31 July 2015

Lothar Mentel

Chief Investment Officer

samuel leary

head of investment communications


1 year Brent Crude oil price chart; Source: Bloomberg.com

Commodity price deflation returns

The past week should have all been about the latest announcement from the US Fed following their FOMC meeting deliberations about when they might raise interest rates. Instead commodities or rather the renewed fall in their prices grabbed the headlines in what felt a bit like a déjà vu of last year’s market action. In my opinion it is likely that the latest movements have been the result of the ‘fast money’ community of hedge fund traders getting it wrong once again. Their renewed bet on rising commodity prices was well known. I suspect that they simply threw in the towel after additional Iranian oil (embargo lifted after nuclear accord) actually materialised and further increased the existing supply overhang. This is where the similarities to last year end. It may still be bad news for the global oil explorers, but this time around there doesn’t seem to be the concern that the prices have fallen because of a worsening economic outlook.

Indeed the consistency of the ongoing recovery was the take away from the Fed announcement. Chair Janet Yellen noted steady growth and progress in the jobs market with somewhat diminishing labour underutilisation. She reiterated the committee’s preparedness to raise rates when required but gave no further timing indication. Given there is no August FOMC meeting, plus there were no particular indications for a rate rise after the next meeting,plus the Fed has been very keen not to surprise markets, we have concluded at Tatton that there is a very low likelihood for a September rate rise. This bodes well for stock markets, which therewith had the second proverbial “can” after Greece kicked down the road.

Further support for stock market upside potential is coming from better than expected Q2 company earnings, which are solid for the US but exceptionally strong for Europe. For the first time in years it looks like European earnings growth will be ahead of the US. With higher grade fixed interest securities still only yielding what inflation is taking away, this makes equity investments by far the more attractive investment for the long term investor.

As ever there are also some clouds on the horizon. For the UK in the form of trade obstruction with the Continent through the near closure of the Eurotunnel freight terminal because of the migrant crisis on the Calais side. Globally, the Chinese slowdown has been elevated to primary macro-economic worry-point, although the recent stock market rout there had very little to do with the actual economy.

To be sure, this is not a sufficient explanation for July’s lacklustre stock market returns which have been somewhat disappointing given a resolution to the Greek issue is now well on its way. Far more likely that the lower commodity prices have once again caught enough investors off guard to result in a short term drying up of market liquidity and rekindling of deflation concerns. Just as last time we expect this to be temporary and for stock markets to slowly but steadily grind higher as the summer progresses.

Dollar and US stocks gain as fed holds rates

The US central bank, the Federal Reserve (Fed) gave another upbeat assessment about the prospects for the US economy, stating that it remains on track to lift rates at some point this year.This is notable, given it’s been the 54ths consecutive meeting with no increase in interest rates (almost 7 years!). The dollar nudged back towards multi-year highs and bond yields (Treasuries) rose, while equities were boosted on the expectation that any rate rises would be gradual.

The trade weighted dollar index gained 0.5% to 97.41, just 3% away from the 12-year high seen in March. Treasury yields added 2 basis points to 0.73% 2-year maturity issues, which is within touching distance of their highest level from April 2011. The VIX Index, which measures volatility in markets, temporarily dropped to an 11-handle (I.e. 11.x%), indicating that levels of stress in markets are diminishing.

The Fed made only a few minor adjustments to its July FOMC statement (Federal Reserve Open Market Committee). The most significant – even if it sounds relatively dull – was the addition of the requirement that members will require "some" further improvement in labour market conditions (rather than just “further improvement”) and also inflation returning towards its 2% target before they start their first rate tightening cycle.

The Fed’s characterisation of consumer spending remained unchanged despite the poor June reading and said it “has been moderate”. The FOMC also noted that there had been “solid job gains and declining unemployment”, while they noted that the level of labour underutilisation has “diminished somewhat”.

The path of US rates remains a key variable for investors and their impact is likely to be significant on market sentiment and equity valuation multiples. For that reason, the timing of the first rate rise is keenly examined. We note that in a recent speech Fed Chair Janet Yellen said, “I expect that it will be appropriate at some point later this year to take the first step to raise the federal funds rate and thus begin normalizing monetary policy. But I want to emphasize that the course of the economy and inflation remains highly uncertain, and unanticipated developments could delay or accelerate this first step.”

We believe that the choice of the words "delay or accelerate" to be an important clue. This would allow the Fed some leeway in respect to when it chooses to pull the trigger. The Taylor Rule suggests that rates should be higher than they currently are in their zero lower bound (0-0.25%). When we add in other recent statements from Ms. Yellen that the “economy cannot only tolerate but needs higher rates”, it is clear that the Fed want to raise rates and just like the QE taper announcement the December meeting could be the ideal time.

A December “lift-off” may not pose a significant problem for markets, even though trading volumes are generally lower over the Christmas period. This is because there appears to be some empirical evidence that financial conditions are usually less volatile in December – it is actually fairly calm - when compared to other months in the year (as seen in the graph above).


Given the above considerations, we are not overly surprised that Fed officials have shown no apparent signs of concern around a December lift-off. We note that the Fed announced the start of tapering (of QE3) at a December meeting and there did not appear to be any adverse consequences. We believe these factors may enhance the Fed’s confidence that a move in December may not unduly impact market sentiment. The only risk to this view is that we see much stronger inflation and economic growth before then, which could bring forward the date at which the US rates lift-off occurs.

UK growth on track as consumers become more positive

It was an upbeat week for the UK’s economy, consumer confidence and business sector. The Office for National Statistics (ONS) said the service sector helped grow the economy – its 10th straight quarter of expansion, while measures of consumer confidence showed that the UK consumer is in a positive mood and domestic firms have been posting solid quarterly results, with a bit of M&A (mergers & acquisition) also thrown into the mix.


The ONS said that the pace of economic growth in the UK accelerated to 0.7% quarter-on-quarter (or 2.8% annualised), as the services sector posted better growth. The print was in-line with consensus estimates, but crucially, GDP per capita (or per head) has now returned to its pre-financial crisis peak almost seven-years ago.Current UK growth still leads that of its G7 peers, outpacing rates seen in US, France and Germany.

The stronger Q2 reading stands in contrast to the slightly disappointing Q1 print of 0.4% quarter-on-quarter (QoQ). On a more detailed look, services output expanded 0.7% (QoQ), while total Industrial Production (IP) increased by 1% QoQ, driven by a 7.8% QoQ increase in mining & quarrying – helped by sharp upward bounce in oil and gas production.

It would seem that the strength of the pound has restrained manufacturers, as manufacturing output fell 0.4% QoQ, while agricultural output declined 0.7% QoQ.

On a trade weighted basis, July saw sterling hit its highest level since 2008, appreciating nearly 10% against the Euro in just this year alone. This means that company order books have retreated to a two-year low and business owners have commented on their perceived reduced price competitiveness with European competitors. British holiday makers on the other hand will have welcomed the extra value the pound in their pocket experiences in Continental European holiday destinations.

Despite the pressures, capex (business investment) has expanded and continues to remain strong. We note that this is a critical component for the UK’s economy to increase productivity and help offset a stronger pound.

This continued run of positive economic growth appears to have fed its way into consumers, who are in an increasingly upbeat mood. The level of UK consumer confidence overtook the global average for the first time in nearly nine-years, according to market research firm Nielsen. For reference, the last time this happened was in Q1 of 2006 – back when Tony Blair was in his 3rd term as PM and interest rates stood at 4.5%.

British consumer confidence is being underpinned by rising real wages, record low mortgage rates and an improving labour market. We note that the number of shoppers “trading down” (buying cheaper food brands) to save money reached its lowest level since 2009, which reinforces the idea that consumers are beginning to open their wallets and this should help boost spending in the medium-term.

A quick update on the corporate earnings season from a UK perspective shows that domestic firms across the majority of sectors are doing pretty well. Royal Bank of Scotland topped the list of gainers on Thursday after it posted a surprise profit increase of 27%(good news for Tax payers). Broadcaster Sky continues to see off challenges from competitors like BY and Netflix by acquiring almost 1 million new customers. Asset manager Schroders had decent earnings, while AstraZeneca, the giant global pharmaceutical firm, put in better than expected results. Aerospace firm, BAE Systems also saw an unexpected rise in H1 sales on the back of a healthy civil aircraft market. Lastly, Reckitt Benckiser, the biggest company you may not have heard of, maker of Dettol, Strepsils and Cillit Bang and worth £43.5 billion, posted higher sales and improving profitability.

Against that positive background, business are also feeling increasingly confident with Zurich Insurance Group reportedly eyeing a bid for Royal & Sun Alliance (RSA) worth an estimated £5.3 billion or just under 2x TNAV (or Tangible Net Asset Value). Car parts maker Delphi Automotives agreed to buy rival HellermannTyton (specialises in cables) for £1.07 billion.

The recent headlines of nearly 20 miles of backed up HGVs on the M20 (heading towards Calais) do make us wonder what effect this will have on trade with Europe, given how leveraged the UK is to road haulage for delivery of goods.

So where does that leave interest rates?

The ongoing recovery continues to take positive steps in a 2-speed way (i.e. stronger services but slower manufacturing). Growth does appear to be self-sustaining, with consumer spending powering ahead. We note that Bank of England Governor, Mark Carney, outlined his conditions for a UK rate rise as being above-average growth of at least 0.6% QoQ, which means this week’s Q2 GDP reading seems to have met this condition.

However, we think the BoE may err on the side of caution and wait for more evidence that growth is becoming more balanced, despite the fact that inflation should start picking up from the zero level in the medium-term. We anticipate the first rate rise to occur near the end of the 2015 at the earliest or even in Q1 of 2016. In recent history the UK Band of England has not tended to lead the rate rise cycle and left it to their US colleagues to make the first step. Watch this space, but we will be waiting for the signal from the US.

is M&A about to lead the way again?

The recent spate of large and high profile M&A (Mergers & Acquisitions) activity, primarily in the pharmaceuticals and technology sectors appears to suggest that we are just at the beginning of a new multi-year cycle.We note Shell’s £47 billion acquisition of BG Group, Teva Pharmaceutical’s $40.5 billion purchase of Allergan’s generic drug unit and Nokia’s €15.6 billion purchase of Alcatel-Lucent spring up as recent highlights. As such, we anticipate that equity valuations could expand from an increase in activity in the longer-run.

The current M&A cycle looks to have begun in 2014. Typically cycles last 3 or 4 years on average and that cyclicality is a result of a number of overlapping factors:

  • Financing or debt costs
  • Strength of company balance sheets
  • Business confidence
  • Cash held by private equity
  • Shareholder activism

Analysis suggests that the above facts are highly correlated, especially in the US, which accounted for nearly 50% of all deals during H1 of 2015.

We think that as those same factors converge worldwide – we note European corporate profits are recovering and shareholders are having an impact on corporate governance in Japan – that transaction volumes in this cycle could exceed previous peaks as the search for new geographical markets and growth expands. UBS predict that M&A volumes will grow by 22% in 2015.

M&A volumes generally peak towards the end of an equity bull market as top line sales growth slows down (economic progress at present appears slow) and profitability or profit margins reach their highs (as in the case for the US). We feel that companies in this cycle may seek to grow by acquisition – to gain access to new geographical markets, new technologies, cash on balance sheets, customers and market share in order to reduce the risk that can come with organically driven revenue expansion.

The main drivers underpinning M&A can be summarised as:

  • Increase economies of scale
  • Enhance sales diversification
  • Increase operating efficiency
  • Enhance financial efficiency (lower tax rates by tax inverting to a low tax country)
  • Access to new products or production techniques

Transaction volumes in the US in 2014 rose 38% to $1.54 trillion and that trend appears to be continuing this year, given that activity levels jumped 50% in H1. H1 volumes amounted to $1.05 trillion, which is more than the level seen during the very peak of the private equity boom back in 2007. We highlight the trend that individual deal size has been large, which could reflect the availability of cheap financing and high levels of cash on company balance sheets. US companies hold $1.43 trillion in cash and short-term investments on their balance sheets, while European companies hold $1.6 trillion. The combined value of cash on company balance sheets in the “west” is more than the entire GDP of the UK (c$2.8 trillion).

Activity in Europe appears to be a few steps behind the US, reaching back to 2007 levels. The deal flow in Europe has centred on the telecom (Nokia/Alcatel-Lucent), materials (Lafarge/Holcim) and energy sectors (Shell/BG). Now that the uncertainty in outlook because of Greece has reduced, the underlying economic momentum is gaining steam, profits are recoveringand business confidence is increasing, then M&A activity tends to follow.

This matters to investors, because M&A has a tendency to act as a catalyst for higher stock market valuations. This is most probably because this type of corporate activity expresses confidence levels which encourages the whole investment community to rethink their valuation metrics.

oil prices decline and car sales rocket

The oil price has fallen back to the lower end of the recent range on the back of increased Iraqi exports and a pick-up in activity of US shale oil drilling. This lent evidence to the idea that the global oversupply of oil looks set to continue. Added to this are reports that Iran had nearly 53 million barrels of oil stored on boats at sea ready to hit the export market as the sanctions fall away as a result of the accord reached on nuclear non-proliferation.

We have discussed in past editions the negative cross-elasticity of demand for cars, which means that as oil prices decline, demand for cars increases due to their complimentary nature. For evidence of this relationship one only need look the improved performance of Ford, which delivered its best quarterly performance since 2000 as the company sold more at higher prices, especially (gas guzzling) Sports Utility Vehicles and pick-up trucks (F150).

Ford beat estimates with a 10% in pre-tax profit to $2.9 billion. Chief Executive, Mark Fields, said the company should see an even better performance in the second half of 2015, as a new version of the F150 launches in its primary autumn and winter selling period. The good news at Ford was mirrored that of rival General Motors, which also said demand in North America was strong thanks to higher margin pick-up tricks.

Back in Europe, Volkswagen is riding better demand on the continent as the Eurozone economy continues to improve. Volkswagen overtook rival Toyota as world’s largest carmaker, selling 5.04 million units compared to Toyota’s 5.02 million units. The German company had set 2018 as the target for which it planned to overtake its Japanese rival, but recovering Europe has helped it meet that goal some 3-years earlier.