Complicated picture suggests taking a step back

19 October 2018

The global equity market sell-off calmed this week, even though the predicted bounce back petered out sooner than most had expected with selling pressures already returning mid-week. This left stock markets roughly where they had been the previous Friday, i.e. in a sad state from a 2018 year to date perspective. Average earnings growth of above 20% reported by the first cohort of US and European companies of this earnings season failed to impress equity investors and were regularly greeted with selling rather than buying orders.

The initial sell-off, triggered by concerns that a bond market riot may be brewing because of normalising yield levels has turned stock market pundits away from the positive US and global growth narrative to look for other reasons with which to rationalise their sudden risk-off stance. And once they are looking they can find far more than just Donald Trump’s trade war poker games: Saudi Arabia threatening with an oil shock; proposed routes to Brexit becoming so confusing and ever changing that all sides seem to be screaming ‘˜No!’  in unison; Italy provoking the bond markets by submitting budget proposals they know are unacceptable for the EU and Eurozone and perhaps most importantly – Chinese stock markets suffering a bigger than -20% and accelerating equity bear market.

The last point may indeed have been the most relevant factor in this week’s lacklustre market recovery. In today’s interconnected capital markets it is entirely feasible that the liquidity squeeze in the Chinese stock markets spread through selling pressures of Chinese institutions and private investors to other markets and exacerbated the newly adopted risk-off mood.

With the exception of the liquidity squeeze – which China’s central bank sought to alleviate through effective monetary counter measures – I struggle to share markets’ sudden and overly negative sentiment. The Saudis had thoroughly miscalculated the collateral damage of first dealing with a critical Saudi journalist medieval style, then denying it and once cornered, threatening to wage ‘˜oil’‘war’ on the world. Their attempts at damage limitation since Monday from the very top – i.e. the king himself-  indicates that it must have dawned on them that their initial strategy would hurt them more then help.

Oil markets appeared to agree, leading to a fall in the oil price back to $80/bbl which makes more sense given supply is very likely to once again exceed demand at such elevated prices and against the not insignificant emerging market deceleration of the past months.

The Italian budget proposal may have been made by radical populists, but its substance has been reported to be solid, professional and not as outlandish as some commentators first suggested. This makes a negotiated compromise solution before year end the most likely outcome, rather than the big stand-off confrontation the bond markets fear and have begun to price in and penalise through higher bond yields for Italian bond issuers.

On the Brexit side finally, most of the points we discussed on these pages over the past weeks have now entered the mainstream of the negotiations. Be they the likely extension of transition periods, a temporary continuation of the customs union to prevent trade disruptions or a bespoke association model for the UK. The seeming unwillingness of the opposing political sides within the UK’s political leadership and parliament to seriously consider any of them makes me suspect that we are witnessing deliberate rather than situational brinkmanship on the side of the government. The more to the wire negotiations appear and the later Theresa May’s team presents any form of Brexit deal, the less the time, opportunity and public support for those who prefer chaos to pragmatic compromise – to agitate against it.

The weeks until year end can therefore be expected to remain as unnerving as the weeks since the summer, which may well put renewed but temporary pressure on £-Sterling, until at the last minute the looming crisis is resolved in a nail biting finale. A strategy which both sides will hope to make the result ‘˜sellable’ to their respective electorates.

For capital markets, not Brexit but the ongoing global US$ liquidity shortage may become the biggest headwind, but one that the continued economic expansion is capable to overcome and reverse. This is unless a strengthening USD counteracts the reduction of liquidity tensions by withdrawing more liquidity from the global economy than the credit expansion of the normalising bank and financial sector can generate through increased monetary turnover. Thus far this has not happened which makes me optimistic that this global risk-off episode will wash over, just like the previous ones and investors will once again focus on real economic progress and corporate earnings rather than on a vast array of ‘˜what-if’ scare scenarios.