Current racing conditions: quicksand remains endemic. Q4 preferences: neutral equities, within equities overweight euro zone and Japan. Overweight cash at the expense of bonds. A short duration bias in bond markets is removed in favour of neutral duration.
This week: No end to the quicksand, neutral duration in fixed income, Volkswagen – so much for state involvement in industry!
No end to the quicksand
- If investing in financial assets were a camel race, it would be abandoned on grounds of too-much quick sand on the track. It’s dangerous out there: nothing is cheap, both equities look vulnerable to higher US rate increases (bonds perhaps less than is thought- see comment below), the US corporate earnings growth cycle has begun to roll over, and meanwhile slower Chinese economic growth threatens to drag down demand growth across the world.
- Furthermore, no one can be sure of the degree of dependence of financial assets on zero interest rate policies (ZIRP) and quantitative easing from central banks, and therefore the impact on global markets as the US Fed attempts to raise rates for the first time since 2006.
- Indeed, the Fed is adding to the confusion. Janet Yellen told us last week that the central bank is still looking to raise rates this year. But weak Chinese economic data – the reason she gave for delaying a hike earlier this month- remains a problem. For instance, last week Chinese manufacturing confidence –a good leading economic indicator- fell to a six year low. Anecdotal evidence suggests the Chinese economy has slowed to around 5% GDP growth, a far cry from the 7% official target rate. Why is weak Chinese data a factor in US rate setting one week, but not in another?
- Unfortunately investors can’t abstain from capital markets when cash returns are near-zero. To use an already over-used cliché, it is a case of ‘keep calm and carry on’. To those who keep a properly diversified portfolio of financial assets, I suggest taking a very low-risk approach for the fourth quarter while we wait for the Fed to move, the US and global economy to react, and for markets to give their verdict.
- I continue to be a long term supporter of Euro zone and Japanese equities relative to the US and emerging stock markets.
Neutral duration in fixed income
- In May we saw US 10 year bond yields leap 25 bps one week, to 2.32%, on fears of imminent US rate hikes. Advisers and market commentators –including myself- recommended short duration Treasuries and other core government bond markets. After all, far better to own a one year bond that will mature in 12 months and then enable you to reinvest at a higher rate of interest, than to be locked into a low-paying 10 year bond until 2025.
- However, today I’m not so sure that core government bond markets will see an outflow from long duration positions when the Fed finally raises interest rates. There is an increasing risk that a premature rate hike will weaken the US and the global economy, and will squash any incipient real wage-driven US inflation in its tracks. If this happens, the Fed will be forced to reverse its wage hike early next year, similar to the experience of Sweden and other countries that have tried in recent years to escape from near-zero interest rates.
- This might explain why, despite Janet Yellen last week reminding us that the Fed wants to raise rates sometime before the year-end, and last week’s upgrading of US second quarter GDP growth to 3.9% annualised, the 10 year Treasury yield is this morning trading at a modest 2.13%. It is also the reason why I am now recommending a neutral duration position in core government bond markets.
Volkswagen – so much for state involvement in industry!
- The Volkswagen emission fraud story reminds us that individual sector and company foolishness can torpedo our savings, irrespective of macro economic themes. It is to avoid the risks associated with individual stock investing that we buy funds.
- While much has been said about VW already, I’ll add a few points. First, Volkswagen’s corporate structure appears to be that of a family company that has grown on the back of regional state support from the government of Lower Saxony and subsidies. It is proof –if any were needed after the experience of the UK car industry in the 1970s- that increased state influence in industry is not the solution for failure of governance. Please not Jeremy Corbyn.
- I haven’t seen any mention of the controversial Transatlantic Trade and Investment Partnership (TTIP) in this row, but presumably it weakens the hand of the EU negotiators. Particularly given that EU officials did nothing about the emissions fraud despite knowing of it for two years, according to Saturday’s Financial Times.
- The TTIP is an attempt to increase trade between the US and the EU by reducing non-tariff barriers. Key barriers are differing health and safety standards, as applied to foods, drugs and manufactured goods. The EU’s stance –at the risk of gross generalisation- is to argue that it has higher standards than the US, and that it’s should prevail. ‘Besides’, European mutter amongst themselves, ‘..we all know how easy it is for big business to knobble regulators in the US in order to weaken consumer protection’. This argument, certainly as regards car emissions, now looks hollow. Not only are the standards for diesel emissions higher in the US, but European manufacturers appear to have had political cover to help cheat them.