Review of the week: Strange signs of optimism

US stock markets reached new high last week, and other less conventional signs of optimism also appeared. In our latest Review of the Week, chief investment officer Julian Chillingworth considers what it all means for the longer term.

Last week was a good one for equities and bonds, as Federal Reserve (Fed) chief Jerome Powell’s dovish testimony to Congress reassured investors that US rates will be cut at the end of the month.

US stock market indices reached new record highs, but what is perhaps more remarkable is a strange, and never-before seen, signal of optimism (or complacency, depending on your view) that has appeared in European bond markets: several high yield (aka junk) bonds are now trading at negative yields. For UK investors, gains in sterling (as it rallied from recent Brexit-induced lows) eroded gains from overseas assets when translated back into the local currency.

High yield bonds are thus named because of their typically higher yields, due to poorer credit quality (rated ‘BB’ and below) and the need to provide more compensation to investors for taking on that risk in the form of higher returns. In this paradoxical situation of negative-yielding ‘high yield’ bonds, investors are paying for the privilege of lending to companies with less than stellar credit quality. The most likely explanation is a firm belief that yields will only get more negative (prices will go higher).

In the short term, this is good news for the companies selling the bonds, but in the long term negative yields – apart from being an aberration - destroy capital. And that’s not good for savers, investors or the economy in general. 

For his part, US President Donald Trump said he believed that the Dow Jones Industrial Average would gain 5,000-10,000 more points if Fed officials would only listen to his advice. The soothing words of Fed officials are unlikely to satisfy Mr Trump’s desire to talk rates down and the market up, so we can expect more of the same. Markets are likely to continue hanging on the words of Fed officials and scrutinising each piece of US data, waiting with bated breath for the first of several expected rate cuts at the conclusion of the Fed’s next meeting on 31 July.

Most commentators are now expecting a further cut in September, fuelling market hopes that the US central bank will do what is necessary to stop the economy going into recession. In this somewhat unusual state, bad news – anything that confirms the US economy is weakening enough to warrant aggressive rate cuts – is likely to be ‘good news’, and vice-versa.

With the second quarter earnings season getting underway, analysts are expecting S&P 500 profits to fall 3% on average. But what is key is company guidance for the future – that’s expected to signal a bottom in declining earnings with a return to positive numbers in the second half. If guidance is unexpectedly negative, equity and corporate bond markets could come under pressure.

What is US data telling us? US core CPI inflation for June came out at 2.1%, slightly above consensus forecasts for 2.0%, but that did little to change investors’ views that a rate cut on 31 July is baked in

Index

1 week

3 months

6 months

1 year

FTSE All-Share

-0.6%

1.7%

10.4%

1.4%

FTSE 100

-0.6%

2.0%

11.2%

2.5%

FTSE 250

-0.5%

0.1%

7.1%

-3.2%

FTSE SmallCap

-0.9%

0.8%

5.6%

-2.4%

S&P 500

0.4%

8.5%

19.4%

15.0%

Euro Stoxx

-0.9%

6.2%

15.2%

3.8%

Topix

-1.0%

6.4%

7.0%

3.4%

Shanghai SE

-3.1%

-6.4%

14.9%

5.4%

FTSE Emerging

-1.0%

3.4%

10.5%

9.1%

 

Source: FE Analytics, data sterling total return to 12 July

Battle lines drawn over oil

Tensions between Tehran and Washington remain high, and an attempt over the weekend by France, Germany and the UK to broker a peace deal had little success. They weren’t helped by more leaked Foreign Office emails suggesting that Donald Trump’s move to tear up the US-Iranian agreement was done more out of spite for his predecessor President Barak Obama, the architect of the deal, than a well thought out strategy.

Meanwhile, it may be getting increasingly difficult for Mr Trump to talk the markets higher, given some unintended side effects of his aggressive policy by Twitter. Tensions continue to rise in the Persian Gulf, with a British frigate moving in last week to protect a UK oil tanker being harassed by Iranian gun boats. The UK currently gets little of its oil from the Gulf, but does import considerable amounts of LNG gas from Qatar, which so far have not been targeted by Iran. The US has ratcheted up pressure on Iran by also imposing sanctions on petrochemicals, another of the Gulf state’s major export earners, in the last few weeks.

In a separate but related issue, China was reported to be importing about a million barrels a day of Iranian oil last month. So far, the US seems to be overlooking it, but with trade talks appearing to stall again over the past week, White House hawks are pushing the President to impose secondary sanctions on Chinese entities. The upshot has been higher oil prices, with Brent crude trading toward $70 per barrel into the end of the week. With the great US summer driving season under way and the race for president heating up, higher prices at the pump aren’t likely to endear voters to the President.

Meanwhile, hopes for a future driven by autonomous electric vehicles got a boost last week when Volkswagen announced it was investing $2.6bn in Argo AI, Ford’s autonomous vehicle unit. Argo will develop vehicles for both VW and Ford, which still owns the majority stake. VW is putting in $1bn of cash alongside its autonomous driving research unit, which is valued at $1.6bn. The deal is believed to be part of a wider alliance between the two companies as they seek to crack autonomous cars.

And lest we forget…Brexit

Back home in the UK, this week will bring an end in the UK to the Conservative Party leadership race – a bit of a damp squib after the recent excitement of the Cricket World Cup, Wimbledon and Silverstone. Favourite Boris Johnson is likely to be Prime Minster by next week, but with a very limited time to re-negotiate a better Brexit deal ahead of the UK’s scheduled departure from the EU on 31 October. Parliament is due go into recess shortly, returning in September. Expect a lot of ‘no deal’ talk in the press this week, with the odds having risen. Once again, sterling will be the barometer as to whether markets believe it is likely – the current reading is a low $1.25, but that’s up from its recent trough. Mr Johnson, in an interview, claimed that the odds of a no deal were a million to one. Decent odds if he would honour the bet.

Bonds

UK 10-Year yield @ 0.84%
US 10-Year yield @ 2.11%
Germany 10-Year yield @ -0.25%
Italy 10-Year yield @ 1.73%
Spain 10-Year yield @ 0.57%

 

Economic data and companies reporting for week commencing 15 July

 

Monday 15 July

US: Empire Manufacturing

 

Tuesday 16 July

UK: Labour market

US: retail sales

EU: Euro area trade, German ZEW economic survey

 

Wednesday 17 July

UK: Inflation

US: Housing starts
 

Thursday 18 July

US: Philadelphia Fed Business Outlook

Japan: Tankan Survey

Final results: Sports Direct

Final results: Moneysupermarket.com

 

Friday 19 July

UK: BoE credit conditions

US: University of Michigan Consumer Sentiment

 

Total votes: 11

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