CIO Weekly - Much to Look Forward To

·     Will the Fed have to move quickly to stay ahead of the market?

·     Equities open on a strong note and the force appears to be with them

·     Bonds under pressure – High yield debt friendless

·     Gold stronger than you might have expected – but probably capped at $1350

As the financial markets open their account in a new year, there is much to look forward to. The global economy has ended 2017 on a positive note. Global indicators of industrial confidence have risen to two-year highs underscoring the current strength of the economic cycle. JPMorgan’s all-industry output industrial confidence indicator, for example, is at its strongest reading since February 2011. All bodes well for a strong reporting season for the fourth quarter (US tax adjustments aside) with upbeat messages from companies, and guidance for stronger corporate profits growth in 2018. In Europe, Japan and the broad emerging markets the newsflow has been upbeat.

How long the bull run in equities will run is highly dependent on how long the central banks decide to accommodate the strengthening growth. For the moment inflation is largely well behaved and markets are not expecting anything to change soon. US and European 2-year break-evens have remained range-bound in recent months and showing little sign of breaking out to the upside. Indeed, some forecasters while expecting headline inflation to pick-up a little have left their expectations of core inflation unchanged.

The big question for markets is whether the major central banks will hold their nerve and maintain their very accommodating monetary policy in the face of the stronger pace of growth. Even in the absence of a pick-up in inflation, the Federal Reserve, in particular, may feel pressured to move more aggressively to increase their policy rates to at least their presumed neutral rate of 2.75% from the current 1.50%.

Last week’s release of the Fed minutes from their December meeting showed that Fed board members remain split on the pace and scale of future tightening. Six of the sixteen board members predicted that the Fed would raise rates three times in 2018. Four governors thought that four rate rises would be required whereas six felt the Fed would need to raise rates by two hikes or fewer. Voting is complicated by a change of leadership with nominee Fed governor Jerome H. Powell set to take over from Janet Yellen in February.

The next Fed meeting is 30-31 January seems too soon to raise rates after the last rate rise in December. However, on the other hand, the subsequent meeting isn’t until the 20-21st of March by which time, at the current pace of improvement in US growth, the market might consider the Fed to be behind the curve.

The short end of the US Treasury curve probably offers better value than the long end. The market prices an 80% probability of a 25bps rate rise in March. Two-year bonds, in particular, have moved very sharply to discount some tightening with yields up to 2%. There appears more value at this short end of the curve rather than the 10-year yield. Long-term bond yields remained anchored by the (correct in my view) idea that will see much lower trend growth than it has enjoyed in the past however in the near term there is the potential for a sharp sell-off to a target yield of 3.0% from the current 2.48%.

The early days of the new year suggest that high yield bonds may continue to be shunned by investors, much like in 2017. High yield bonds ended up broadly returning just their coupon last year with returns in the range of 6-7%. Investor cash flows in 2017 were largely focussed on equities and safer bonds such as investment grade. High yield bond funds saw very little in the way of new inflows from retail investors. As we turned the year Lipper reported that high yield bond mutual funds recorded net outflows of $240million.

Equity markets look likely to continue to build on the positive momentum of the second half of last year. In our view equities still have further potential upside with industrial confidence strong, earnings upgrades evident in most parts of the world and a recent renewal of money flows into equity mutual funds. Key to equity sentiment in the coming weeks will be the US corporate results. Earnings reports are complicated by the implications of the US tax changes particularly the drop in the value I think investors will largely look through the near-term noise and try to understand what companies are saying about the current pace of new order growth and whether companies feel they are likely to have to pay higher wages retain/hire workers.

From a purely technical perspective, the strong start to the year for the equity markets sets them up for further gains. #Bill Sarrubi of Cycles Research notes that “for the first time in its history the S&P500 managed to start a New Year with back-to-back gains of more than 0.5% with a 52-week high on both sessions. Bill has a target of 3435 for the S&P. In the very near term, there are reasons to believe that there is room for some consolidation but little to suggest that markets will have a serious setback.

With such positive news around the world, it might surprise many that gold has performed so well in recent trading sessions. Adrian Ash at BullionVault noted that Wednesday last week the gold price in Dollars has just made its strongest run of back-to-back daily gains since February 2016, rising on 10 out of 11 trading days ending Wednesday. Gold has only done better 8 times in the last half-century. January and February are typically strong for months for gold on this occasion helped by the weakness of the dollar. I suspect that traders are looking to buy into the strength with near-term targets of $1330 and $1350.

Gary Dugan