Market Commentary – 2nd August 2017

Could Brexit stretch until 2022?

Chancellor Philip Hammond has given the clearest indication yet that the UK will not make a sudden exit from the EU in 2019. He said that the UK would quit the single market and customs union in 2019, but said “literally nobody” wanted a post-Brexit migration “cliff-edge” because “we have a high level of dependence on foreign workers in the UK”. Also, MPs have warned that the next general election will be a “second referendum” on Brexit, if Philip Hammond gets his way, over a transition period lasting up to three years. Meanwhile, London mayor Sadiq Khan says Brexit could be avoided if the Labour party included the pledge in an election manifesto or committed to a second referendum.

Global Economic News

In the UK, tomorrow the MPC is due to have its meeting on deciding if interest rates should now finally be increased, after 10 years of low rates to stimulate the economy from the 2007/8 financial crisis. Some may argue that rates should be increased and some argue that it shouldn’t. This is now a more complex situation by factoring in Brexit. The outcome of the last MPC meeting in June and comments by some committee members since, have implied a shift in thinking against the current level of monetary support. But weaker than expected growth and inflation, and the likelihood of a downgrade in growth forecast in August’s inflation report suggests that hawkishness will be rowed back this month. You may remember, in the meeting there was a 5-3 vote to keep the Bank Rate on hold in June, which left the MPC more divided than at any time since 2011 and caused a sizeable shift forward in investors’ expectations of the timing of raising rates. This shift was subsequently supported by a surprising hawkish speech by the Bank’s Chief Economist, Andrew Haldane, who suggested that a partial withdrawal of monetary stimulus “would be prudent moving into the second half of the year”. Only time will tell what the 8 members will decide tomorrow. Today, we received construction PMI and this shows that growth in the UK’s construction sector fell to an 11-month low in July. The UK construction Purchasing Manager Index (PMI) fell to 51.9 from 54.8 in June. Yesterday, manufacturing PMI was published. For a sector as export-orientated as UK manufacturing, it seemed only a matter of time before the dual boost provided a weak currency and a stronger global economy materialised. July’s CIPS manufacturing survey suggests that point may have been reached. A rise in the PMI to 55.1 from 54.1 in June was the first increase since April and left the index well above the long-run (post-1992) average of 51.6. Driving this expansion was a particularly marked increase in the balance of firms reporting a rise in in export orders. This hit the second highest level since 1992, beaten only by that recorded in April 2010. Growth was broad-based, with UK manufacturers reporting a rise in orders from all the major global regions. July’s survey also delivered more reassurance that the recent session of rising inflation is on the decline. Input prices rose at the slowest rate in a year and growth in output prices also eased, both consistent with the trend indicated by the official less timely data. This further bolsters our expectation that the MPC will deliver a firm majority in favour of keeping monetary policy on hold when its next meeting concludes on Thursday. But it remains to be seen whether what has been a striking discrepancy between weak official manufacturing data and more robust survey evidence, narrows as we move through Q3. With debt levels, a slowdown in consumer credit growth in June means that the latest household lending numbers for June should offer a modicum of comfort for financial regulators. The data also pointed to a slowdown in the mortgage market. But with household finances under pressure from elevated inflation, borrowing is providing a useful fillip to consumer spending. Advocates of action to cool households’ appetite for debt should be careful what they wish for.

In Europe, GDP releases reinforce the view that economic activity intensified in Q2. GDP releases for France, Spain and Austria point to a 0.7% quarterly expansion for the Eurozone as a whole. In Spain, GDP rose 0.9% on the quarter, its strongest in two years, and Austria saw its economy expand by 0.8%. France registered stable growth in Q2, with GDP rising by 0.5% for the third quarter in a row, suggesting that the recovery there has reached a more self-sustaining cycle. As such, the composition of growth in France points to a more mature cycle. While investment growth slowed following a surge in Q1, household spending recovered from its Q1 slowdown to rise by 0.3%, supported by a vibrant labour market. Meanwhile, net trade added 0.8% points to GDP. Exports rebounded by 3%, offsetting the Q1 slowdown that was linked to one-off factors in Q4 2016 and highlighting that French exporters have benefitted from the upswing in regional and global trade. However, inflation pressures remain contained and even though economic growth has probably reached a peak in the Eurozone, the picture for inflation remains weak. Eurozone GDP grew by a preliminary 0.6% in Q2. The number was in line with consensus expectations, but was a slight disappointment. While the number could still be revised up, it appears to confirm that surveys have been overestimating growth in the first half of the year. The final manufacturing PMI for July was revised down to 56.6 points. Although this marks the lowest level in four months, the overall picture remains one of robust activity in the Eurozone manufacturing sector going into H2. Decreasing consumer confidence seem to point to momentum turning down on the consumer side. Yet this drop was mainly driven by French households being less upbeat about their savings and their future situation. Although this is at odds with an improving employment and economic backdrop, it perhaps suggests that consumers are wary of the budget cuts announced by the Macron government. Elsewhere, in Germany, Italy and Spain, confidence levels rose, with households still expected to complete major purchases such as cars in the coming months. Lower savings prospects and a more upbeat employment outlook suggest that consumers expect some of the real disposable income squeeze on consumption to be offset by higher employment and a lower capacity to save. This also explains a more upbeat tone in services, which reported higher demand and employment expectations, as well as further rises in capacity utilisation.

In the US, yesterday we received data that the ISM Manufacturing Index dipped 1.5 points to 56.3 in July from 57.8 in June. Still strong, however there were declines in the components for new orders, production, employment, and delivery times. However, the slower readings still left the components at levels consistent with robust conditions in the factory sector. The ISM noted that the economy has expanded for 98 months in a row, and that survey respondents were generally upbeat on the outlook for manufacturing activity. It is expected that rising manufacturing activity will support solid real GDP growth over the coming quarters. Construction spending disappointed expectations with a 1.3% month on month decline in June. On an annual basis, construction spending was up only 1.6% in June, down from May’s 3.8% annual gain and the weakest since November 2011. The decline in construction spending in June (coupled with revisions to spending data for April and May) points to a downward revision worth roughly 0.2% points off of Q2 real GDP growth, bringing the estimate down to 2.4% from the BEA’s initial estimate of 2.6%. The Department of Commerce’s national account revisions show real disposable income trending just above 1% year on year since the start of the year, which is much lower than the pre-revision 2 to 2.5% trend. As the data stands, real disposable income growth has not breached the 2% mark since early 2016. Consumers had been spending within their means from the Great Recession through 2015. However, in 2016 the income and spending trends started diverging. While US households maintained a steady pace of outlays around 2.5% year on year, income slowed and the shortfall was filled by a “savings dip.” The latest data shows the personal savings rate at 3.8% – much lower than the pre-revision level around 5% and down about 2% points since the start of 2016. The general concerns on this front is two-fold. First, low real disposable income growth comes despite low inflation – with core PCE inflation running at a 10-month low of 1.5% year on year. Second, “savings dips” tend not to be sustainable in the medium run. Outside of income and savings, alternative sources of consumer spending growth could come from credit or wealth. However, consumer credit growth has also slowed in recent months, the non-revolving portion owing to weaker light-vehicle sales, while the plateauing of revolving credit is due to a mix of weaker demand and slightly tighter bank lending. On the wealth front, rising stock prices are a positive for confidence, but the financial gains generally benefit wealthier individuals with low marginal propensities to consume. And while real estate assets continue to rise, the progress has been quite gradual. In short, this points to modest consumer spending growth which equates to approximately 2% on wage growth, a fiscal stimulus program or a greater savings dip. It is expected that only gradual wage growth may accelerate low odds of a major fiscal stimulus, and it does not expect much downside to savings given the closeness to previous cycle lows.

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 57% of the companies in the S&P 500 reporting actual results for Q2 2017), 73% of S&P 500 companies have beaten the mean EPS estimate and 73% of S&P 500 companies have beaten the mean sales estimate. For Q2 2017, the blended earnings growth rate for the S&P 500 is 9.1%. Ten sectors are reporting earnings growth for the quarter, led by the Energy sector. This has been a busy time as we have been getting quite a bit of earnings data from companies. The S&P 500 is the highest it’s ever been.

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 with corresponding valuations increasing in Europe and the UK. The opposite is true for the US, where yields increased with corresponding valuations decreasing. 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 and both sides prevaricate, then reappreciate towards year end to roughly where we are now or slightly higher.

Over the past week, we have been watching the US Spot Dollar Index (DXY) which shows us the strength of the US Dollar relative to a basket of foreign currencies. The US Dollar has been weakening based on the latest meeting of the policy-setting open markets committee. The Fed statement didn’t have anything too unexpected and didn’t raise rates. This has been sending down DXY to its lowest level. This means that in relative terms, the currency exchange markets will strengthen as the US Dollar is the underlaying global currency. This now means that cable (GBP / USD) is trading above 1.32 on the backdrop from Dollar weakness. In Asia, the Japanese Yen has strengthened due to high export data following strong global demand and a cheaper USD.

GBP / USD – Range 1.32 – 1.20 – Today at 1.32
GBP / EUR – Range 1.22 – 1.12 – Today at 1.11
GBP / JPY – Range 150 – 130 – Today at 146

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 very interesting, rising for the most of it and dropping sharply yesterday. WTI Crude is currently trading at $48.79 and $51.46 for Brent, up approx. 0.9% for WTI and approx. 1.7% for Brent. The market is burdened with a huge overhang from three years of excess production and the oil price is still only around half of its pre-summer 2014 level, when it crashed. Brent crude, the international oil price benchmark, fell from two-month highs yesterday, after a report showed OPEC output rose in July. However, that is still markedly higher than price levels in the $40s that persisted for most of the past two months. The recent upsurge, apart from yesterday, was driven by the powerful OPEC cartel agreeing to extend its ongoing production cap to Nigeria, albeit at 200,000 barrels above current output, and to limit exports from its largest producer, Saudi Arabia, in August. There was also a report suggesting a hefty drawdown of US crude oil stocks and that new shale-oil drilling in the country is slowing.

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 increase approx. $20 an ounce to $1,265 a troy ounce. Gold has made strong gains after the latest Federal Reserve policy statement. Another reason why gold is relatively strong at this juncture is based on the US Dollar weakness, which in turn followed from the latest meeting of the policy-setting open markets committee. The Fed statement didn’t break unexpected ground, but by not being hawkish it validated the recent dovish shift in expectations of a flatter rate hiking trajectory. That sent the dollar down to its lowest level against the euro for 14 months and so helped to lift gold, which is typically held as a hedge against the greenback.

Model Portfolios & Indices

Over the last week we have seen most of the indices that we track remain relatively flat. Momentum in the markets has been improving this week following strong earnings from various companies. US Stock Markets are performing at record levels and this is true for the Dow Jones, which is almost reaching 22,000 and the S&P 500, which has been at its highest level. In Europe and the UK, we have too been receiving strong earnings reports, which boosted the FTSE 100 yesterday (almost up 1%). The FTSE 250 has been performing well due to a devalued sterling and has helped improve firms purchasing power parity in exporting terms. Asian shares have been performing well on the backdrop of poor performance from the USD and therefore, jumps in exports due to an increase in global demand. Japanese Yen has also strengthened against the dollar improving Japanese stocks.

Our portfolios have remained relatively flat over the past week following all the volatility in the markets, however volatility has been lower than it has been historically and we continue to monitor the correlation between assets and the value at risk for each element of the portfolio. As we progress through the economic cycle, we will continue our defensive approach and will directionally invest your capital in areas we have strong conviction in, once markets start to improve.

This Day in History

On this day in 1880, the British Parliament officially adopts Greenwich Mean Time (GMT) when government legislation finally settled on a single standard time zone for the country, but by then most towns had seen the writing on the wall and had already made the necessary changes, and it was all thanks to the GWR – God’s Wonderful Railway. The GWR company, running trains to the west country and Wales, soon found that there was considerable confusion as far as guards, station masters and the all-powerful railway timetables were concerned. Watches were having to be continually altered as the trains moved rapidly from one ‘time zone’ to another, perhaps within the space of just 20 or 30 miles. And, of course, with trains beginning to run from all parts of the country such confusion invariably led to an increasing risk of accident and collision.

As always have a wonderful week and stay safe.

VBW

Jason