for its loosening. This was obviously a bearish response which again has clear recent parallels elsewhere.

What must surely be only a little less obvious are the implications of this response for imminent policy action in other places. Mr Carney at the Bank of England has just dismissed the idea that the kerfuffle within and over China will throw the MPC off their envisaged tightening path for rates. In the US, speculation over the timing of the first hike in the fed funds target since June 2006 has reached fever pitch. Will it motor up to 0.5% in two weeks’ time, as the majority of forecasters currently expect? Or will there be a delay?

Most importantly for investors: would a September hike be taken as evidence of a strong recovery, or would it ignite fears that the Fed is taking away the punchbowl too soon? And would delaying until next month be seen as a welcome reprieve, or betray a conviction that the US economy’s expansion is weaker than was thought?

The consensus from market participants still seems to be that monetary tightening will be accompanied by the upward march of equity benchmarks because (a) tighter money is a sign of economic strength and (b) that’s what happened last time. But as the events of recent weeks have shown, markets can get nervous again very quickly. And the Chinese experience is a reminder that in those circumstances, even positive policy decisions are taken as a sign of something bad.

It is difficult – even, perhaps, irrational – to dislike stocks more today than before they tumbled. There does not appear to be a new recession suddenly lurking around the corner. But complacency over the ability of today’s stock markets to take higher rates in their stride sits uneasily with the reaction to China’s very modest devaluation and other policy manoeuvres.

 

03/09/2015 at 3:43 pm

The Bottom Line

One of the key themes this blog identified on the eve of 2014 was earnings growth. Equity valuations in the major markets had reached territory that needed to see a higher denominator in the p/e ratio or risk looking overvalued.

Since then we have seen a quarterly contraction in the US, patchy outcomes for GDP across the Eurozone and tax-related volatility in the Japanese economy. There has thus been reason to suspect that this growth would disappoint. And that is before considering any confidence impact from events in Ukraine, the Middle East and elsewhere.

So the Q2 US earnings season which opened in early July was arguably more important than most. When it opened, consensus expectations as followed by Bloomberg were for a 4.5% increase on the prior year, barely higher than the 4.2% increase in nominal GDP over the same period.

In early August, however, just as the S&P 500 had fallen back towards 1900, things were looking rather better. By this time the first 200 companies had reported their results. The increase in EPS was averaging 12%. The analyst consensus began to catch up, and the final outcome for Q2 was then expected to reach 8.2%.

Now the season is essentially over with 499 companies having reported. Index earnings for the S&P rose by 10.3% over the prior year. In price terms the 500 is up by more than 18% over the last 12 months, but supported by that bottom line growth the exuberance does not appear irrational – especially if most of the momentum can be maintained, as is expected.

There was an interesting story out this morning on European earnings growth too. With the sovereign debt crisis and the double dip recession, the outcomes for reported EPS on the Stoxx 50 have been dire. But for the first time since April 2012, there are now more positive than negative earnings revisions coming from analysts covering European stocks. In the words of one such:

“There are signs that the pressure on European companies … is beginning to abate. We’re beginning to see small upgrades in earnings estimates overall for the first time in absolutely ages.”

There is a connection here to recent euro weakness, and a further connection to the open mouth operations of the ECB. There is also a lot of ground to make up: simply stripping out reported losses reduces the historic p/e on the Stoxx to 16.1x from over 23x. For the S&P 500 this makes almost no difference – 18x drifts lower to 17.8x.

These markets are not a steal any more – in isolation, certainly. (Relative to bond markets they still look very cheap, but that says just as much about poor value in rates.) It has been a long wait for many to see real, underlying growth actually return to growth assets. What it needs to do now is continue.

 

12/09/2014 at 4:58 pm

Finding Some Direction

We are now comfortably over half way through 2014. After a shaky start, and despite persistent jitters, much of the year was actually quite undramatic for financial markets. For a while it looked as though asset prices were struggling to establish any direction. In some areas this has remained the case. But since the spring there have been signs of movement, and these have been mostly supportive of the pricing of risk.

Starting with assets which have prolonged their mundanity: gold, at just under $1,300 an ounce, is priced almost exactly in line with its average for the year to date. Despite some volatility over May and June it shows no sign of directional movement whatsoever. The story is the same for oil, which spiked up as news broke of the crisis in Iraq but has since fallen back again to about its average level for the year so far.

Government bonds have not been terribly exciting either, at least in general. The ten year gilt yield, for instance, has moved within a range of 2.5%-2.8% since mid-February and currently stands at 2.6%. On the other hand the ten year German bund yield hit a record low of 1.15% only this week, having tumbled from 1.94% at the end of 2013. In recent years this might be seen as a reaction to crisis fears in Europe, but this time round it would appear to have more to do with declining inflation and anticipation of the ECB’s policy response: bond spreads in the peripheral eurozone countries have, without exception, tightened over the year to date.

In fact, credit markets generally have been giving the strongest risk-on signals. High yield spreads, as measured by the Markit iTraxx Crossover index, narrowed with conviction as the year wore on. Twelve months ago they were above 4%. Now they are under 2.5% and have closed below 2.2% in the last few weeks. At that level they were almost exactly in line with the average for 2006 when the Great Recession was a mere glint in the US mortgage market’s eye. Consider also that only this month we saw a default event materialise in the banking sector of a south European country. Just imagine the effect this would have had on markets in late 2011 / early 2012. In this case spreads came off their lows but by no stretch of the imagination has there been any sign of real panic. The transformation is astounding.

Equity has found some tentative direction too. As late as mid-April, year to date returns for both the MSCI World Index of developed-world markets and the MSCI Emerging Markets Index stood at an unbeatably dull zero. But since then they have now risen to 7.3% and 9.4% respectively.

Past performance, as they so rightly say, is no guarantee of future returns. There are several “known unknowns” to contend with as the year continues. Political risk in the Middle East and Ukraine shows no sign of subsiding. Earnings growth, especially in Europe, needs to come through to support equity markets at current valuations. And the ancient phenomena of price inflation and monetary tightening could provide unsettling surprises as the quarters grind on.

While there is nothing to stop them being unwound, however, these signs of a rediscovery of market direction are cautiously encouraging. Looking forward the safest observation we might make is that the behavioural inconsistency in some asset prices should not be expected to persist indefinitely. Bears, as well as bulls, now have a little more scope to position themselves accordingly.

25/07/2014 at 4:04 pm

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