Tuesday, 26 August 2014


It has been another record setting week for equity markets. Despite summer normally being known as a 'quieter' period, the S&P 500 hit a new high, while bond yields retreated on the expectation that Federal Reserve Chair Janet Yellen would deliver a dovish assessment of US economic growth prospects

Summer trading volumes continued to be light, but that does not take away from the fact that investors appear to be in an optimistic mood and are increasingly favouring risk assets like equities. Corporate bond markets also moved tighter, relative to government bonds, but they remain more restrained than stock markets. Gold moved lower, falling 2% on the week and is crucially back below $1,280 a troy ounce, even as the US dollar fell on broad weakness (due to the strength of the Euro). US government bonds declined in the face of the strength of equities, with the 30-year yield down 3 basis points and the 10-year yield hitting around 2.4

Now that we have moved into the second half of 2014, it is becoming increasingly evident that different parts of the global economy are moving at different speeds. On a global level, the forward looking indicators are suggesting a further period of expansion is ahead, albeit within a fairly compressed range. However, the divergence in prospects for the US, UK, China, Japan and Europe could not be more clear. Purchasing Manager Indices show that the US and UK are powering ahead, while China looks to be re-accelerating as a result of stimulus measures and mildly accommodative monetary policy.

In contrast, the fortunes of the Eurozone and Japan appear more mixed. Japan has now essentially recorded almost no growth in GDP over the past year, as consumers come to grips higher sales taxes and businesses are seeing sluggish volume growth in exports, although a weaker Yen would provide a solid boost. Growth also seems to be elusive for the Eurozone, with countries stagnant or in outright recession. It is possible that the sanctions European leaders put on Russia could further dampen prospects in the near-term. Countries that have higher leverage to the Russian market are already calling for a moderation in the sanctions, as their economies are seeing export demand plunge and prices drop as supplies of agricultural produce, flood the market. German banks remain undercapitalised and their balance sheets loaded with sovereign debt, so any potential quantitative easing programme would need to be mindful of this fact

At some point, either European governments or the European Central Bank will have to bite the bullet and launch large scale structural economic reform (governments) or some form monetary stimulus (ECB), or potentially some combination of the two. All of the current ECB actions appear to have been designed to buy time and allow governments to enact structural reform. Italy's new youthful Prime Minister, Matteo Renzi has a large opportunity change the country for the better. Until some significant action occurs, the Eurozone may bumble along, flirting between mediocre growth and recession, like Japan did for nearly 20-years and this might act as a drag on the wider global economy.

Tuesday, 12 August 2014


This week it felt like August picked up and continued exactly where July ended รข€“ geopolitical events overwhelming the positive macro-economic news front and driving equity markets lower. The one positive to record is that Israel ended its offensive in Gaza and US president Obama agreed to provide air strike support to Iraq to prevent the ISIS' extremists from further massacres of non-Muslims

The global capital markets media homed in on Russia's counter sanctions as the reason for the continued market sell-off. I would beg to differ and see these geopolitical tensions as the catalyst for the rout at this moment. I see the equity market weakness more generally as a precursor to this economic cycle entering a period of rising interest rates. In the past, during such periods of rising interest rates, equities (and bonds!) have sometimes suffered sustained losses, when central banks misjudged the strength of the economic momentum and rather than cooling it down to prevent overheating, have prematurely choked it off through too fast and large a rate rise, causing recession. This is what market participants are currently most frightened of. 1993/1994 was one of those relatively rare negative occurrences of such policy errors, whereas normally the economy continues to expand (and in its wake equities) while interest rates are slowly adjusted upwards from a post-recession level back to more normal long running averages. This time around one could argue that last year's 'taper tantrum' of parallel equity and government bond value declines was this cycles' 'rate-rise-prospect-wobble'

However, I have to admit that quantitative easing (QE) on top of extremely low interest rates make the onset of monetary tightening (interest rate rises) in this cycle particularly unnerving for market participants. As a result I am observing what can only be described as policy error paranoia. Despite the US and UK central banks continually reassuring markets that they will not prematurely raise rates, the market chatter and action in this respect has been relentless. I take comfort from the macroeconomic and company results news flow, which tells us that the economy is steadily expanding with increasing momentum and companies are able to improve their results. Last year we saw equity markets fret the beginning of the QE reduction (taper), but when it actually began they moved on and actually rallied substantially following the announcement (just before Christmas). It is possible that the first actual rate rise may have the same effect, but on the basis that history never quite repeats itself exactly it is just as possible that markets move on earlier. In this regard we observe that shorter term yields rates have already gently moved up in anticipation of an also gentle rate rise, which is a far more proportionate reaction by the bond market than the indiscriminate and sudden upwards jolt of the yield curve over the taper tantrum last year

Matters like these were discussed at length this week in preparation and during Tatton's monthly investment committee meeting. The outcome of this comprehensive review of the medium term economic prospects and anticipated market reflection has resulted in a decision to adjust the fixed income investments of the Tatton portfolios to take account of the anticipated environment ahead. In summary we have come to the conclusion that as a consequence of the past years' desperate search for yield of so many investors, corporate bonds have now reached a level of overvaluation as we previously experienced with government bonds at the beginning of 2013. The distinct difference between government bonds (gilts) and corporate bonds (investment grade, high yield and junk bonds) is that gilts only carry yield curve risk (that yields will rise and fall), whereas corporate bonds additionally introduce an element of company risk exposure, which is akin to stock market risk. It has become all but consensus that the yield uplift corporate bonds provide in return for the additional company risk is now so low that the combination of the underlying components or government bonds (yield curve) and a smaller proportion of equities (corporate) generate a very similar risk characteristic, but at the moment with a much improved return profile. So while we have avoided government bonds for the past 18 months, we are now reintroducing them to the portfolios. After the gilts value declines of 2013 we now see a much reduced capital loss risk in them over the medium term, while they once again provide their extremely valuable risk counterbalance to stock market investments

While remaining confident about the US continued economic recovery, she noted that wage inflation remained "very low" at 2%. Markets took comfort in the expectation that, while short-term rates may rise, long-term monetary conditions will remain accommodative. With the impact of the US's cold winter on the first half of the year, it was no surprise that overall 2014 growth forecasts were reduced. The Fed still expects growth for the remainder of 2014 to continue at strong (weather-unaffected) levels. Indeed, the Fed's own expectation for the timing of first rate rise is now more hawkish (read: earlier) than the markets had priced before the meeting. This is a reversal of last year's situation, when the Fed guided that the first rate rise was likely to be later than the markets were anticipating. It appears that, as is often the case, markets have overshot the target on the other side now

As discussed in last week's edition, portfolio orientations which add value over the medium term, can sometimes lead to the opposite results over the shorter term, while day to day markets gradually oscillate between fear and greed towards a more rational valuation level. I am therefore bracing myself for the potential of some pain before the gains can be enjoyed. I so wish it was possible to refine the timing of these moves, alas, where short term developments are dominated by human emotions rather than the laws of natural science, only the investor for the longer term will look through the short term fluctuations as a necessary evil on their investment path. At Tatton, we are convinced that over the next 12 months it is a larger risk to long term returns to be underinvested in equities, than it is to be invested. In the shorter term this conviction may well initially face some testing times.