Reflections of the CIO...

It wasn’t just the weather that turned out worse than usual in April, market performance was also weak across the board, as a confusing mish mash of forces ultimately ended up pushing global equity indices sharply lower.

In our reports of the last few months, we have been suggesting that a test of the last six months optimism was overdue. When the first test came in March – courtesy of ‘sticky’ US inflation figures – markets were able to shrug off any negativity, encouraged by the Federal Reserves relaxed verbal responses to the issue. However, as evidence built that the US economy and labour markets remained very strong, positive market sentiment faced another test. This time the Federal Reserve rhetoric had to shift to reflect the reality that there was no fundamental justification for cutting interest rates at this point, and certainly not at the speed with which bond markets had been assuming only a few months before. The resulting adjustment to market expectations prompted a sharp retreat in stock markets, which, admittedly felt a bit more like a bout of aggressive profit taking, than anything more sinister.

April was also a month where geopolitics and corporate earnings reports had, on the surface, a rather confusing impact. The negative connotations of an escalation in Middle Eastern violence weren’t enough, in the end, to move oil prices, which remained flat on the month. Similarly, the positive effect of a strong US earnings season wasn’t enough to stop the S&P 500 falling c -5.4% at its worst point.

Dis-entangling how both good and bad news can be ignored, or spark the opposite effect than one might think, essentially boils down to understanding what is broadly ‘in the price’ of an asset before an event happens. For example, the oil price already had a significant risk premium built into it for any further bad news, so the exchange of fire between Israel and Iran and its subsequent de-escalation, wasn’t enough to move the needle further. Similarly, the strong performance of US equities in the run up to earnings season had already built in the expectation of good results, which duly arrived but didn’t bring enough in the way of ‘new’ news to move stocks higher than they all ready where.

Assessing where we go from here also depends largely on how much good or bad news is priced into asset markets and the answer to that differs markedly throughout the investment world. For example, just as most global stock markets were retreating in April, UK equities managed to deliver an against the grain positive performance. This was driven by more than just the familiar strength of resource based larger companies, with notable performances coming in further down the market cap scale too. With UK domestic headlines also not exactly being full of positivity during the period in question, this performance is another one suggesting that a lot of bad news is ‘in the price’.

One significant issue which is beginning to be seriously addressed by markets is the forthcoming US election and the impact of the winning candidate’s likely policies. There has been a pickup in the number of analytical pieces chewing over the various scenarios, over short and long term time horizons. At this point not too much is clear, but from what we know so far, the latter part of November is likely to be volatile and hard to call in advance. Gauging how much discipline bond markets impose on a new administration is crucial, as any new policy will need to be funded. Campaign rhetoric is one thing, the actual ability to deliver on what a candidate says another, a situation which will be influenced heavily by how convinced markets are when asked to stump up the money. This so called ‘bond vigilante’ discipline is what we think in the end should bring some of the more radical ideas down to earth, just as it has been able to do in the past.

As a consequence of these looming issues, we would reiterate what we wrote in last month’s report, that the summer period will see markets wrestling with a wide range of particularly tricky issues. Solid global growth and likely falling inflation are the major positive forces facing off against uncertain interest rate policy in the USA and the potential negative impact of political change. The net result is probably a more muted market performance in the next quarter or two, compared to what we have enjoyed year to date. Beyond this period, we continue to think that the peak in the interest rate cycle should ultimately be a powerful enough force to overcome other risks, keeping the outlook for the year as a whole a broadly positive one.