Market Commentary – 6th September 2017

Brexit negotiations hit choppy waters

As we had feared, the third round of Brexit negotiations ended with little tangible progress being made and both sides expressing frustration at the approach of the other. The UK’s complaints stem from a perceived lack of flexibility from its counterparts, with the mandate given to the European Commission’s negotiators requiring them to focus on separation issues and not engage in talks about trade and other aspects of the future relationship. Meanwhile, the EU is frustrated by the UK’s reluctance to engage on separation issues, despite having previously agreed to this sequencing of talks.

There will be another round of talks in the week beginning 18th September but the next key date is the meeting of the European Council on 19th October. This is the point at which EU leaders are due to decide whether “sufficient progress” has been made on separation issues, such that discussions can then move onto the future relationship. On the face of it, it looks unlikely that the answer to this question will be “yes.” But the UK clearly hopes that it can convince the EU leaders to alter the mandate they had previously given Michel Barnier and allow him to talk about the future relationship in parallel with the separation issues. The UK hopes to achieve this outcome by playing hardball over money.

Global Economic News

In the UK, the recent economic data showed a continuation of the themes which have developed during 2017. On the consumer side, there was further evidence that the boom in unsecured lending, which has helped to cushion households from the effects of the real wage squeeze, is fading. June and July have seen a clear softening in lending growth, particularly in terms of non-credit card borrowing. And while the GfK measure of consumer confidence ticked up in August, it remains at subdued levels and consumers show no real desire to make major purchases, which suggests that lending growth is unlikely to rebound in the near future. This cooling in lending will no doubt be welcomed by the Financial Policy Committee, given their recent concerns, but it provides further evidence that consumer spending growth is set for a lengthy soft patch. August’s CIPS services survey offered further evidence of diverging fortunes between different sectors of the economy. The survey’s headline activity balance dropped to 53.2 from 53.8 in July. While still indicating expansion in the sector, this was the weakest reading since September 2016 and noticeably softer than the 54.2 averaged in the first seven months of 2017. August’s slowdown was driven in part by hotels, restaurants and other consumer-facing businesses, with survey respondents citing uncertainty about Brexit and the domestic economic outlook as factors weighing on business confidence and activity. That said, and somewhat at odds with the weak headline reading, the survey’s measure of backlogs of work rose at the fastest pace since July 2015 and jobs growth touched a 19-month high. August’s weaker services reading followed a drop in the same month’s construction PMI. While the manufacturing survey pointed to stronger growth in that sector, manufacturing’s small weight in the economy meant that August’s composite PMI fell to an 11-month low. Taking an average for July and August, the composite measure is consistent, on the basis of past form, with GDP growth in Q3 repeating the second quarter’s sluggish 0.3% pace. So, another reason for the MPC to exercise caution when it makes its next interest rate decision on 14th September.

In Europe, tomorrow is the European Central Bank’s Interest Rate decision day. It is unlikely that a rate hike will be announced, and the focus will rather be on tapering their Quantitative Easing (QE) program. Also, this morning the decline of German factory orders in July is not as much of a big concern, although it surprised the markets. The monthly fall of 0.6% came after two strong months. Moreover, excluding the drop in volatile big tickets orders, “core orders” increased by 0.6% on the month. Thus, the underlying order momentum (3-months on 3-months change) only eased a little suggesting healthy demand for German manufacturers at the start of Q3. Despite the strengthening of the euro in recent months German export orders seem unaffected so far. Overall export order momentum remained robust and stable in the past three months with a small pick-up in orders from non-Eurozone countries making up for an easing of orders from the other Eurozone countries. This would support the notion of the more hawkish ECB council members that the effect of a stronger euro on activity could be limited at the current juncture and more a sign of Eurozone recovery. More timely measures of export demand like IFO export expectations and PMI new export orders, on balance, also point to solid demand in the months ahead. Overall, Euro-boom seems to continue in Q3. With the recent strength of the euro apparently not denting external demand yet, messaging will be key for Draghi at tomorrow’s ECB press conference. It is expected that he, as well as the ECB council, will show their pleasure with the on going strength of the recovery and highlight that core inflation is some way off its lows. However, that will be balanced by dovish rhetoric regarding the euro and its disinflationary impact. It is generally doubted that there will be any specifics on the likely reduction of the monthly QE purchases already in September. An announcement in October is more likely and given recent press reports December has become possible.

In the US, as expected, nonfarm payrolls rose by a solid 156,000 jobs in August following an upwardly revised July increase of 189,000 jobs (previously +209,000). Revisions showed 41,000 fewer jobs were added over the two prior months, but the twelve-month moving average remained steady at a solid 175,00 jobs per month. Overall, this is a solid report that reflects a maturing labour market with ongoing cyclical tailwinds to labour force participation offsetting headwinds from ageing demographics. Wage growth remains moderate but this is not surprising given low inflation and productivity growth. The private sector added 165,000 in August with an outsized contribution from the goods producing sectors. Mining added 6,000 jobs whilst the construction sector added a very encouraging 28,000 jobs and manufacturing employment advanced by a surprisingly strong 36,000 jobs, coming in large part from the motor vehicle sector. Going forward, these sectors may see less growth on account of cyclical trends and disruptions from Hurricane Harvey. The service sector had a lacklustre month with only 95,000 jobs added. Retail trade only added 1,000 jobs while leisure and hospitality disappointed with a meagre 4,000 jobs gain during a normally busy summer season. Finally, the public sector witnessed an expected 9,000 jobs decline led by job losses in states and localities. Average hourly earnings increased 0.1% in August and wage growth remained on a moderate 2.5% y/y trend for the fifth consecutive month. The official (U-3) unemployment rate rose a tick to 4.4% on weaker household employment but remains at a historically low level, whilst the U-6 unemployment rate held steady at 8.6%. The labour force participation rate also held at 62.9%. This report, in conjunction with PCE inflation at 1.4% y/y, will persuade Fed policy makers that another rate hike in 2017 is not warranted. Instead, we see the onset of balance sheet normalisation as a signal of passive and predictable monetary policy normalisation into 2018. With the US ISM Manufacturing Index, this rebounded to 58.8 in August to its highest level since April 2011. “Steady” and “strong” are the watchwords for the factory sector. Four out of five components had increases led by employment and inventories. New orders were virtually unchanged.

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 99.6% 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 70% have reported positive sales surprises. For Q2 2017, the blended earnings growth rate for the S&P 500 is 10.3%. 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 increase with corresponding valuations decrease in the US and the Eurozone. The opposite was true for the UK with bond yields decreasing with corresponding valuations increasing. Bond markets have been quite volatile recently given the geopolitical tensions between North Korea, and the US and the US’s allies. 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.

The pound has climbed despite the weak services sector data out earlier. The currency, which was skirting an 11-month low, is now up 0.2% against both the dollar and the euro. A strong pound tends to devalue the foreign earnings of London-listed firms, hitting their share prices. Due to the relative weakness in the pound recently, manufacturing and exports are doing well driving growth, however inflation will start to become more of an issue and impact domestic demand. Earlier this week, the pound slipped slightly following weaker-than-expected construction PMIs. Compounding matters is a growing belief among economists that the Bank of England will not raise rates until 2019. This would account for the pound’s recent weakness, as the markets no longer believe that the BoE is willing to raise rates, a marked difference to the excitement over the ECB’s anticipated quantitative easing tapering that has boosted the euro from strength to strength.

GBP / USD – Range 1.32 – 1.20 – Today at 1.30
GBP / EUR – Range 1.15 – 1.04 – Today at 1.09
GBP / JPY – Range 150 – 130 – Today at 141

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 seems to be improving. WTI Crude is currently trading at $48.75 and $53.45 for Brent, down approx. 5.6% for WTI and approx. 3.4% for Brent. The tropical storm which struck the coast of Texas on 25th August took out almost one quarter of all US refining capacity. Eight refineries, with the capacity to refine 2.1 million barrels per day, remained shut on Monday. It might seem logical that the price of oil would increase when production was restricted by storms. In fact, it fell, partly because refineries were no longer buying and partly because America’s fourth-largest city, Houston, was brought to a standstill and stopped buying gasoline. The price of oil in the UK was boosted yesterday by hopes that OPEC nations and other major oil producers might extend an agreement to cut the amount of crude oil they produce. Oil’s long price slump from highs three years ago has been caused by a huge global oversupply of the commodity, put simply, with more oil on the market, the price is lower. Last year, OPEC nations and other producers including Russia announced their most concerted efforts yet to limit production and raise the price. But factors including natural disasters and political events have conspired to keep oil around the $40 to $50 mark. Now, Russia and Saudi Arabia have discussed extending the production cut, giving traders some hope for a price rally this year.

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. $31 an ounce to $1,338 a troy ounce at the time of writing. Given the current global outlook, investors seem to be seeking safe-haven assets as the current market risks are high following Hurricane Harvey and the geopolitical tensions between North Korea and the US. Gold passed the $1,300 mark when Donald Trump’s threat to shut down the government if he is not granted funds to build a wall on the Mexican border, has been generally positive for gold. Since that has started to die down, Gold futures remain relatively expensive given the tensions in the market.

Model Portfolios & Indices

Over the last week we have seen most of the indices that we track improve. However, since Sunday markets have slowed down when North Korea carried out its sixth nuclear test. This move is a direct challenge to Donald Trump. South Korean media said the blast was 9.8 times the strength of Pyongyang’s test last September. Investors are relatively cautious moving forward in this economic cycle as the risks have increased and investors are seeking safe-haven assets. Traders are clearly nervous, as stocks are lower, but the sell-off early this week hasn’t been as bad as previous ones. This suggests that dealers are getting somewhat used to the situation. The fear-factor is certainly doing the rounds, but investors’ nerves are a bit more resilient this time around. The UK economy seems to be falling further behind the eurozone as firms worry about Brexit and consumers feel the pinch of rising inflation and the weak pound. Manufacturers are benefitting from increasing demand in Europe and beyond, but the much bigger UK services sector grew at its weakest pace in nearly a year in August.

Our model portfolios have increased slightly over the past week given the nature of the portfolios being well diversified with a strong equity and non-equity split. We will remain relatively cautious through this economic cycle and will diversify the proceeds of recently sold positions (such as the Artemis Pan European Absolute Return Fund) into areas which have strong upside potential.

This Day in History

On this day in 1916, the first true supermarket was opened. Famously known as the “Piggly Wiggly”, it was the first self-serviced store and was opened by Clarence Saunders in Memphis Tennessee.

As always have a wonderful week and stay safe.

VBW

Jason