Having spent the second half of last week on the road meeting investors, I have not yet managed to catch up on all the nitty gritty of what happened at the coal face. This is not always a bad thing as the market often creates a lot of noise close up, whereas the 30,000 feet view of life can often help simplify our thought process. So here goes with my simple view which will be relatively short and sweet this week.
The ECB decided to cut their monthly purchases by EUR20 billion although the commitment to keep going at the new EUR60 billion a month to at least December 2017 appears dovish and a little open ended, as Draghi appeared very content that QE will extend some way past the end of next year. Furthermore, technical changes to the eligibility of bonds that can be bought under the QE programme (NCBs can buy shorter dated bonds at below the current -0.40% deposit rate) and reductions to the ECB inflation forecasts added to the feeling of a dovish ECB outcome.
With the short term bullish feeling in developed equity markets, the ECB’s dovish stance was very much welcomed by investors. Indeed, there is a feel of a bullish breakout to European equities. For a number of months, I have highlighted the sideways action in the broad European equity indices. As can be seen in chart 1 below, it would appear that the market is finally breaking out of this range to the topside. This bullish breakout could herald a new cycle of rising prices, with ECB QE perhaps finally filtering into equity markets. On the other hand, the future may continue to be choppy as political headwinds seem set to dominate Europe next year and the Fed begins to raise rates in earnest. For the very short-term, we find ourselves modestly on the bullish side of the ledger but will very much temper our enthusiasm.
Chart 1 – European Equity market; a bullish breakout?
US equities were also on a tear last week, with all major indices hitting all-time highs. With the action pretty positive in all developed equity markets last week, the bull camp is beginning to salivate about the prospects of a major extension higher in markets. This is possible, of course. However, US equities are extremely expensive, and frankly we do not see Trump’s economic policy mix as able to create a significantly better outcome than in recent years. So, for equities to generate returns higher than nominal GDP growth (let’s say 4% to 5%), valuation will have to get more expensive. This is a daunting prospect as buy and hold returns, which currently look like they will be low single digits for the years ahead, will have to be even lower if prices rise a lot in the months ahead. We will touch upon this in more detail in the New Year.
Although the ECB was clearly dovish last week, that is unlikely to be a global game changer. The US Federal Reserve is THE most important central bank, and we will get an update from them next week. It would be a true shock if they failed to raise interest rates by 0.25%, and so it is the accompanying statement and press conference that is important. Although there is a small chance that the Fed will come out a bit hawkish; we suspect that they will want to let the economy run a little hot and wait to see the details of Trump’s reflation policies before committing to a series of rate rises next year.
We think that the bond market and the US Dollar will be more sensitive to any Fed nuances next week than the equity markets. Bond and FX traders have definitely seen the Trump victory as a bit of a game changer expecting both yields and the Dollar to rise quite a lot in the months ahead. We too have been in the bullish Dollar and yields camp, although we do worry that Janet Yellen is from the same dovish mould as her two immediate predecessors, and could easily continue to sound a note of caution over the speed of any rate rising cycle next year. Being overly bullish of the Dollar into Fed meetings has not been particularly profitable in the last few years and we are paring back our exposure here from a very short term tactical perspective.
So, to wrap up here this week, it appears that the equity bulls are fully in charge despite plenty of identifiable risks and expensive valuations (egregiously so in the US). The ECB continues to run an extremely loose monetary policy, and we doubt that the Fed will come across as hawkish after delivering the widely expected second rate rise in 12 months. Our bullish US Dollar trades have worked nicely in recent weeks, but we are paring those back ahead of the Fed just in case Yellen’s dovish tendencies prevail. We are even tempted to jump on the bullish European equity theme for a trade, although risk budgets would be tightly managed if we do.
Stewart Richardson
RMG Wealth Management
