A fortnightly look at global financial markets – 11 April 2016

The following is a detailed commentary and analysis from deVere Group’s International Investment Strategist, Tom Elliot asking; does another downward lurch in stock markets beckon? Giving up on over-weights in euro zone and Japan, and the E.U referendum principle arguments.

Q2 asset allocation preferences (unhedged US dollar-based, updated at start of quarter): neutral equities vs. fixed income. Within equities, favouring a low volatility/ high dividend strategy with no active regional or country positions. Longer term outlook is to be pro-risk assets.

Does another downward lurch in stock markets beckon?

• Is the second quarter going to start as badly as the first quarter? After last week’s volatility, investors can be forgiven for fearing as much. But there are three reasons why I doubt it:
• First, the Fed is far more emollient in its forecasts for US rate hikes than it was three months ago, while recent economic data suggests continuing stable economic growth in America. Second, the much-forecasted hard landing for the Chinese economy has failed to materialise. At 6.5% the economy is still growing at a decent clip.
• Third, as I discussed a fortnight ago, a major source of weakness on financial markets in recent years has been the resources sector. But this is going through a period of period of self-healing. Certainly, it remains very susceptible to news flow from China regarding potential demand growth. But the over-supply issues that bedevil companies in the resources sectors are being addressed through the axing of new energy and mining projects, and closing of uneconomic operations. Companies are bearing down on operating costs, and less generous but more sustainable dividend policies.
• This is not to ignore the many worries that investors legitimately have, but it helps balance a diet of negative news stories that – like moths to a lamp – investors such as ourselves are always drawn to. Right now these include central bank policy errors, the significant non-performing loan problem that hobbles China and Europe’s banks, and fears of the impact of Brexit on the UK and European economy. Furthermore, this week sees the start of the second quarter corporate earnings season, which could be awkward for Wall Street. Thomson Reuters’ forecast for Q1 profit growth in the US have moved from 2.3% y/y growth to a fallof 6.9%.
• The solution, as ever, is to be fully diversified into risk-sensitive assets such as equities and credit, and into defensive asset classes such as government bonds. Longer term investors should have a bias towards equities, which have consistently outperformed bonds and cash over meaningful lengths of time.

Giving up on over-weights in euro zone and Japan

• The popular consensus at the start of 2016 amongst investors was to be overweight continental Europe and Japan stock markets, on the grounds of their having looser monetary policy than the US. Although this bet having paid out well last year, results in the first quarter were bad – even in USD terms, despite the dollar being this year’s surprise weak currency.
• The root of the problem is that neither the ECB nor the Bank of Japan are getting the weaker currencies, and inflation, that they had hoped would launch self-sustaining real economic growth. This is despite persistent expansion of the quantitative easing policies being used, to include more assets by value and by type, as well as imposing negative interest rates on banks’ deposits with the central bank. Indeed, the euro actually rosein March on ECB’s Mario Draghi’s announcement that more euros will be created through expanding QE.
• It is becoming clear that lowering interest rates to below zero will not produce the same result as lowering them does when in more normal positive territory. Instead of stimulating bank lending and consumer demand, negative rates eat away at banks profit margins as banks find that they cannot pass negative interest rates on to depositors. We can expect to hear more about this in first quarter European bank earnings results, to be announced next month. Meanwhile, there are reports of strong demand in Japan for 10,000 yen bank notes, and for home safes to keep them in, as household deposits flee bank charges. This reduces the amount of cash available for lending by Japanese banks.
• Far from boosting money supply, and the rate of the circulation of money in the economy (its velocity), negative interest rates may be impairing both and so helping to generate the very deflationary headwinds that the policy is designed to prevent.
• Both central banks look set to persist with deeper negative interest rates. In the absence of proof that they boost inflation, weaken currencies and lead to a happy outcome on the growth front, I fear more unintended consequences.
• From an investment perspective, I prefer a neutral position in both regions’ stock markets relative to their benchmark.

E.U referendum principle arguments

• On 23^rdJune Britain will vote in a referendum on whether to remain in the E.U, or to leave. The vote will play a key part in shaping the economic and political future of Britain. Below is an attempt to summarise the principle arguments from both sides. Within the E.U, the UK is unique in defining its relationship with the organisation strictly in economic terms. The geo-political aspects of the advantages or disadvantages of the E.U do not, therefore, feature much in the campaign.

Leave

• The Leave campaign wants to regain sovereignty over policy making – particularly on who can settle in the country and thereby gain access to public services. It wants the government to decide who should come into Britain to work, using a point-based system.
• The E.U is described as a spent force led by an unaccountable elite, while ‘meddling from Brussels’ causes unnecessary costs to the economy. The approximately £8.5bn net payment for EU membership could be better spent elsewhere.
• Britain would be able to sign favourable trade deals with other fast-countries and regions. Our trade deficit with the E.U means that Brussels will probably allow our exports similar access to the E.U as we enjoy today. A libertarian wing of the Leave campaign argues for a unilateral end to all import tariffs, which would make trade negotiations interesting!

Remain

• The Remain campaign argues that the E.U is our largest trading partner, the largest source of foreign direct investment, and is the world’s largest free-trade area. Any disruption to our relationship with it will cause economic damage. E.U negotiators are unlikely to offer the U.K the same access to the E.U market as before, since it would risk encouraging other traditionally euro-sceptic countries – such as Denmark- to follow Britain’s example.
• They argue that being a member of the E.U is not what holds back our exports to faster-growing parts of the world – just look at Germany, which exports around nine times as much as us to China.
• In return for the £8.5 bn net contribution, we have a seat at the policy-making table and can help set the rules. The Remain campaign acknowledges the need for reform of the E.U. The Remain campaign argues that if we were to leave we may well still have to obey E.U trade rules, and also pay an annual fee. But we will have no voice, or votes, in Brussels and unable to push for reform.
• On E.U immigration, we are reminded that the economy and the Treasury’s tax receipts benefit from their presence. And that the U.K operates border controls and therefore can, and does, turn away E.U citizens with criminal records.

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