Market Thinking - A view from the equity market

• Bonds and equities are on hold while the noise markets take over. The FX markets have pushed the yen and euro down a bit against the dollar and the pound down a lot as it became clear that the UK really is leaving the EU

• After a quiet summer, technical levels are breaking, oil has broken out while gold is breaking down and traders are scrambling to cover while commentators are struggling to find fundamental stories to suit. Forced buyers and distressed sellers matter more than economics.

• Weak sterling over the last year may or may not lead to inflation, but one thing for sure is that it has left many UK investors in international funds considerably better off – Asian markets for example are 35% higher in sterling terms. This may well impact themes for next year.

The markets in Asia have been distorted over the last couple of weeks thanks to a series of public holidays, most notably the ‘Golden Week’ holidays in China and this has tended to make markets globally a little less liquid and a lot more ‘skittish’. As we have seen over the years, a sideways moving market and low liquidity provides an opportunity for mischief, particularly in the chart driven ‘noise markets’ like foreign exchange (FX) and also in commodities, especially gold, which is often traded like a currency. When writing these commentaries, I tend to jot down a paragraph every now and then during the week, consolidating it to produce the Market Thinking. More recently I shifted from Friday to Monday, given the propensity for policy makers in Asia to make announcements over the weekend, but that can drift into Tuesday or Wednesday if, like this week, we have holidays or if too much happens over the weekend. As such I had already written a paragraph or two about the UK government and its announcement on Brexit that had caused the pound to weaken noticeably before the sudden flash crash on Friday. These were not the cause of the crash I suspect, but they remain important to the longer term trends in sterling. However, the two issues, sterling weakness and the flash crash need to be treated separately in my view.

On the sterling crash, nobody knows exactly what caused the dramatic sell-off in sterling on Friday morning Hong Kong time, but I think we can be reasonably sure it wasn’t any of the widely touted fundamental reasons (which we shall come back to in a moment). Much more likely is that in ‘thin’* markets someone decided to give sterling a push and discovered no liquidity and no resistance to the downside. To switch metaphors, the currency hit an air pocket and dropped sharply, both scaring away other traders and (likely) triggering some real money stop losses. One clue to the latter is an official RNS statement from the London Stock Exchange by UK retailer Sports Direct who said “extreme movements [in the currency markets] overnight resulted in a crystallisation of [the hedge] rate at 1.19, resulting in a negative impact of approximately GBP15m”. In other words, the move through $1.19, albeit briefly, triggered a hedge loss for the real world corporate.

Similarly thin markets may also be behind the weakness of gold, often traded as a form of currency and which had been very strong over the last 12 months. If we look at Chart 1, which shows the movement in gold and sterling since the June referendum on the European Union (EU), we see something rather similar.

Chart 1: Gold and sterling since Brexit

Source: Bloomberg, AXA IM, October 2016

Gold last week was almost as puzzling as sterling, but looks like a more traditional forced redemption story, rumour has it by one or two large US hedge funds, but the point is similar – not really about fundamentals. These sudden large movements (remember that in FX world the second decimal place is referred to as a “big figure”) have caused everybody to turn to their technical analyst for help. For gold, depending on your favourite techniques, there are supports around $1245 (long term trend average and 38.2% Fibonacci retracement, $1200 (round number, don’t underestimate it!), 1180, horizontal support line, $1015 (12 month low) and so on. For euro, which has broken its long term support, the rate against the US dollar could go to just below here on the basis of a trading wedge (trend support from the November and July lows- $1.098 (July low), $1.08 (61.8% Fibonacci retracement of rally from December low to May high,  or even $1.06 (the November low). For sterling/dollar, the problem is that there are no obvious technical supports at all. We haven’t been here against the dollar since 1985/6. Against the euro, which is obviously not traded as heavily, there is some support around the euro 1.10 level (which is where it is now) with a Fibonacci at EUR1.08 and a further low in at EUR1.05.

The reason for citing all these technical levels is not that they contain any great insight, but rather that this is the only road map anybody really has especially as we suspect that as we saw with Sports Direct there will be a number of embedded landmines in markets as corporate stop loss positions get triggered around some of these indicated levels. The problem is, we aren’t really sure where they are. It’s like playing a giant game of battleships; every now and then you hit something and find out it’s an aircraft carrier.

Part of the problem, of course, comes back to the very fundamentals I said earlier on I did not believe had much to do with the Friday crash. The weakness in sterling earlier in the week had clearly come on the back of statements made at the ruling Conservative Party Conference where newly anointed leader Theresa May not only stated that the process for the UK leaving the EU (known more generally as triggering article 50) would take place before the end of March 2017, but also that following that there would be a so called Great Repeal Bill, the purpose of which will be to overturn the European Communities Bill of 1972 – the act that took the UK into the European Economic Community as it was then. This means that from the day the UK leaves the EU, the authority of the EU law will cease. The article 50 process means that will be no later than two years after the invocation, likely therefore to be around Easter 2019. This makes a lot of sense politically since the timetable for the next General Election is for May 2020. Now, in my view, any reversal of the Brexit decision is going to have to arise from a General Election vote to take the UK back into the EU, rather than a spoiler campaign to prevent it leaving. It was this recognition, in my opinion, that led some last remaining “Brexit doesn’t have to mean Brexit” campaigners to cut their positions in sterling and thus trigger the slide that led to the crash.

The weakness of sterling has a number of implications for the economy and the markets. It is not as simple as saying that a weaker currency means imported goods prices go up and therefore there is inflation. Consumers may simply substitute for a local alternative meaning that importers will have to cut margins. On the other hand, weaker sterling may lead to a boost in demand for exports such that there is a temporary shortage and that does increase prices. This may well be the case for goods (and particularly services that attract overseas buyers. To people in Asia, the UK has just become a far more attractive place to visit. If that mops up excess demand then discounts disappear and prices rise which  is great for any company ‘exporting’ to these buyers. As investors we need to look at the bottom up supply and demand pressures before drawing any conclusion. We must also look at the impact of taxes – one of the UK’s biggest imports is of course oil, but the impact of the price of oil on the average gallon of petrol adds up to only around 35% of the total cost as the rest is duty and VAT.

In financial markets, weak currency is often matched by strong asset prices – often keeping the dollar return flat. We saw this with Abenomics and also post the European financial crisis when the euro plunged. The same thing has happened post Brexit – sterling is down but the FTSE 100 is up.

Sterling is now down something like 16% against the dollar since the beginning of the year which has made it a particularly good year for any sterling based investors in overseas bonds and equities. Out here in Asia, for example, a sterling based investor would have seen equity returns from an Asia ex Japan ETF of almost 35% over the last year! Emerging market funds produced a similar return in sterling. Now we know that past performance is no guarantee of future performance but it can potentially be a good indicator of funds flow. While we do also know that funds flow does not automatically move share prices in some sort of hydraulic fashion, it does work through the concept of the risk premium; where funds are moving the risk premium does tend to expand and contract alongside. This is but one of the reasons for the observed phenomenon that says while fundamentals may be the ultimate driver of equity returns in the long run, over a shorter, one year period, it is multiple contraction and expansion that may account for up to 40% of returns.

Gold has done even better, it is up almost 90% in sterling terms over the last 12 months – although at one point that was 140%! It looks to have hit something of an air pocket in recent days, possibly reflecting profit taking at quarter end.  I note the spike in value traded in the SPDR Gold Shares ETF was the largest since the jump immediately following the Brexit referendum and prices are back close to that level as well. Gold shares too have rolled over quite aggressively. Perhaps some UK based investors are taking profits?

Finally, the US election. Much as we might like to, we can’t avoid it and as discussed last week, it looks to be becoming increasingly rather than less partisan as both sides try to get out their core vote. “None of the above’ would walk it, but they aren’t on the ballot. As we grind through the final rounds of US politics and I detect some attempts to shift the narrative onto the trade aspects of a possible Trump win. Rightly or wrongly – either in the prediction or the analysis – it doesn’t matter so much as the narrative to encourage trading is likely to produce incentive to take profits in emerging markets. Certainly in the same way sterling was used by markets as a barometer for Brexit, so the Mexican peso is being used as a barometer for a Trump win. On such a basis, Hilary seems set to win, but then sterling also said the UK was going to remain…. less than a month to go.