Market Commentary – 04th October 2017

Does Boris Johnson want the PM job?

Theresa May will tell the Conservative conference today that infighting over Brexit must stop in order to “fulfil our duty to Britain”. The PM will demand that her colleagues stop worrying about their own jobs and instead focus on the jobs of “ordinary working people”. She is reportedly under pressure to fire Foreign Secretary Boris Johnson.

Boris Johnson delivered a speedy speech to the Tories yesterday, saying it was time to “let the British lion roar” as he called, for Brexit to be a moment of national renewal. Mr Johnson addressed his ministerial responsibilities to cover issues such as low pay, childcare and green technology. Johnson vowed the UK would not “bottle out” of Brexit and dismissed pessimistic predictions of the damage it will cause. Following his speech, there was no sign that he was looking at the PM for her job, yet.

Meanwhile on the continent, the European Parliament has offered up a savage assessment of Britain’s Brexit negotiating strategy after passing a motion calling on EU leaders to delay the next phase of talks. It is important to note that sufficient progress has not yet been made on major divorce issues, including the rights of EU citizens, the Northern Irish border and the so-called Brexit divorce bill. Next week is when the fifth round of talks are due in Brussels and they will be aimed to move to the next phase of negotiations, and agree a post-Brexit trade deal in time for this month’s European Council Summit. At the time of writing, the PM is making her key speech to the Conservative Party conference in Manchester. The European Parliament’s chief Brexit negotiator Guy Verhofstadt said he hoped May would use the speech to provide more “clarity” on the Government’s plans for the UK’s withdrawal from the EU.

Global Economic News

Being the beginning of the month, we have been receiving Purchaser Manager Index (PMI) figures from Markit which imply economic strength. Figures above 50 indicate growth and below 50 indicate a decline.

In the UK, though the headline PMI from the CIPS services survey edged up from 53.2 in August to 53.6 in September, this still represented a below par outcome. With the manufacturing and construction surveys weakening in September, this left the composite PMI barely changed compared with August. This implies that GDP growth has continued to run at a quarterly pace of around 0.3%. Any good news from the uptick in the headline balance was offset by more worrying signs in the detail, with growth in new orders slowing to a 13-month low and more rapid growth in input costs and output prices. The recent behaviour of the MPC suggests that these latter two developments are likely to be of greater concern to Committee members than the further evidence of sluggish activity. Despite the case for a rate hike being weak, the MPC appears to be virtually convinced of the need to make its move. And there was nothing in today’s survey which is likely to dissuade the Committee from this view, given that it had made clear that a continuation of the recent sluggish growth rates would not be enough to prevent them from acting. It is expected that the MPC will hike interest rates at its early-November meeting. Admittedly, a small rate rise would slow growth only modestly, but the message sent by such an action risks pushing the economy further into a low growth expectations trap. And the Bank has alternative tools for dealing with the adverse side-effects of ultra-low rates. A rate rise in November would be a mistake. It is necessary to go all the way back to July 2007 to find the last occasion on which the MPC raised the Bank Rate. But the MPC’s recent mood-music suggests that the 10-year break will end soon.

In Europe, the final Eurozone manufacturing PMI for September was a touch lower than the flash estimate, but at 58.1 is the highest reading in seven years. This is good news for the Eurozone as the sector accounts for 20% of total output, with the sharp rise of the euro seemingly not having a negative impact on export performance so far. But survey data has recently overestimated the hard data. Industrial data for August (to be released at the end of this week and at the start of next) will give the markets more clarity regarding the momentum in industry in Q3. For the moment, it is expected that Eurozone GDP growth will decelerate in Q3 to 0.5%. The estimates of the Italian and Spanish indices, which did not report the flash estimates two weeks ago were positive. The Italian manufacturing PMI was 56.3 in September, unchanged from August and remaining at a six year high. The increase in capacity pressure also means that employment creation will remain supportive and that capital investment will start to accelerate at a stronger pace. A key factor behind the resilience of Eurozone may be the ongoing strength of the labour market recovery. August’s Eurozone unemployment figures showed a 40,000 fall in the number of unemployed and the jobless rate remaining stable at its eight-year high of 9.1%. This is confirmation of the strong German labour market results released on Friday, along with other countries such as Italy, which continue to show that the labour market is continuing to recover at a reasonable pace. The trend of labour market strength is expected to continue over the coming months, as is clear from employment expectations released. The employment intentions indicator is consistent with a robust quarterly rise in employment of around 0.5% q/q. After 1.3 million jobs created in H1 (Q1 and Q2), this would imply yet another substantial number of workers entering work in the Eurozone, which is a strong barometer of growth and indicator of the bloc’s resilience.

In the US, the ISM Manufacturing Index rose 2.0 points to 60.8 in September, a second month of upward momentum and cresting the 60-mark for the first time since June 2004. While the number makes for good headlines, there isn’t too much emphasis on this month’s reading by investors. Much of the rise was due to a sharp increase in delivery times, as supply chains felt the impact of two major hurricanes hitting the Gulf Coast and South-eastern states. It is expected that the spike in the headline number will fade as activity in the affected regions comes back online. However, with production firmer and new orders turned higher, there is still plenty of reason to be upbeat on the outlook for manufacturing. Absent the noise from the storms, conditions in the factory sector are still humming along and there is plenty of indication that the solid expansion will continue. Four of the five components in the ISM Manufacturing Index were up and one was down. As noted above, much of the increase was concentrated in supplier delivery times and new orders, but the components have remained consistently solid so far in 2017. This one-month spike higher is likely to fade, but it should not change the story of underlying robust conditions. The new orders index was up 4.3 points to 64.6 in September, its highest since 65.1 in February. The component has remained at a 60+ level for the past four months, a string of readings that point to consistently solid conditions. The sub-index for order backlogs inched up to 58.0 in September, not far above the recent trend, but the highest since 61.0 in April 2011. Taken together, new orders are strong and allowing some build-up in the pipeline that will support activity going forward. The production index rose 1.2 points to 62.2 in September from 61.0 in August. This component has also now spent four months in a row above the 60-mark. The employment index was little changed, up 0.4 point to 60.3 in September from 59.9 in August and was the highest since 61.0 in June 2011. Survey respondents noted that shortages of skilled workers are being felt as businesses ramp up production.

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. 

For Q3 2017, the estimated earnings growth rate for the S&P 500 is 4.2%. Eight sectors are expected to report earnings growth for the quarter, led by the Energy sector. For Q3 2017 (with 16 companies in the S&P 500 reporting actual results for the quarter), 13 companies have reported positive EPS surprises and 13 companies have reported positive sales surprises. The forward 12-month P/E ratio for the S&P 500 is 17.7. This P/E ratio is above the 5-year average (15.6) and above the 10-year average (14.1).

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 across the bloc for the US, UK and Europe. Risks in the markets are relatively subdued, 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 and both sides prevaricate, then reappreciate towards year end to roughly where we are now or slightly higher.

Sterling over the past week has dropped against the US Dollar and has improved slightly in today’s trading following positive Services PMI data. The latest survey on the services sector has come in better than expected, which has improved the negative sentiment around the markets following recent disappointing data releases for the UK economy, such as yesterday’s Construction PMI which indicated a contraction in the industry. Regardless of all this volatility, Sterling was the best performing G10 currency in September. Sterling was coming from a weak base; however, it is improved due to the more hawkish commentary coming out of the Bank of England about interest rates and how we could expect a rate hike in November. As the Services PMI data was above 50, this gives the MPC ammunition to increase the bank rate. However, based on tomorrow’s figures for new car registrations, if this is also weak, it will be very difficult for the bank to hike rates. Sterling remains resilient at the top of our range.

GBP / USD – Range 1.32 – 1.20 – Today at 1.32
GBP / EUR – Range 1.15 – 1.04 – Today at 1.12
GBP / JPY – Range 150 – 130 – Today at 149

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 decreased and is remaining quite volatile. WTI Crude is currently trading at $50 and $55 for Brent, down approx. 2% for WTI and approx. 5% for Brent. Oil had a bit of positive sentiment from the response to Turkey’s threat to cut off Kurdish oil exporters, after the Kurds voted overwhelmingly for independence. Kurdistan produces just 600,000bpd, or about 15% of Iraq’s total output. However instead of focusing on the volatility, we should look at the current price and understand what this means. Brent prices have only moved up into the upper-$50s because the underlying fundamentals have improved markedly in the last few months. Rising demand and flatlining global supplies, coupled with OPEC’s cuts since January, seem to be finally putting upward pressure on the commodity after three years in the doldrums. Still, OPEC shouldn’t jump the gun by declaring victory. The third quarter is typically when demand is strongest, and shale oil producers may well respond to the upward trend by ramping up supply even further. OPEC members themselves might also be tempted to capitalise on the new environment, which would quickly depress prices again. OPEC and others have cut production by 1.8 million bpd, but U.S. shale producers have not held back. Their output is set to rise for a tenth month in a row in October.

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 drop approx. $17 an ounce to $1,275 a troy ounce. Gold has dropped slightly as economic conditions have improved and risks in the markets seem to be less, even though volatility remains high. Investors are long gold futures over the risks of inflationary pressures which will continue being a problem. Gold reached touching distance of recent highs during the Jackson Hole talks. Since then, gold has been relatively flat after reaching highs in September.

Model Portfolios & Indices

Over the last week, we have seen all the indices that we track improve marginally with most of the gains made in the US and Europe. The reason for this is mostly driven by the dampened geo-political and economic risks facing the markets especially with the tensions between North Korea and the US slows. Stock markets have been able to focus on strong earnings with diluted risks and in the US, stock markets are reaching record highs whilst the US Dollar remains relatively weak.

Our model portfolios have benefited from this week’s lack of geo-political and economic risks, and we are in line with our expectations. Following last month’s quarterly rebalance, we are seeing our new positions benefit the portfolios and provide the portfolio diversification they need in this economic cycle. Given our current defensive stance, if the risks highlighted above were to feed themselves back into the markets, our portfolios would remain in line with our expectations as we have reduced the risk off the table.

This Day in History

On this day in 1911, the first escalator was installed on the London Underground. Construction of the Underground began in 1858 and opened to the public in 1863. The escalator in question was installed at Earl’s Court Station.

As always have a wonderful week and stay safe.

VBW

Jason