Despite a calm exterior in terms of broad market price action, the under currents remain strong. The UK remains front page news with the Pound hitting multi-decade lows. However, it is the more subtle changes in central bank policies that continue to dominate our thinking, especially with global debt at record levels and a lack of any cohesive plan on how to generate real economic growth. There remain a large number of talking points, some of which we have discussed recently, others we will consider in the near future. For this week’s commentary, we shall have a look at some market dynamics.
Let’s start with equities, and have a look at the S&P 500. In chart 1 below, we show how the previous resistance around 2120 (using closing prices) became support for the market during the recent correction. We can also draw a trendline off the February and June lows, which is currently not far away from this area of chart support. Our view is that a meaningful break below the 2120 area would be damaging to the short term bullish scenario.
Chart 1 – The S&P 500 over the last two years
Continuing with equities, chart 2 shows the Eurostoxx 600 Index with the ECB’s balance sheet and deposit rate in the lower panel. Having sworn in August 2012 to do whatever it takes to save the Euro, Mario Draghi’s ECB became much more active in using experimental policies starting in June 2014 when he first cut the deposit rate into negative territory. The Eurostoxx 600 index has declined marginally since that meeting in June 2014 despite a further three interest rate cuts and approaching EUR1.5 trillion of QE. There are those who are beginning to wonder how bullish of equities current ECB policies really are, and what would happen if they do indeed begin to extricate themselves from the monstrous hole they have dug for themselves.
Chart 2 – The Eurostoxx 600 Index with ECB balance sheet and deposit rate
We see Japan and Europe in a similar position. Despite years of extraordinary policies (including outright purchases of equities to try and boost the market), Japanese equities have made virtually no progress and are trading only modestly above a critical zone of support. It is absolutely our view that the move to yield curve control with result in reduced QE, which may have a greater impact on market pricing than the Bank of Japan would like.
Chart 3 – The Japanese Topix Index
One last equity chart before moving on. The rush into Emerging Markets in recent months has been quite extraordinary. Although valuations have undoubtedly been cheap in emerging markets relative to developed markets, we are struggling to convince ourselves that we should be jumping on the emerging market bandwagon at current prices. Chart four shows how a popular Emerging Market ETF traded in the United States has been struggling in recent weeks at a very significant zone of resistance. A move lower in the weeks ahead would only strengthen this resistance.
Chart 4 – Emerging Market Equities
Moving on to Government bonds, we believe that these are the most sensitive to a potential change in central bank policies away from experimental policies of zero or negative interest rates and QE. With the Bank of Japan now controlling their bond market (something that will end badly in our opinion), the most sensitive bond markets to these changes are in Europe. Chart 5 below shows the 10 year German Bund yield, and after rumours that the ECB is considering reducing QE, it is not surprising that yields are nudging higher again. It is our view that European bond yield are carving out a generational low and this view will be strengthened if the Bund yield starts trading north of 0.15%.
Chart 5 – The German 10 year bond yield
The situation is not dissimilar in the United States (chart not shown) where the 10 year yield, which is trading just above 1.70% is approaching resistance in the 1.75% to 2% range.
Finally on the US Dollar, chart 6 below shows the Bloomberg US Dollar index which has been tracking broadly sideways for nearly 20 months. Frankly, the US Dollar appears to be consolidating the previous 20%+ bull run before breaking higher. Indeed, the support and resistance zones appear to be well defined. We continue to look for a break higher at some point, and the strength seen in the last week or so has the feel of something important developing.
Chart 6 – The Bloomberg US Dollar Index
Looking across markets, there appears to be a lot of indecision in the big picture. Despite years of extraordinary monetary policy, equity markets in Japan and Europe appear mostly range bound. Although the US appears to be modestly stronger, it would not take much downside price action for support to give way. Where monetary policy has had more impact is in the bond markets, but even here we think there are signs that the good times are over (Europe and Japan especially) and that the tide is turning as central banks hit capacity limits and begin to extricate themselves from a ridiculously large hole. The Dollar is also range bound, but we need to remember just how deflationary a strong Dollar will be, and so signs of a breakout need to be taken very seriously.
Whilst we watch these markets, we get an overriding sense that the narrative is changing (slower than we would like, but changing nonetheless). Markets are no longer a one way street on the back of central bankers doing whatever it takes. Markets are in multi-year consolidation patterns that will end at some point. Although we have to give some probability of the reverse happening, we continue to believe that the next big move will be bearish of bonds and equities and bullish for the Dollar. This thought process is strengthened as we watch recent price action, especially on days when it appears more obvious that central banks are nearing capacity limits.
As we have stated in recent weeks, getting the timing of such a bearish move right is just not possible, however, it will be better to take action now whilst markets are relative calm, rather than wait for prices to be moving rapidly.
Stewart Richardson
Chief Investment Officer
