The newswire services rushed out to announce a “new deal”, the basis of which is that Northern Ireland stays in the customs union but can benefit from any trade deals the UK strikes. The pound rose and the stock market rose. Since expectations have risen that a deal would be found, the pound has risen around 5%, those stocks exposed to the domestic economy have risen sharply. The FTSE 250 index has risen likewise by 5%, the index back to highs of a year ago. The FTSE 100, far more exposed to the international markets, lagging at just over 1%, and despite the weakness of sterling in the past year remains well below its high off a year ago. The announcement of a deal was quickly followed by the expected groups who say they will reject the deal. Labour, Liberals and the DUP. Many continuing to call for a second referendum.
The positive momentum for sterling, on the expectation a deal will be reached over Brexit continues. The European economy remains in a fragile state; economic indicators would suggest Germany is either in a recession or very close to it, probably strengthening the UK hand. The release on Tuesday of Germany’s ZEW economic sentiment index compiled from institutional investors and analysts confirms the negative view of the economic outlook for the German economy. Inflation rates remain well below the ECB’s target of 2%.
Another roller coaster of a week, one in which equities started on the backfoot but finished very much on the front foot. Hopes trade talks between China and America were on track and headlines of a possible breakthrough in the Brexit negotiation, reassuring investors. The Brexit hopes saw the pound have its best two day rise in 10 years. On Friday there was a strong performance from those stocks exposed the UK economy, banks, property and insurance, outperforming those more internationally focussed stocks, such as the non-discretionary consumer sector. The sharp upward move in sterling and the domestic earnings-related stocks would suggest there was a lot of closing of short positions taking place. Emphasising this point the FTSE 250 index, rose over 4% on the last trading day of the week.
Equity investors have become more and more immune to geopolitical risk over time. It is however slightly surprising that the developments in the Middle East, post Donald Trump’s decision to withdraw troops from Northern Syria, and the resulting escalation in violence has not unsettled equity investors at all. The oil price is likewise almost unmoved.
Despite a Wall of Worry that gets ever taller, equity markets remained on the front foot in Europe, at least on Monday. There was something of a belated reaction on Tuesday. The latest bricks, more whistle-blowers coming out from the woodwork over the allegations that Trump asked the Ukrainian president to investigate Joe Biden. Angela Merkel has apparently told Boris that the chances of a deal are “unlikely”. The China-US trade talks resume this week and appear to be off to a nervous start as Washington blacklisted Chinese companies over human rights and Trump said a quick trade deal was unlikely. The riots in Hong Kong continue and capitals around the world are being brought to a stand-still by climate change protesters. Any wonder no-one can get to Pizza Express.
Looking at the above you wonder why equities continue to remain underpinned. We and many others continue to debate the disparity in yields between equities and bonds. Juliet Samuel, writing in the Telegraph, points out that British American Tobacco’s 30-year debt offers just over a 2% yield, the equity just over 7%. You get paid more than twice as much for owning an asset that is expected to go up in value over time. We also talk about fear and greed, the disparity between bonds and equities suggests fear remains elevated. Juliet goes on to quote a report from Goldman Sach’s that calculates the current gap between bonds and stocks assumes no dividend or earnings growth.
The current yield on global equities is around 4 pct, far above that of borrowing costs. Governments aim to offer cheap money for investment. Instead, companies are issuing cheap bonds and buying back shares. Helping to fuel the stock market rise. Many company CEO’s are rewarded partly on share price performance and often will have share options. What is more attractive, buy shares now with borrowed money or finance investment which could take years to provide a shareholder return. You do the maths!
The risk is one-day corporate leverage without earnings growth could become a problem. If interest rates rise and or earnings fall companies will fail to meet the payments. The quality of debt issued in the past ten years has also fallen. Debt to GDP ratios is higher than they were before the crisis. The conundrum central bankers face is by continuing to offer cheap money they further exacerbate this problem, by halting they risk growth.
Central banks only hope is that eventually, cheap money for long enough will create the growth required to pay down the debt which will allow them to rebalance the debt to equity ratios. For now, the equity market continues to be the best of the bunch, but it will remain feared rather than loved.
On a slightly separate note, one chart added from the Wall Street Journal daily shot on hedge fund stock selection performance. Blueline is the performance of their long positions, the red their short.