Market Commentary – 16th August 2017

Has the geo-political landscape calmed down?

Following on from last week’s commentary, it seems that the geo-political tensions between North Korea and the US have eased off, as North Korean leader Kim Jong-Un has decided not to immediately launch a missile strike at the US base on the Pacific island of Guam, rather it was more of a war of words. These tensions eased over the weekend after Trump spoke to the Chinese premier Xi Jinping who said both parties should “maintain restraint”. Moon Jae-in, the president of South Korea, which along with the US is still technically at war with the North, insisted “the North Korean nuclear situation must be resolved peacefully”.

We would like to highlight that these are just minor hiccups in the markets, clearly over the short term these geo-political tensions can affect markets, but over the medium to long term, they have very insignificant impact. This shows that from an investors perspective, we cannot focus and relay on the “political noise”. Sure, we should be vigilant around the noise and keep a close eye if it was to escalate, however our concerns should be more focused around the economic fundamentals, which are the key barometers and drivers for economic growth.

We’ve had a bit of news with regards to Brexit, as the government has published its latest position paper and says it wants to agree upfront with the EU that there will be no hard border between Northern Ireland and the Republic of Ireland, specifying there is no need for “physical infrastructure”. The document also suggests a “new customs partnership” with the EU. Also, the government wants the EU to agree a temporary customs union for up to two years after Brexit. After that period, the UK will either enter another union with the EU or match its customs arrangements closely. Labour’s Keir Starmer said the plans were “incoherent and inadequate”.

Global Economic News

In the UK, early this week we got inflation data and this morning we received unemployment and wage data from the Office of National Statistics. The Consumer Price Index (CPI) is now at 2.6% in July which was the same as it was in June, and the Retail Price Index (RPI) climbed to 3.6% up from 3.5%. Labour market numbers for the three months to June continued the broadly positive theme, familiar from recent releases. The number in work increased by 125,000 compared to the previous three months, lifting the employment rate to a new record high of 75.1%. Joblessness dropped by 57,000, cutting the LFS unemployment rate from 4.5% to 4.4%, the lowest since May 1975, and the number of unemployment people per job vacancy remained at a record low of 1.9%. The theory that workers are effectively pricing themselves into employment continued to be supported by the performance of wages. Granted, headline (three-month average of the annual rate) growth in average weekly earnings edged up to 2.1% in June from 1.9% in May. But the latter had been the lowest three-month growth rate since February 2016, and in real terms, pay continued to fall, down 0.5% in the three months to June. But the squeeze was not quite as sharp as in the previous set of earnings numbers. Meanwhile, the only source of sustainable long-run growth in pay rising productivity remained absent in Q2. Output per hour fell by 0.1% in the quarter, following a 0.5% decline in the first three months of the year. This left productivity no higher than the pre-crisis peak, nine years earlier. Combined with a sluggish economy, this suggests that the outlook for earnings and hence consumer spending growth remains poor. But that the number in work is holding up so well at least offers one silver lining.

In Europe, one of the Eurozone economy’s puzzles is how wage growth has remained remarkably subdued, despite an almost record number of new jobs created during the current upturn. It is expected that the Eurozone economy will now hit a sweet spot. After a protracted period of slow but steady economic growth, a cyclical upturn starting last year is likely to drive the fastest GDP growth in a decade this year. As a result, the output gap, which is the deviation of actual output from potential output, has shrunk significantly from a trough of -3.7% in 2013 to an estimated -1.2% this year, and will continue to diminish further. The labour market finally started to pick up too. In the first quarter of the year, more than 650,000 found jobs – the largest quarterly increase in employment since the financial crisis. Yet at the same time, this exuberance in the real economy is inconsistent with the weak price dynamics we currently see in the Eurozone, which is puzzling central bank officials. Eurozone industrial production staged a bigger than expected decline in June, falling 0.6% on the month from a downward revised 1.2% increase in May. However, the series revisions meant that the general forecast of 1.2% QoQ growth in Q2 was realised, and that Eurozone industry enjoyed one of its best quarters of expansion since 2010 and contributed nearly a third of the Eurozone’s 0.6% QoQ GDP growth in Q2. While the latest readings leave industrial output lagging the pace of growth indicated by surveys, such as manufacturing PMI and European Commissions production expectations, they are still at the top-end of the recent range. Furthermore, because the June figures were heavily distorted by calendar effects in Germany and the notoriously volatile French reading, it paints a positive picture heading into Q3 with surveys remaining elevated. The breakdown of the subcomponents provided a more serious tone, with capital goods and durable consumer goods exhibiting the largest monthly falls of 1.9% and 1.2% respectively. In fact, the only sector not to exhibit a decline was energy, which increased 1.8% on the month. Such consistent declines across most of the subcomponents has not been seen this year and is again likely a manifestation of the volatility at the country level mentioned above. We, as well as our fund managers, are still optimistic on the Eurozone outlook heading into H2. Consumers are showing resilience to higher inflation, helped by the Eurozone’s remarkable employment gains, and investment is showing signs of a material pickup which is largely attributed to the Eurozone’s export-led growth this year.

In the US, putting all the geo-political tensions aside, the economy is looking relatively strong with markets reflecting strong earnings. With the economics, the July CPI rose 0.1%, following an unchanged reading in June. The core CPI was up 0.1% in July also, following a similar increase in June. We also had strong retail sales data for July. Retail sales were up 0.6% in July, better than the estimate of 0.3%. The June 0.2% decline was revised up to a gain of 0.3% while the May 0.1% decrease was revised to a very modest increase of 0.04%. Auto dealer sales were up 1.2% in July, a second month of solid gains. Unit auto sales were little changed in July, but auto dealer sales were likely boosted by an ongoing abundance of incentives and discounts. Auto dealer sales were up 5.7% YoY July, still strong but slipping from the prior month’s annual change of 6.0%. Excluding auto-dealers, retail sales rose 0.5% in July, following a 0.1% gain in July (revised up from -0.2%). This was stronger than the estimates of 0.3%. Excluding auto dealer, sales were up 3.8% YoY in July, versus 2.7% in June. Gasoline station sales were down 0.4%, owing to declining prices. Gas station store sales were up 2.1% YoY, versus unchanged in the prior month. Excluding gasoline station sales, July retail activity surged 0.7% following a 0.4% gain in June. YoY, excluding gas station stores, sales were up 4.4% in July, after being up 3.6% in June. Excluding both the volatile auto dealer and price driven gasoline station components, July retail activity was up 0.5%, after rising 0.3% in June. From a year ago, this component was up 4.0%, up from 3.0% gain in the prior month.

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 91% of the companies in the S&P 500 reporting actual results for Q2 2017), 73% of S&P 500 companies have reported positive EPS surprises and 69% have reported positive sales surprises. For Q2 2017, the blended earnings growth rate for the S&P 500 is 10.2%. Ten sectors are reporting or have reported 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 edge up then fall back down and they have decreased slightly with corresponding valuations increasing in Europe and the US. With the UK, yields headed higher then fell back to parity with corresponding valuations remaining relatively flat with risks priced into the assets. The outlook in this space is not as positive as it was with yields continuously dropping since Donald Trump won the US presidential elections and therefore risks are high, which justifies a cautious stance moving forward with this asset class. A turning point would be once central bankers bring rates higher which will reduce the volatility in fixed income 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.

Following the unemployment and wage data that came out this morning, sterling improved slightly. It is however still lower than it was last week, when it was trading around the 1.30 mark with the US Dollar attributed to the better-than-expected inflation figures for July released yesterday. These lower-than-expected inflation figures have sent the pound lower, largely because they make the prospects of a rate rise this year more remote. As the Eurozone continues to strengthen, the Euro conversely strengthens which means that from a GBP / EUR perspective, this is edging closer to parity and means that we have had to change our range. We do not see the Euro weakening at this juncture and will therefore take appropriate actions in our portfolios to reflect this.

GBP / USD – Range 1.32 – 1.20 – Today at 1.28
GBP / EUR – Range 1.14 – 1.05 – Today at 1.10
GBP / JPY – Range 150 – 130 – Today at 142

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.

Oil has recently been a very interesting story and its price over the past week has fallen. WTI Crude is currently trading at $47.80 and $51.14 for Brent, down approx. 2% for WTI and approx. 2% for Brent. Most of this drop was attributed over the concerns about China, the world’s second largest oil user showed that there was a “steeper than expected” drop in oil refinery inventories in July, knocking trader sentiment on supply. Another reason was the drop in the US Spot Dollar Index (DXY) as oil is priced in US Dollars, which measures the US currency against a basket of six peers, as tension between Donald Trump and North Korea’s Kim Jong-Un seemed to ease. On the supply front, the Nigerian subsidiary of Royal Dutch Shell has announced it has lifted a force majeure on some exports from the country. Despite falling US reserves in recent weeks, all of this gives a sense that the global market remains over-supplied and will remain over-stocked following years of excess production. The Chinese data is especially important. A report from the OPEC cartel last week identified rising demand as the one bright point in the market, after it admitted its own output was 400,000 barrels above its pledged cap.

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 sharply increase, then sharply decrease as investors saw refuge in the safe haven asset after the geo-political concerns regarding North Korea and the US increased, then diluted down. Gold is currently trading at $1,270 a troy ounce after peaking close to $1,290 as the world awaited a response from North Korea leader, Kim Jung-Un to Trump’s “Fire and Fury” statement. From here, it could be expected that the price of Gold futures could continue to fall as there are less risks in the markets and more positives.

Model Portfolios & Indices

Over the last week we have seen most of the indices that we track drop following the geo-political tension between North Korea and the US and their allies. Since the weekend, we have seen the threat fade away and markets are continuing their rally upwards.

Next week Tuesday, 22nd of August, we will be holding our Investment Committee Meeting in which we will complete a top down analysis of the world and re-review our asset allocation with any areas we think we should make changes too. For example, as the Euro continues to climb, we will discuss and change our currency hedged positions share classes to reflect the upwards potential in the Euro. We will also consider our forward guidance and will change any positions we highlight risks moving forward.

This Day in History

On this day in 1989, a solar flare from the Sun created a strong geomagnetic storm and when this hit earth a few minutes later due to the distance, this affected microchips which led to a halt of all financial market trading on Toronto’s stock markets.

As always have a wonderful week and stay safe.

 

VBW

Jason Stather-Lodge  CFP, MCSI, APFS
CEO & Founder
Chartered & Certified Financial Planner
Chartered Wealth Manager