The US debt ceiling looms yet again. In 2011, a Democrat executive faced off against a Republican Congress and eventually a compromise was found, but not before a sovereign downgrade. US treasuries promptly rallied then. Equities fell, although a European crisis was probably a factor. This time we have House, Senate and White House controlled by the Republicans making a shutdown damaging to the party if it came to that. President Trump is agitating for funding for his Mexican Wall.
How much longer can the US stock market keep rising at the current pace? In the last two years, the S&P500 has risen at a rate of 16% per annum, well ahead of earnings, thus pushing valuations to a PE of circa 21X. What if market returns mean reverted to 10%? Even without a serious correction, returns would need to slow to circa 4% per annum for the next two years for the market to return to its long term trend. This analysis while crude and not taking more factors such as earnings growth, valuations and credit conditions, puts the current rally into perspective.
For central banks the world over, inflation is too low, apparently. Continued efforts to reflate economies have led to some growth and employment but have not had much impact on inflation. As asset markets make new highs and valuations get more stretched, labour markets become tighter and growth stabilizes, central banks are at a loss as to why their policies have not created more inflation. Despite highly accommodative policies we continue to see weak consumer price inflation and weak wage growth. One distinction that perhaps blunts measurement is that there are various strata of society and each has their own consumption patterns and thus price baskets. From 1982 – 2016, the Forbes Cost of Living Extremely Well Index (CLEWI), has risen at 5% per annum compared with the CPI which rose at 3% per annum. A 2% gap over 35 years adds up. Manhattan luxury housing has risen at a pace of over 6% p.a. over the last 10 years compared with 0% for the Case Shiller 20 City Composite Index. Coutts Luxury Price Index rose 6% YOY compared with a UK CPI of 2% and in China, the Hurun Luxury Price Index rose at 3.6% July YOY compared with a CPI of 1.4%. Could it be that central banks are simply missing the fact that we have 2 speed economies the world over?
Mid August saw a pick up in volatility. Volatility has been declining since March 2016 with equity and credit markets rising steadily. Most asset markets are quite expensive if not acutely so and investors are struggling to find value and sources of safe yield. Summer is usually a quiet time but we note the following:
- US high yield is beginning to wobble although fundamentals are probably strong enough to see the market through.
- US treasuries have continued to rally as the market absorbs the Fed’s normalization talk. In addition, US treasuries have been the safe haven asset for whenever there is turbulence in the White House or even when a debt ceiling negotiation looms.
- European stock markets have been hurt by the strength of the Euro. Otherwise, PMIs are rising and the ECB is unlikely to taper significantly soon.
- HK listed China H shares surged in the last two weeks driven by stronger earnings, a recovery in metals and mining, and Chinese banks as the PBOC is seen as being less hawkish than previously thought.
- The oil term structure has flattened with WTI in backwardation. This could imply support for the spot price going forward.