The room’s getting crowded, the party’s been going on a while but more people could arrive. Just beware fair weather friends and a sign it could be time to think about leaving…
Gemma Godfrey, head of investment strategy for wealth management firm Brooks Macdonald, argues that the small drop in US economic output shows investors may have got carried away in recent weeks.
She warns that the stock market rally may prove fragile:
As investors dismiss the economic contraction to focus on the resilience of consumption, they miss the risk that this will come under pressure over the coming months as fiscal cliff measures come into play.
Market rallies have been driven by the fear of an imminent risk receding, but growth is now needed for another leg up in markets. Instead, the ‘pain trade’ is now missing out on equity upside, implying fear of underperformance may be driving investment versus conviction in the outlook for markets going forward. Exemplifying this is the recent rotation by Hedge funds into financial stocks, following the positive earnings momentum, which of course is backward over-the-shoulder looking, rather than based on confidence in the future.
After hitting multi-year highs, can the FTSE 100 continue its recent rally?
NO – The FTSE 100 has been rallying as the fear of risks, like a Eurozone exit or fiscal cliff stalemate, has receded. But growth is now needed for another leg up: there has been relief in the diagnosis, but the patient must now show signs of recovery. The concern for the UK is that it is tough to see a possible source of growth, especially after the latest economic figures showed us courting a triple dip recession. Looking overseas – as many FTSE companies do – the outlook for growth is more encouraging. But troubles in Europe and the US are far from over, as the former grapples with fiscal and banking union, and the latter with delayed spending cut decisions. Equities may provide value over the longer term, but you will have to encounter heightened volatility – and a likely correction – in the immediate future.
Inflation, hard-to-beat expectations and political stalemate provide a significant downward risk to market this week. (Quoted in the Weekend edition of the Financial Times)
Last week was dominated by disappointing manufacturing data from Europe and China, whilst markets shrugged off a less than impressive Budget. After such a substantial rally year to date, this correction is healthy.
This week, issues concerning Europe’s firepower, the US consumer and broader economic growth will determine the direction of markets. Inflation, hard-to-beat expectations and political stalemate provide a significant downward risk to market, although upward momentum could always drive them further.
As fuel price inflation dents sentiment in the US, the consumer may be squeezed and figures for income and spending may disappoint. Furthermore, the opportunity for upside surprises in durable goods orders and Q4 GDP growth is limited as forecasted figures are already high.
A two-day meeting of Europe’s finance ministers will be closely watched for signs of an expansion in the firepower of the rescue fund. The deadline to do so draws near and the pressure for progress grows. However, Germany remains staunchly against such a move and, even if achieved, the figure reached may still not be enough.
From the world’s best performing index in the first three months of this year, to a laggard this quarter, the Russian index has offered dramatic returns as well as downside risk. What has driven investor sentiment and what are many investors missing?
The World Leader Slips to World Laggard
Russia’s RTS Index was the world’s best performing index in the first three months of this year but has now fallen by around 11% in value so far this quarter (Source: Bloomberg). Moves in this market are often attributed to sentiment over the oil price due to the significant revenues generated by the country exporting this commodity. Therefore speculation over economic growth (read: oil demand) is highly influential. This year has been no different. Turmoil in the Middle East can be attributed as one of the main drivers of a strong rally in oil in the first quarter and concerns over economic growth has caused a reversal since that time. However, is this too simplistic a view and aren’t there other factors to which an investor in Russia should be paying attention?
It is clear to see why investors play so much emphasis on the oil price as a dictator of Russia’s financial health. Supplying some 11.4% of the world’s oil supply last year, Russia is the “biggest single source outside the opec cartel”. Although official figures calculate its contribution to Russia’s GDP at 9%, it is important to be aware that speculation over tax avoidance suggests the value may be nearer to 25%. Nevertheless, what is often overlooked is the specific oil price factored into their budget. For this year, a price above $75/barrel will produce a deficit reduction. With Brent currently standing at $115/barrel, a fall in the Russian Index in reaction to a fall in the oil price to anything above $75/barrel may be missing the point.
Boosting Ties with Iraq
With Russian oil fields maturing and production growth resting heavily on foreign investment, the country is looking externally for new sources. Iraq offers potential opportunities and TNK-BP, Russia’s 3rd largest oil producer and BP Plc’s 50-50 joint venture, isn’t holding back. The relationship between the two countries dates back many years and in 2008 Russia wrote off most of their $12.9bn debt mainly generated pre-gulf war from the Saddam Hussein government purchases of Soviet weapons. Interestingly, last October the Russian President, Dmitry Medvedev announced his country was ready to strengthen co-operation with Iraq, the same month TNK-BP gained the right to bid for 3 natural gas areas in the region.
Mediating the Exit of Qaddafi
Within the political arena, Russia has been just as active. In addition to fighting for a stronger developing market influence at the IMF, Russia has offered its services to facilitate the exit of Qaddafi from rule in Libya. This is the first time it has shown support for the NATO-led military campaign after abstaining from UN Security council vote in March which authorised the intervention and accusing NATO of violating the resolution by backing anti-Qaddafi rebels and causing civilian casualties from air raids. Due to the belief that Qaddafi has “forfeited legitimacy”, they are willing to negotiate his fate with members of his entourage. Evidence of the country’s powerful network, the value of their political clout has been highlighted.
Driving the Agriculture Market
Back to commodities but from a different angle, the Russian weather is an influencer to watch for investing in the agriculture markets. Fine weather has prompted an upward revision of Russian grain production with the Federal Hydrometerological Center reporting the warmer weather has improved the prospect for crops. This has led to speculation that Russia’s ban on grain exports may be lifted on 1 July. Wheat future prices saw double digit losses.
The Chinese Buyer
One particular potential buyer of Russia’s resources is China, state media reported last Monday. China Investment Corp (CIC), the country’s $300bn sovereign wealth fund, was set up in 2007 to invest some of the country’s massive foreign exchange reserves. With the world’s largest foreign capital resource, at $3.0tn, they are keen to find better sources of return and commodities to fuel their rapid economic growth.
G-8 Bullishness Boosting Appetite for Risk
Despite these many factors which may influence Russia’s outlook, financially, economically and politically; its index continues to exhibit a strong correlation to the oil price. This week we’ve seen oil (and Russian equities) respond positively to the declaration by the Group of Eight that the global recovery is strengthening.
Nevertheless, to differentiate between short-term over-reaction and more logical fundamental moves, being aware of all the issues will equip you with the insight to navigate this volatile but potentially profitable market.