Broadgate: Weekly Briefing 19/01
19 January 2015
It was a volatile start to 2015. We’ve had six trading sessions so far this year, and in three of those, the European equity market, as measured by the Eurostoxx 50, has moved plus or minus 3% on three occasions. To put that into context, the Eurostoxx 50 moved by that amount only four times in the whole of 2014. As a result of that volatility, most equity markets are now in the red (year-to-date). This is something we expected to happen at some point in 2015; we expected it would be a more volatile year, that we would see periods of sharp moves in equity markets, but even we’ve been surprised that it’s happened so early on. It’s worth looking at the fears that are driving this. Firstly, let’s look at central banks. One of the reasons we expected volatility at some point in 2015 is because we expect central banks to start taking different paths. Up until now, the banks have pointed in the same direction, towards easier monetary policy and more liquidity being injected into the financial system. We expect that to change this year, particularly with the central banks in the UK and the US beginning to tighten monetary policy and perhaps raise interest rates. Meanwhile, we see central banks in Europe and Asia easing monetary policy and continuing to push on with quantitative easing (QE).
But that’s not enough to explain the volatility that we’ve seen so far in markets, because at this stage, those potential rate hikes in the UK and the US are being pushed out much further into 2015 than perhaps we thought. That leads to the second point on what’s driving this climate: the sharp fall in the price of oil is a key driver for financial markets. The delay in rate rises may in part be down to the fall we’ve seen in the price of crude and the knock-on effects in terms of reducing inflation. But from an equity-market perspective, the situation has changed from December, where the fall in the price of oil to around USD$65-70 per barrel was seen as a positive by equity markets because of its impact on consumer demand via the lower prices for petrol. And that is still the case: consumer-led data is beginning to show increased spending on hard goods and soft goods. But in the equity markets, with oil now below $50 per barrel, much closer attention is being paid to the impact on corporate earnings.
A lot of major companies, many of which are energy companies, are starting to hurt from this drop in oil. Currently, people are recognizing that many of the positives from an economic-growth perspective, particularly in the US, have been related to the infrastructure spend going on in oil, for example through fracking and natural gas. Though this has had a positive effect in terms of capital expenditure, a loss of employment has been generated in these industries, leading to concerns that if prices stay where they are today, then perhaps things will reverse, with a negative impact on the US economy.
Where do we think oil prices will stop?
It also leads to the question ‘Where do we think oil prices will stop?’ The most honest answer to give is that we don’t know. But let’s look at both the demand side and the supply side. First, the demand side: one of the drivers of lower commodity prices over the last few years has been the weakness in the Chinese economy, and expectations are for that to continue, notwithstanding the fact that the Chinese authorities have continued to pump money into that system to try and stimulate economic growth. But we don’t think that’s going to be enough to have a meaningful impact on crude-oil demand. It’s difficult to see where there would be an increase in demand sizable enough to mop up the supply. It comes down to when we think supply will start to dwindle. This is a long-run picture, and we are seeing some tentative signs that supply will begin to be curtailed. One of the statistics you can look at is the number of rigs being employed in the US, which has started to fall. We’re also seeing companies beginning to remove money from capex programs designed to investigate new supplies of energy. But that’s a long-term game to be played out. So ultimately, it’s difficult to see oil prices recovering meaningfully anytime soon. We think markets will start to price in oil prices remaining lower for longer. For example, if you look at market expectations going in to 2016-17, expectations are that prices will recover to around $70 per barrel, and that may lead to further pressures on oil price, when people’s long-term expectations start to fall. Elsewhere, we’ve seen speculation about the upcoming Greek election; Syriza still shows a small lead. The challenge here is that we are likely to see a coalition coming out of that election, and it will be a long time before there is any certainty around Greek policy.
So, was there anything that did well over the start of the year? We’ve seen a decent bounce in the price of gold, from $1,185 to $1,224 per ounce. The strength of the US dollar has continued; the euro is now trading below 1.20 versus the dollar. Government bonds also did well; 10-year US Treasuries are trading below 2%, and 10-year gilts are trading at 1.6%. Similar to gold, gilts and Treasuries are a clear beneficiary of sentiment regarding rate rises being pushed farther into 2015. One equity market that has gotten off to a good start is China. This is surprising given the poor economic news coming out of the country, and we suspect growth will slip below the 7% target. But the government is increasing liquidity flows into markets, and equities have been responding to that. As a result, Chinese equities are up 2% on the week. However, we think the Chinese economy is still going to struggle, so that’s an area we’ll avoid. The outlook ahead is all about the European Central Bank meeting on 22 January. Expectations are high that Mario Draghi will introduce some form of QE, so there is scope for volatility and disappointment around that.
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