Gaeia’s Market Insight – July 2014

The year began well as the optimism prevalent in late-2013 carried through into the New Year, with investors confident that the "Goldilocks" scenario would play out, i.e. financial markets could happily cope with the gradual tapering of the $85bn monthly quantitative easing programme in the US. However, this swiftly turned to concern over the path for emerging markets given slowing Chinese industrial data and fears that the Federal Reserve's tapering would see money flow out of emerging economies and hurt asset prices as a result. Turkish political unrest and falling Brazilian consumer confidence during an election year were other concerns that came to the fore, but just as "crisis" was talked about, markets recovered. Events in Ukraine and Russia's subsequent annexation of Crimea then caused a reappraisal of risk sending oil prices higher on concerns over supplies and gilt yields lower on a flight to bonds over equities. The more recent events surrounding the apparent shooting down of a Malaysian Airlines civilian passenger jet by separatist rebels coincided with a terrorist surge in Iraq. As investors assessed that a full-blown invasion of the Ukraine by Russia was less likely but that unrest in the Middle East was likely to be prolonged, markets gradually recovered as investors have remained surprisingly sanguine. Emerging markets industrial production weakness has actually resulted in oil prices falling to below their levels at the start of the year as demand slips, more than offsetting the spike in prices as a result of the above mentioned conflicts. On the domestic front, the sharp moves in the first quarter prompted by emerging market issues was followed by a recovery in the second quarter which saw UK equities move higher overall, although within this there was a marked polarisation of returns within different areas. The mid-sized company arena suffered a series of sharp selloffs and ended the quarter c.3.5% lower in capital terms, following a period of 18 months where this part of the market had performed very strongly. The selling pressure was not entirely surprising given pockets of elevated optimism and a succession of aggressively-valued companies coming to market, especially in the retail sector, that indicated excessive exuberance. The counterpoint to the mid-cap company sell off was a period of strength in many emerging market assets, as the consensus caution on them was challenged. This saw the likes of the Brazilian stock market and currency rally, while UK equities with emerging market exposure also fared relatively well. Political risk was not absent from the UK market either as the house building sector fell sharply in anticipation of UK interest rate hikes coming closer. This sector has become increasingly exposed to various policies such as 'Help to Buy' and with next year's General Election looming, a degree of "second guessing" which support measures may last has resulted in more near-term share price fluctuations. It is also a sector that has attracted attention from the Bank of England, in particular via the PRA (Prudential Regulation Authority) and the FPC (Financial Policy Committee) which are bodies set up to monitor, assess and respond to financial market risks and which have begun to address the issue of perceived riskier mortgage lending practices. Moving away from the market discussion, the wind of positive change continues to blow in many corners of the world. In particular, the movement to divest from fossil fuel investments has gathered rapid pace, boosted by President Obama speaking on legislating to tackle climate change. Senior management at oil and gas production companies have remained unflinchingly unconcerned (at least publicly) about the threat to their businesses, with heads firmly buried in the sand. They can't see that the tide is turning against them. Of course, it isn't all good news here, with the UK government continuing to row back on support for renewable energy sources whilst bending over backwards to promote shale energy production. But the most important point is that these industries are growing, and fast. Elsewhere, pressure continues to be applied to companies to pay the Living Wage to all employees. These are significant steps forward. To conclude, the UK economy has continued to look healthier – something that has led to the first interest rate rise being expected sooner than was the case. Sterling strength has helped to dampen inflation, albeit at the expense of export growth. Consumers are getting close to seeing real wage growth, something which until now has evaded the economy given where inflation had been running. This would be a meaningful boost for household finances. Meanwhile, the Eurozone is still flirting with deflation and has seen the ECB move to negative deposit rates to try to force cash into the economy. Current US data is mixed, with the extent of weather distortions from the extreme Arctic front on economic activity widely debated. However, what is clear is that growth expectations are being reined in. This is particularly important when corporate profit margins are close to all-time highs and equities have performed as they have over the past couple of years. Valuations realistically need earnings upgrades to support them. Elsewhere, there are further signs of froth in the bond markets, with corporate yields at historic lows and strong demand for the government debt of the likes of Ecuador and Jamaica, two countries with particularly poor records of defaulting on their obligations. Sticking to investing rather than speculating remains the key.

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