Market Commentary – 12th July 2017

How resilient is the UK economy?

There hasn’t been much happening in the face of politics this week, which we feel is important to highlight. Yes, it is apparent that Theresa May is still struggling to make her time in Parliament a success. However, what is important lies in the data coming out of the UK. Today morning, the Office of National Statistics (ONS) released employment data which showed that unemployment fell to 1.49m down from a previous 1.53m. This just shows the resilience of the UK economy, despite all the uncertainties surrounding us politically and economically. The UK employment is at its highest level since 1971 which shows that 32.01m people are currently in employment.

On the contrary, the ONS also released wage growth data which showed that wages have increased at 2%, but slower than inflation which is currently at 2.9%. Higher employment is translating to higher wages, however a reduction in real pay (adjusted for inflation) doesn’t fair well for economic growth as the UK economy is heavily reliant on the consumer and falling real incomes will inevitably translate into lower retail sales. Wage growth is one of the Bank of England’s (BoE) key metrics when setting interest rates, as higher wages will ultimately create upward pressure on prices. Weak pay growth makes it increasingly likely interest rates will be held at 0.25% for now – a view reinforced yesterday by BoE deputy governor Ben Broadbent, who declared he isn’t yet ready to vote for higher rates. This makes it virtually certain that Bank Rate will remain at 0.25% at the August meeting. All Committee members apart from new external member, Silvana Tenreyro, have now commented on the record since the June meeting and of which only two, Ian McCafferty and Michael Saunders, have suggested that they will vote for higher rates in August.

Global Economic News

In the UK, while recent economic data has generally pointed to a slowdown in economic activity, labour market numbers covering the three months to May showed little sign of that weakness hitting the jobs market. The number in work increased by 175,000 on the previous three months. This was the biggest gain in a year and pushed the employment rate up to an all-time high of 74.9%. Meanwhile, a 64,000 fall in unemployment to 1.495m sent the Labour Force Survey (LFS) jobless rate down to 4.5%, a rate last seen in the summer of 1975. The inactivity rate also dropped to 21.5%, the lowest since records began in 1971. This solid performance probably reflected in part the continued ‘cheapness’ of workers. Total pay rose by only 1.8% in three months to May on a year earlier, down from 2.1% in April. This was the slowest rise since November 2014 and alongside rising inflation, corresponded to a 0.7% fall in real earnings, a pace of decline not seen for three years. A combination of strength in labour market quantities with weakness in wages offers a mixed picture in terms of households’ ability to spend more. Given that the jobs market tends to respond to economic activity with a lag, firms’ willingness to hire may falter given signs of an economic slowdown. The continued absence of wage pressures is further reason for the more hawkish members of the MPC to pause for thought.

In Europe, earlier this year, there were concerns that the hard data was not matching the increasing strength seen in the surveys. That argument now appears to have been decisively answered, with the hard data closing the gap. Leaving all the Easter-related distortions behind, the May industrial production data has been nothing short of stratospheric and suggests that the European corporate sector is enjoying a veritable boom. Industrial production (excluding construction) rose by 1.4% in Germany, 1.9% in France and 1.2% in Spain. Without question this means the industrial sector is set to make a very significant contribution to growth in these countries in Q2. GDP indicators now point to growth of 0.9% in Germany, 0.8% in France and a full 1% in Spain. Across the euro area, growth looks almost certainly looks set to record 0.7% expansion but it could easily be higher. For the year as a whole, GDP growth is now likely to average at least 2.1% but could easily be higher. This would be the fastest and most sustained pace of European expansion for 10 years. Encouragingly, the recent survey data suggests the momentum has been maintained going into Q3, potentially pointing to a repeat of Q2’s stellar performance. Interestingly, this month’s French service sector PMI was revised up by a full 1.6 points between the flash figure and the final release. Normally the revisions to the PMIs amount to no more than a few tenths of a point, so this is a huge revision. As a result, the euro area services PMI was revised up to 55.4. In addition, Eurozone industrial output increased 1.3% in May (after a downwardly revised gain of 0.3% in April), beating consensus estimates of a 1% rise, but more in line with our forecast of 1.2%. This recovery in industry has been broad-based across the Eurozone, with country-level data indicating a synchronised increase in output in Q2 so far.

In the US, Nonfarm payrolls rose by 222,000 in June following a revised May increase of 153,000 (previously +138,000). April’s payroll gain was also revised higher to 207,000 (previously +174,000). Quirks in the timing of the Bureau of Labour Statistics (BLS) payroll survey suggested that the payroll data might come in higher than expected, a reversal of the lower than expected reading in May. Overall this is a solid report that reflects still strong increases in payrolls, modest gains for earnings, and very little slack. Average weekly hours rose a tenth to 34.5 while average hourly earnings increased 0.2% month-over-month and were up 2.5% year-over-year. Despite strong payroll gains, wage growth continues to disappoint. Overall, the jobs report is encouraging for the Fed. It allows policymakers the option to announce balance sheet normalisation starting in Q4 on account of the employment mandate being met, but gives them a rationale to delay rate hikes into 2018 on account of a still-weak trade-off between unemployment and wage growth. In other updates, June manufacturing payrolls rose by 1,000 after edging down 1,000 in May. Durable goods industries posted a payroll increase of 9,000, while nondurable goods industries suffered a loss of 8,000 jobs. Much of the weakness in the nondurable sector was related to food processing. Leisure & hospitality payrolls rose 36,000 after rising 25,000 in May. The gain was driven largely by food service payrolls, which dropped by 3,300 in June. Retail payrolls increased by 8,100 after declining by 7,200 in May. The June gain seems to be an artefact of the calendar effect associated with the early May reference period. Overall, the retail sector is losing jobs owing to the closure of many chain stores, reflecting the switching from brick and mortar operations to internet-based selling. Construction payrolls increased by 16,000 following a 9,000 gain in May. Here again, the early reference period in May seems to have lowered the May increase in construction payrolls, but gave a boost to category in June. Natural resources/mining payrolls increased by 8,000 in June after rising 6,000 in May. June presented the 8th consecutive monthly increase in the series. The improvement is related to higher oil prices of late and an increase in the number of operating oil rigs, which has been addressed in the barometers below.

Barometers

The Barometers below look at some of the data we review on a day by day basis and by having these detailed, it gives you some insight into what is happening.

US Earnings are important because if the US starts to slow down, then so does the rest of the world.

As of today (with 5% of the companies in the S&P 500 reporting actual results for Q2 2017), 78% of

S&P 500 companies have beat the mean EPS estimate and 87% of S&P 500 companies have beat the mean sales estimate. For Q2 2017, the blended earnings growth rate for the S&P 500 is 6.5%. Nine sectors are expected to report earnings growth for the quarter, led by the Energy sector.

UK & Non-UK Gilt Yields;

UK and Non-UK Government Debt are a good measure, as they indicate whether we expect the economy to improve or worsen, with rising yields reflecting positive environment and reflecting positive interest rate movements as we look out. The opposite with lowering yields as the expectation is worsening economic conditions.

Over the last week, we have seen bond yields decrease slightly with corresponding valuations increase in Europe and North America. The opposite was true for the UK with valuations decreasing and yields slightly increasing. Across the board they have been relatively flat with not too much change over the past week, however volatility remains high in these assets which should not be functioning like this. This is a further example of why we are still not directionally investing into these assets.

GBP to USD/Euro/JPY;

We monitor the GBP rate to see how much of the returns are coming from underlying equity valuation increases and movements in the currency, to see if we should be locking in the gains and hedging the risks. We have changed our 12-month expected range for sterling across the US Dollar, Euro and Japanese Yen. This is to reflect a stronger pound, following Brexit, and less negative risk due to the UK economic data stabilising, and therefore uncertainty risk is dropping off. As Brexit matures, we expect Sterling to weaken over the coming months as negotiations set off both sides prevaricate, then reappreciate towards year end to roughly where we are now or slightly higher.

With the UK employment data out today, sterling has gained some ground from its volatile session as it struggles to pass 1.30 against the US Dollar. Currently trading at 1.28, sterling is a sensitive topic at the moment and any news seems to have an effect. Sterling did stumble yesterday after Broadbent’s comments of not voting to increase the interest rate in the next MPC meeting in August. With markets still pricing in around a 45% chance of a rate hike later this year, this remains the key downside risk to sterling in the near-term.

GBP / USD – Range 1.32 – 1.20 – Today at 1.28
GBP / EUR – Range 1.20 – 1.10 – Today at 1.12
GBP / JPY – Range 150 – 130 – Today at 145

Oil Price;

We monitor the oil price as it is a strong indicator of global consumption when balancing the output and storage data. Strong supply and usage denotes a strong global economy. Opposite reflects underlying weaknesses.

The price of oil over the past week has been quite volatile and has dropped, but is edging back upwards. As a whole, oil is improving slightly with WTI Crude currently trading at $45.94 and $48.34 for Brent, down approx. 2.3% for WTI and down approx. 2.6% for Brent. US regulator, the Energy Information Administration (EIA) said last week that both raw crude and petrol stocks had declined markedly, which should be a bullish sign. But as global oil reserves are holding stubbornly near record highs, attention is being focused on production figures and the number of active US drilling rigs which rose last week for the 24th time in 25 weeks. OPEC, Russia and other producers have said they will maintain production cuts of 1.8 million barrels a day until March, but it is questionable OPEC’s powers in term of limiting output. Those cuts have succeeded in stemming increases in global reserves, but without meaningful inroads into reducing inventories and with production rising in the US, pessimism reigns. For prices to rally more sustainably, OPEC will have to deepen these cuts, or at least extend them to cover Libya and Nigeria, the two members currently excluded and which are ramping up output. US output is now above 9.3 million barrels and some believe it could hit the ten million mark by next year, putting it on a par with the biggest producers in the world.

Gold Price;

Gold is a safe haven and a spike in price can be an indicator of increasing underlying economic concerns and as always, the opposite.

Over the past week, we have seen the price of gold remain relatively flat and dropped only approx. $7 an ounce to $1,216 a troy ounce. It is speculated that the price of gold could fall below $1,200 an ounce in the coming days amid speculation of tighter monetary policy by central bankers. The hawkish tones around the globe are mainly driven by sturdy US jobs data which was released last Friday. This has acted as a catalyst for the gold traders to push the price below the mark of $1,200. These “hawkish tones” includes comments by the European Central Bank that they might begin to raise interest rates and reduce their bond buying programs. In addition, there is the decision by the US Federal Reserve to raise interest rates twice so far, this year, with further tightening predicted after figures last Friday showed the economy added 220,000 jobs last month which makes it a high possibility.

Model Portfolios & Indices

Over the last week we have seen most of the indices that we track remain relatively flat with some rising. Hong Kong’s Hang Seng reached a two-year high when their markets closed today, with banking shares helping to push the index past the 26,000 mark. The Bank of China and the Industrial and Commercial Bank of China both rose by more than 3%. Elsewhere, stocks headed lower as the US dollar slipped in the wake of the latest controversy for US President Donald Trump. Japanese, Korean and Australian markets all headed lower as local currencies strengthened against the US Dollar. UK markets have gained some ground today morning following positive data from the ONS showing that unemployment has reduced and wage growth as increased (still not in line with inflation).

Given all the volatility in the markets, it’s important to note that our portfolios have remained relatively flat over the past week. With regards to the equity and non-equity elements of the portfolios, our equity positions have remained strong as we have skewed most of the allocation towards Europe and other prospering markets, which is doing well following strong economic data. With regards to our non-equity exposure, with bond yields increasing, risks are raising following hawkish tones from central bankers. Bond prices vary inversely with interest rates and it is expected that these risks will continue to rise until we get some clarity from central bankers on their stance to tackling global inflationary pressures. Until then we remain cautious of these high risks and will tackle the issue when we feel that risks are too high.

This Day in History

With Wimbledon exciting us all, we thought we’d let you know that on this day in 1928, the first televised tennis match was broadcasted. The details of the match are not clear and nor is the results based on the time elapsed.

As always have a wonderful week and stay safe.

VBW

Jason