7 November 2017
Let’s start this month by telling that within the politics arena, Mr Abe has achieved the super-majority in parliament he had hoped for. Japanese equity has been the place to be this month. We would allow the major Japanese indices to advance another 1-2% this week, after which the profit-taking will doubtless be irresistible. After all, the pre-electoral surge of virtually 10% has already been impressive. In such cases investor expectations of new policy initiatives of significance are frequently disappointed.
Asia has become a region of competing nationalisms under the shadow of the power project of rising China. We note that the left-liberal establishment in the West seems to find acceptable in Asia what it would assimilate to proto-fascism at home. But then the codes of political correctness are not applied beyond the boundaries of the West. There is no “populism” in Asia because there is no neo-liberal order to defend.
By the international standards of the late show European equity has performed poorly so far the past month.
Two influences have combined to produce this effect. On the one hand, the investment consensus has under-estimated, once again, the vigour of the US equity market. On the other hand, the immediate benefits of the growth shock delivered by the euro zone are fading.
The Euro has been telling us since the summer that the initial wave of enthusiasm for the euro zone has broken. The Euro-US$ parity is moving back slowly to its support at the US$1.16-1.17 level.
The first wave of appreciation of the Euro’s value is complete. We think that the next wave of Euro appreciation will come when correction become apparent on Wall Street. At this time widening interest rate differentials should maintain the US$’s advantage.
We are also aware that political risk has not disappeared from Europe. It has merely changed its nature. It is symptomatic in this respect that so many investment houses have under-estimated the significance of the Catalan crisis. It is unwise to be overexposed to the Spanish market until there is a realistic prospect of de-escalation of the standoff between Madrid and Barcelona (see figure 1).
Figure 1: Political Risk Premium [SPAIN]
The under-estimation of the risk created by the crisis in Catalonia contrasts with the enduring conviction within the investment industry that Brexit is a permanent handicap for financial assets in the UK. Why the asymmetry of perception? The risk that the Brexit negotiation breaks down in an atmosphere of antagonism is high because the protection of Europe’s nascent political order prevents agreement upon mutually advantageous economic outcomes.
The Brexit talks have reached a critical juncture. The positions of the UK government and those of the representatives of the EU organisation are irreconcilable. We will discover in the next few weeks whether the German government is ready to impose a compromise.
The fixed income world is assuming that the ECB’s tapering programme will bring no significant disruption to debt markets. Our perception is that price adjustment in bond markets is resuming, but it is led by the US debt market at this point.
Correction in the form of an “inverted U” is more plausible that an “inverted V”. We have no strong reason to think that the correction in the equity world will occur quickly, if only because we do not under-estimate the influence of momentum in today’s markets. The period of vulnerability could extend from November to next February.
It may be that equity markets consolidate near their highs through December. The most dangerous month is probably January. In other words, a degree of patience may be required before profit-taking degenerates into selling.
Naturally, everyone wants to know what is the “cause” that produces the effect of market correction in our argument. There are seldom discrete, identifiable “causes” in financial markets. Nothing is more grotesque than the kind of commentary that claims to isolate the cause of every financial movement. Our list of potential catalysts for market correction is long. The way in which they will combine in the period ahead is unpredictable.
We could isolate one factor in particular, in the manner of America’s new Secretary of the Treasury who said last week that the stock market will fall if tax reform fails. The expectation of lower taxes, if not a coherent tax reform, is one of the ingredients of the late show (see figure 2).
Figure 2: Trump “Winners” & “Losers”
We prefer not to under-estimate the intelligence of our readers by claiming to know what will be the crucial trigger of trend discontinuity.
The short explanation for market correction is that next year’s investment climate cannot, in all probability, be as favourable as that created by the “growth without inflation” surprises of 2017.
Accordingly, the current trajectory of major financial markets is not sustainable. To our way of thinking it is implausible that the transition to a less friendly investment environment can take place without disruption.
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