A review of 2018 ..... and it's only Jan 16th

Tuesday 16th January 2018

ref :- "Bond sell-off and soaring euro take centre stage" , The Financial Times , Markets and Investing

Well, not so much a review .... more a quick resume of the dominant themes for investors so far in 2018 -- or three of them at any rate (themes that is, not investors). With immaculate timing, it so happens that two of the themes identified by the FT are taking a bit of a breather this morning (euro strength, bond weakness). No matter .... both have been highlighted as early trends for the new year and nothing moves entirely in straight lines, as we know.

Euro gains momentum

There was a bit of "to-ing and fro-ing" in early January, and the failure of the euro to break up through the $1.21 level that had assumed growing significance led some dollar bulls (a minority group in early 2018) to hope that the US unit might be on the point of staging something of a recovery. It was not to be ..... a break of that technical barrier to a three-year high of about $1.2285 (last at $1.2210) theoretically opens the way for further euro gains. We've discussed the underlying (possibly selective) fundamental rationale behind euro strength before : the ECB is yet to embark on a policy-tightening cycle that robust Eurozone growth makes inevitable, whereas US rate hikes are well-signposted and already largely priced into the market.

More recently, the release of the minutes of the last ECB monetary policy meeting revealed a small but significant shift to a marginally more hawkish position. Such a shift from the ultra-cautious ECB was certainly supportive for the euro, but the factors that provided the final push through $1.21 were : the positive early progress towards Mrs Merkel finally being able to put together a working coalition, and the dollar-negative interpretation given to US inflation data that might have gone either way (headline numbers were weak, but core numbers strong).

So, after a hesitant start one of the more popular trades heading into 2018 (Long euro / Short US dollar) is working well and confirmation that momentum is with the euro has got quite a few analysts marking up their expectations for EUR / USD for the first half of the year at least. As the FT points out, one headwind for the dollar that has yet to really attract due attention is the probable ramping-up of trade tensions globally as a result of the administration's America First policy.

It's possible that the Eurozone's insipid inflation data (out this week) might put the brakes on the euro rally for a time. It's also possible that given his record, ECB president Mario Draghi might go out of his way to stress that any acceleration in tapering of QE is out of the question, which might suggest the process of normalising monetary policy is going to be a very slow one indeed. But for now, the strong euro trend is still well and truly in play.

Jury is out on bearish bond run

We've often had cause to mention high-profile bond market gurus who are warning of the end of the 30-year bull market in bonds. Well, it's a very big deal indeed ..... given the enormously high levels of government and corporate debt across the globe, the ramifications should bond markets tumble (and bond yields spike higher) are huge. The thing is, not only does the market appear a long way from any kind of meltdown but it appears reluctant to indulge in any kind of significant reversal even though all the conditions for such an event seem to be in place.

In what seems like a bit of a climbdown (not that he would call it that), even bond market Cassandra-in-Chief Bill Gross is now dialling back on his expectations of how much bond prices might suffer (and yields move higher). Yes, global central banks are buying fewer bonds and in the case of the Fed are already lifting rates and reducing the balance sheet. And yes, faster global growth should yield to higher inflation expectations, and therefore higher yields. And yet last week the US Treasury auction of 10yr and 30yr bonds saw very healthy demand indeed. For all this year's upward move in bond yields, the March 2017 high on the 10yr Treasury remains intact at 2.63% -- the high last week was 2.59%.

Bond bulls might be happy at the apparent irony developing in bond markets : in the short-term at least, stronger growth and its inflationary implications will be tackled by Fed hikes -- we may see four this year and the market is only pricing in something a little over two. At the same time, a strong response to inflationary pressure , which long bonds hate, might actually be good for bonds. That would mean yield curve flattening as short rates rise of course but not necessarily jumps in longer-term yields.

Over a longer period, one might expect extended higher short-end rates to lead bond yields higher too, but bond market dynamics have changed in the low-interest rate era. The factors that have supported prices and suppressed yields are still in place : high levels of savings in search of both yield and security, demographic shifts and the deflationary effects of technological advances. Not only are they still in place, there's no obvious evidence as yet that their influence is on the wane.

As the FT says, the jury is still out. The word is that a break of 2.63% leads to a new target of 3.00% for the 10yr Treasury yield -- it's perfectly logical but not yet totally convincing.

Are tax cuts baked into valuations ?

Okay , we get it ..... tax reform, particularly a large reduction in corporation tax, means companies are more profitable ..... which means shareholders get to receive bigger dividends ..... which means the shares that they hold are more valuable. Yes, we understand why the tax reform package has been seen as good for stock markets.

Of all the trends identifiable so far in 2018, the continuation of the massive stock market rally is the most obvious. Since the tax reform bill was effectively guaranteed to be passed, the S&P 500 has rallied 4.1%. Is that a fair reflection of the effect of the tax package ?

Bank of America Merrill Lynch estimated in early December that the package COULD add up to 14% to stock valuations, but then again the S&P has rallied a lot more than that since Donald Trump was elected 14 months ago with a promise of tax reform so it's difficult to be sure how much was already in the price. But now, or rather last week, Warren Buffett no less has stated his belief that the huge cuts in corporation tax are not yet "baked in" to stock prices.

That's not going to make those already uneasy with the vast rises in asset valuations feel any more comfortable. But so far in 2018 the FOMO factor (Fear of Missing Out) is still in control, and many judges do not see a change in sentiment til mid-year. Perhaps ..... but we may get a better idea once we get a look at 4th quarter earnings, which are beginning to emerge .... well, any minute now.

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