Market Insights – February 12th 2018

Update on the economic news of the week

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The sharp volatility on the stock markets does not seem to have triggered a flight to gold, which has put in a disappointing performance for a safe-haven asset. Against all expectations, gold dipped from its recent 25 January high – a rise in bond yields may have reduced its appeal.

After starting off the week at 13, the USA’s VIX volatility index peaked at 50 before closing at 30 on Friday. This sharp movement hurt a number of very popular strategies that were betting on volatility remaining low. Some funds were even forced to liquidate after taking considerable losses.

Chinese exports rose 11.1% year on year in January, while imports increased by 36.9%. China’s trade surplus therefore narrowed sharply compared with December, to USD 20.3 billion, coming in below market consensus. The seasonal effect of the Chinese New Year makes these figures difficult to interpret.


Fear replaces euphoria

Over the last 18 months, Wall Street reached new record highs without experiencing any real correction. This no doubt played a role in investors’ complacency. It was only a matter of time before things returned to normal and volatility increased. But it was a rude awakening. In just two weeks, excessive optimism was replaced by fear and even panic. It’s difficult to find a fundamental and rational explanation for this change in course.

The sharp correction seems to have been caused primarily by pressure on long-term interest rates, which are being pushed up by exaggerated fears of a surge in inflation after hourly wages rose in the USA. This could prompt the Fed to be more severe in its monetary policy tightening, at a time when the change in the Fed’s leadership is also causing some concern. The stock-market downturn has spread across the globe, but the impact on the real economy should be minimal. Luckily, this correction has come at a time when the economic climate is very buoyant.

The US economy started 2018 in a very solid position, as illustrated by the job creation figures for January and the business confidence index for the service sector, which is at its highest level since 2005. Economic growth continues to pick up around the globe, and inflation is not showing any real signs of coming out of its slumber, except in the USA. Monetary policies should remain broadly loose, particularly in Europe and Japan. And a sharp upturn in long-term interest rates would not be justified. We think the stock-market correction is a temporary adjustment, and it does not alter our bullish view on equities.

The fall in prices has put valuations back at more reasonable levels, at a time of rising corporate earnings. We therefore think it’s a good idea to remain calm in light of this fresh bout of financial-market volatility. We are even getting ready to strengthen our positions in certain stocks that have dipped in recent days.

UK stock market “very interesting indeed!”

Unsurprisingly, the Bank of England kept its key rates unchanged. However, it did upgrade its growth and inflation forecasts. And a second rate hike could take place as early as May. Sterling rose against the major currencies on the news.

We have long preferred eurozone markets to the UK – and rightly so up to now. The UK market is currently the least popular in the world, according to Bank of America Merrill Lynch surveys, and investors are even more bearish than they were right after the Brexit vote, amid concerns about the negotiations between the UK and the EU.

Nevertheless, its discount to the rest of the world has returned to the level it was at in 2003, when the market began a period of outperformance. We therefore think that the UK market is likely to rise as fund flows turn positive. If interest rates are raised in May, we will strengthen our positions in domestic stocks. In the meantime, we recommend buying life insurance company Prudential.

The insurance sector will be boosted by monetary policy normalisation. With its strong franchises, notably in Asia, in the medium term Prudential offers greater structural growth potential than the sector as a whole. Prudential is currently trading at the same level as the rest of the sector, so this factor has not yet been priced in.

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