Market Update. August 2016.

Central banks

At the beginning of the month the Bank of England cut interest rates from 0.5% to 0.25%. The market expected the move, however the reaction was strongly positive due to additional stimulus being announced – including an asset purchasing program for corporate bonds. A summary can be found in a previous post. In the US the Fed has given mixed messages, economic data is reaching levels that should justify a hike, unemployment is at 5% and PCE inflation is at 1.6% (2% is target), however officials remain uneasy over global growth and BREXIT uncertainty. It is also possible they are trying to take it slow, due to a bubble emerging in ‘safe haven’ government bonds. A sudden hike could case investors to sell government bonds, in what Singer, Elliott Management Hedge Fund states will be “surprising, sudden, intense and large”.

What can we expect? Bank of England to keep UK rates at 0.25% until late this year. The Fed to um and ah, most likely having one rate hike nearer Christmas.

The trade. Long on FTSE index tracker. I’m expecting article 50 not to be exercised and the Bank of England to possibly lower rates further, both positive for the UK stock market over the next year.

BREXIT

BREXIT is still dominating the headlines. Will the UK leave? When will article 50 be exercised? Most importantly for financial markets, will the US banks send their staff overseas? Before the referendum many American banks noted that they would move staff abroad. This is set to become a reality, Morgan Stanley are looking at a headcount of 2,000 and JPMorgan 4,000. Their biggest concern is over the future of financial passports – the ability to perform financial services in mainland EU but from London. This is potentially very damaging to the UK services industry. According to New Financial 87% of US bank’s EU staff are based in the UK, with 78% of capital market activity occurring in The City. The exodus is expected to be so significant that the banks are set to coordinate the timing of their applications for EU domicile, in order to prevent regulatory staff becoming too overloaded.

On a positive note UK data post-BREXIT doesn’t look too bad, yet. Retail sales were up +1.4%, compared to an expected +0.2%, and those claiming unemployment benefits fell by 8,600. As usual the summer heat fed the market’s obsession of attributing unexpected results with the weather, which is claimed to be the major cause of the retail sale’s figure.

An interesting development post-BREXIT has been the fall in UK government bond yields. The UK 10 yr yield has fallen from 2% at the beginning of the year to near 0% following BREXIT. This is a complete detachment from fundamentals. The value of GBP fell following BREXIT over fears of a weaker UK economy. This economic weakness, combined with a credit rating downgrade, should have pushed up UK government bond yields. With less confidence in the UK economy investors should sell the bonds, decreasing their price and raising their yield. Instead we’ve seen a tremendous increase in demand for UK government bonds – without context you would think it is a safe haven asset. Why?

The answer to this is central banks, and the result is a bubble in bonds.

What can we expect? BREXIT to continue dominating the headlines, uncertainty building up towards the end of the year as the market tries to guess when Article 50 will be exercised. UK economic data to worsen. US Banks to likely keep quiet about jobs until BREXIT is confirmed.

The trade. Binary betting on UK economic data may prove profitable. Buy government bonds and ride the capital rise, however good luck getting out before the bubble bursts.

Markets hitting record highs

In the US markets hit record highs, with the S&P at 2,183 and the Dow Jones at 18,552 . The Fed showing increasing support to keep rates at current levels for the foreseeable future and the Bank of England lowering rates is causing a search for yield, which has led to an increase in the demand for stocks. This is, in some ways, a tactical approach from the central bank. Higher stock markets raise individual wealth and thus cause more spending. Furthermore businesses see their value increase, which allows greater borrowing and investment. However this means that stock prices are becoming, similar to bonds, detached from fundamentals and simply part of a redistribution of funds forced onto investors by the Fed.

The main fundamental points currently affecting the markets is likely to be Oil nesting above $40 and retail companies coming out strong. The oil industry in the US is vast therefore a potential increase in profits is going to push the markets up, especially if OPEC agree on a supply freeze. Likewise retail companies are rallying, which indicates an increase in consumer confidence and a broader rise in spending.

What can we expect? I feel we’re on the edge of a burst, stock markets and bond markets are going to end up down. Either rates will rise bringing markets down, or Banks will fail due to low base rates causing an economic standstill on terms with 2008.

The trade? Long S&P500, ride the honeymoon period until October – pay attention to Fed minutes and decision. Make sure to place a stop loss.

 

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