JP  Capital    Perspective  is  everything  

October 15, 2015

Equities The S&P 500 rose 3.3% last week, tracking higher into earnings season. Expect a sell off if the fundamentals don’t validate multiples Fixed Income The benchmark 10 year rose 9 basis points to 2.09% as risk on sentiment appears to be the play going forward Currencies Crude rose 8.9% to touch $49 a barrel even as OPEC is hesitant to restrict supply Commodities Gold rose 1.6% as Gold bugs anticipate a Fed rate rise and renewed inflation expectations

Market roundup

Source: Bloomberg, Spot returns. All data as of last Friday’s close. Past performance is no guarantee of future returns

EquitiesTotal Return in USD (%)

Level WTD MTD YTD

DJIA 17,084.5 3.8 5.0 -2.3Nasdaq 4,830.5 2.6 4.6 2.9S&P 500 2,014.9 3.3 5.0 -0.5MSCI World 1,673.8 4.2 5.8 -0.5Fixed Income

Total Return in USD (%)Yield WTD MTD YTD

U.S. 10- Year Treasury 2.10 -0.9 -0.3 2.1U.S. Corporate Master 3.41 0.0 0.3 0.2ML High Yield 7.63 2.7 2.1 -0.4Commodities & Currencies

Total Return in USD (%)Level WTD MTD YTD

Gold Spot 1,157 1.6 3.8 -2.3WTI Crude $/Barrel 49.6 9.0 10.1 -6.8

Current Prior Week End Prior Month End 2014 Year End EUR/USD 1.12 1.12 1.12 1.21USD/JPY 120.3 120.6 119.9 119.8

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EQUITIES

Correlation correction

Bonds tend to move inversely to equities, however in recent times, due to large-scale central bank intervention, they have moved in tandem. Historically though, bonds seem to show an inverse correlation, in turn supporting the theory of risk on/ off (see Exhibit 1). Having a bond allocation softens an equity sell off as investors seek the safe havens. But, bonds even though are more beneficial than cash, do have their downsides. Firstly, you could get back less than you invested, if you bought higher than its nominal value, commonly called price risk. You have default risk, which if the lender goes bankrupt, particularly if it’s a high yield bond, is lower don the capital structure, hence paid out after senior creditors. However, typically the greatest risk is inflation risk, which erodes the coupon payments. Because we haven’t seen any inflation in recent years and central banks have owned the market, bonds have risen consistently.

Next- FX update: Euro holds up

Exhibit 1: Risk on versus risk off

Source: BoAML

Equities therefore should in theory sell off, if one goes by history. But these times are far from ordinary so traditional theory is about as useful as lagging indicators. In recent years, because of the increased correlation amongst all asset classes, it seems the safest play is to be in cash given inflation is next to 0. If earnings come out low in Q3, expect to see a sell off similar to what we saw when China went for its Yuan move. However, a more deeper issue is not this quarters earnings, but rather a resurface of the Greek debacle and the effects the Yuan move is having on emerging markets, PMI’s continues to report lower with China opting for a beggar thy neighbor strategy.

If the Fed goes for another delay in raising rates, equities we feel, may actually sell off, because it will signal a lack of confidence in medium term earnings,

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FOREIGN EXCHANGE

Euro resilience

Next- Commodities update: Gold bugs return

Exhibit 2: Euro stages a rally

Source: Bloomberg data

EUR/USD- Mr Draghi and Forex traders are not exactly best friends right now. Draghi has made out to believe that it is important for the Euro to be as weak as possible against the Greenback as they’ve repeatedly acknowledged a weaker Euro would help the economy by boosting growth and inflation. It is expected that a 5% drop in the currency can boost the Euro economy by 0.3% and inflation by 0.5%. Now that was all good news, especially when we saw the Euro down to $1.04 at the start of QE in March. Since then, the Euro has gone up and is now trading at $1.14. Let’s not forget that at the start of the year, everybody was talking about parity at year-end. This has completely changed. Nowadays the consensus is that the Euro will more than likely be standing around the $1.10 mark. Is it all Draghi’s fault? We don’t believe so. The Euro is now becoming like the Yen, a safe haven. So, the Euro isn’t decreasing because of a Fed rate hike, it is also not decreasing due to the global economic situation, and in fact it is now attracting more and more foreign investment. In other words, if the Euro is to go down, Draghi needs to do something quite spectacular!

USD/SGD- A fair amount of news has come out of Singapore in the last few days, mainly because a lot of people believed of a technical recession for the country in the third quarter. However, they have just managed to miss the technical recession by posting a 0.1% growth. The central bank is definitely looking to ease their policy by adjusting the currency band. Instead of using interest rates to guide the economy, they utilise their currency. Unfortunately, the central bank does not disclose more information than this on their adjustment but what we do know is that it mentioned in its statement today that it would “slightly” reduce the pace of the currency’s appreciation versus those of its trading partners; leaving us to believe that it will adjust the slope of the band, rather than the centre or the width of the band. SGD is currently trading at 1.385; we are looking at the currency to drop to 1.40 in the very short term and to about 1.43-1.44 by year-end. That would equate to an 8% loss against the Greenback for the year. The issue is that Singapore is an export led economy and has been deeply affected by Chinas Yuan move. It is important to note that there may not be such a drastic move as mentioned above, indeed the economy is still expecting to grow this year and so it is not so doom and gloom.

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COMMODITIES

Oil- Yes I know, we talk about oil a lot, but we have to remember that oil is one of the most important commodities, because it directly affects everyone. We have in the past few days since a glimpse of hope for oil, so the task is to figure out whether or not the low oil prices are done? We don’t believe so. Indeed, the depreciation in oil prices in the last few days has mainly been affected by a specific piece of news. Russia, one of the world's top three oil producers, said it was prepared to meet OPEC and non-OPEC oil producers to discuss the market if such a meeting is called. Further the slowdown of the Greenback, and higher stock prices encourage an increase in crude prices. Effectively, we believe that this is just a patch, and that the $40-$50 mark is here to stay through to at least 2016. Don’t be fooled by the number of rigs closing down. That does not mean that supply will automatically drop. 62% of oil rigs in the U.S have been shut in the last year, yet output keeps on increasing (see Exhibit 3).

Exhibit 3: Output surpasses rigs

Next- Bond update: Consensus

Glittering Gold

Gold has not been enough in the spotlight in the last few months, indeed, when stock prices go higher, normally gold doesn’t. Gold is really a reflection of investors’ attitude toward monetary uncertainty and current or future central bank actions, primarily those of the Federal Reserve. Well, in the last few weeks, all we have been getting from the Fed is that the rate hike is complicated due to the environment. Further the IMF has announced that the global economic growth is set to be lower then estimated. So, investors should turn to gold for some safety. It is exactly what is happening, gold is now sitting at $1,178; let’s not forget that about a month ago, gold was just above the $1,100 mark. The sudden climb is a reflection of two things. The first being that the FED is not raising rate, therefore, the attitude towards the rate hike is becoming more and more pessimistic. Second being that the greenback is weaker, both of these factors help the precious metal. Two months ago, if you said that gold would be this high, you would be called crazy. Now, if the FED doesn’t raise the rates in December, and the USD keeps going down, who knows where gold will be!

Source: Baker Hughes

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FIXED INCOME

The consensus is often caught out. Entering 2014, bond yields were forecasted to soar to 3%; didn’t happen. As we entered 2015, markets expected a similar move, again didn’t happen. The strap line at the Fed is ‘data dependency’. One might say that such a method is backwards looking. However the data they analyse are leading indicators, not lagging. Exhibit 1 point towards the classic downward revision. When the year begins, markets are optimistic about almost everything. Bond yields, GDP and equity markets all have high expectations heaped on their shoulders, only to be revised lower as things don’t pan out as expected. It is debatable whether QE has worked. Employment is rising yes but that’s just the headline measure. Dig deeper into the employment report and we see some structural, longer-term issues surfacing. Long term unemployment and youth inequality remains stubbornly high, which persists

over the life of an individual’s carrier. Markets interest rates show that a rate rise is likely at the end of Q1 2016. That said if inflation remains low and the long-term prospects of people do not improve, Q2/3 will likely begin with the zero interest rate policy. If the data continues to be sluggish, what tools does the central bank have? It could reduce rates to negative but the Fed will never do that. It could restart QE, which would lower market rates across the curve, but as we’ve seen market participants front run the Fed often creating a situation, which is the opposite to the intended. Yellen could imply Draghi tactics, where he talks the exchange rate lower and holding fire on its tools. One thing is for sure we are at a pivotal stage of the business cycle. Now is the time to see this loose policy come to the front and to see its full effect.

Exhibit 4: Consensus

Great expectations

Source: BoAML

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JP  Capital    Perspective  is  everything  

Jonathan Taubert FX and Commodities

Pete McCarthy Equities and Fixed Income

JP Capital Team

Going forward Markets remain in buoyant mood even though the underlying factors haven’t changed considerably over the past month. The trend is your friend so the old adage goes, but while markets rejoice a delay in rates, investors should be wary of an impending mood swing. Inflation remains subdued coming in unchanged Month over month at -0.1%. U.S jobless claims declined to 260,000 for the week ended October 3, from 276,000 in the prior week. Next moth PMIs should be a great indicator of future positioning. We remain cautious on equities even though they have recovered from their summer sell off. Sitting on the sidelines means missing out on gains, but also missing out on losses.