It feels like the market’s focus remains far too heavily skewed to what’s happening in the US, and despite our best efforts to discover the next important narrative, we keep coming back to the US. Having moved offices last week and settling in for the Easter weekend, we will keep this week’s missive nice and short.
Geopolitics is clearly increasing as an important factor for investors to consider as we head into the long weekend. For the most part, these little flare ups tend to get traders excited in the short term, then fizzle out reasonably quickly. That said, we have a more unpredictable White House sending an armada to front up against a very unpredictable dictator, coupled with some interesting dynamics that have been developing in markets for a few weeks now.
We have been discussing the developing set up regularly in recent weeks. In short, we had a robust cyclical upswing in motion from last summer that was super charged by the Trump victory. Soft economic data (business and consumer surveys) rose to very elevated levels and the bulls told us this was a harbinger of better economic times ahead. In markets, the reflation trade was easy; buy equities and the US Dollar and sell bonds. We have been leaning against the reflation trade for some time now, and in the bond market especially, we seem to be getting some traction now.
Chart 1 below shows the US 10 year bond yield in white and the 10s less 2s yield curve in green. The 10 year yield has broken down through a well-defined support level created over the last 4 months. Simple market analysis would indicate that yields are now capped and the trend is towards lower yields. This theory is supported by the flattening yield curve.
Chart 1 – US 10 year yield with the 10s2s yield curve
The cyclical upswing from last summer was boosted by the rise in the rate of inflation, which was mostly driven by the very low base effect from the price of oil. We have previously highlighted how this low base affect from oil would drop out in Q1 and that inflation should peak as well. The US released the monthly inflation report on Good Friday with consensus looking for a modest increase from 2.2% to 2.3%. However, the outcome was a rare month on month decline resulting in the year on year rate of core CPI coming in at 2%
Chart 2 is an update of a chart we have shown before illustrating several measures of inflation along with a core measure of wage growth (please note the PCE measures for March are not available yet). It appears to us that the year on year rate of inflation has indeed now peaked and could rollover in the months ahead. Key here will be monitoring wage growth, however, we hold to the view that this will not become a problem and that inflation does indeed drift lower.
Chart 2 – Various measure of US inflation
We would also point out that the decline in yields has occurred across the developed markets, which is either indicative of the view that the cyclical upswing from last summer was a global event, and the peak we are seeing now also applies globally, and/or markets are just all the same and investors are simply highly prone to herding at the moment. We think both views are valid.
Elsewhere, in FX the US Dollar has been keying off the movements in the bond markets and has remained sluggish. However, with yields dropping everywhere, the US Dollar has not been as soft as we would have expected had this been a pure US slowdown. FX has also been influenced by the increasingly geopolitically motivated swings in the last couple of weeks, and as a result the Japanese yen (which for the time being is seen as the main beneficiary of risk off markets) has assumed top position.
The big question for FX markets is whether we begin to see an escalation on the geopolitical front, and does this spill over into the markets. If we do, then the Yen will continue to rally and we would expect EM currencies to give up a reasonable portion of their recent gains.
Lastly, equity markets have to quite a large degree shrugged off the escalating geopolitical noise, although as they closed for the long Easter weekend, nerves were certainly a little more frayed. To be clear here, markets are within a few per cent of recent highs (all-time highs in the US), and the damage has so far been contained. In fact, one or two very short term market signals are close to triggering a buy signal. Our bias on equities in the short term is still bearish, but we will be watching closely to see whether recent weakness can be reversed. This view is semantics really, as our big picture view remains that equities generally, and the US in particular, are extremely expensive (let’s call it what it is – bubble valuations).
Taking a step back, surely bullish investors are beginning to be disappointed with the lack of progress being made in Washington and the pro-growth rhetoric from Trump. Q1 growth is set to disappoint (the Atlanta Fed GDP Now model is predicting real growth of only 0.5%) and worst case scenario, having failed to gain any positive policy wins in his first 100 days, Trump is now firing missiles at sovereign states, risking a real escalation on the geopolitical front.
We have often highlighted work from great value investors like Jeremy Grantham’s GMO and John Hussman that indicates returns from traditional assets will be very modest in the next 7 to 12 years. We are of the view that equity markets will not achieve these low returns by idling sideways in a low volatility environment. The next equity bear market is lurking out there somewhere and could strike at any time.
Stewart Richardson
RMG Wealth Management
