A critical week ahead

Monday, 24th August 2015 10:32 - by David Harbage

A critical week ahead...or is it? After a tumultuous week in stock markets, the week ahead appears critical for short term traders - if not long term investors - in equity.

A six year low in the preliminary manufacturing PMI survey data from China provided further ammunition for bears suggesting that the world's second largest economy is slowing much faster than consensus expectations, and that GDP growth will be below the local government's forecasts of 'around 7%'. The prospect of this particular engine of global growth faltering has driven a dramatic fall in commodity prices of industrial minerals and metals, extending to other natural resources such as oil (where Brent crude lost 7.3% to US$45.46 per barrel last week) and gas.

The Dow Jones industrial average recorded its weakest week in four years, closing under the critical 17,000 level, which has held good since October of last year, and ending down 5.8% at 16,459.75. Political turbulence continues to dominate in Europe, with another Greek election on the horizon following the resignation of prime minister Alexis Tsipras, and the German DAX index fell 7.8% to 10,124.52. By contrast with the continent of Europe, the UK's equity market is typically less volatile but the FTSE100 still closed at a 2015 low, after retreating 5.5% to 6,187.65 and the mid cap FTSE250 index gave up 4.2% to close at 16,876.6.

Chartists, also known as technical analysts, will be keenly watching for equity markets to fall through their perceived positive resistance or support levels - typically defined by moving day averages - as a means of determining if markets are set to move lower and have changed course from being in an upward bullish trend (which has been in place since 2009) to adopting a new bearish tack. This should not be confused with a move into recession - which is an economic state, defined by two consecutive quarter-year periods of negative growth or lower output. Both bond and equity markets look ahead to determine what is likely to be occurring in the offing (a nautical term describing the sea or water that can be seen from the coastline or land), and will value their respective assets by reference to what appears likely to occur and impact in the foreseeable future.

Accordingly, traders in index futures, bonds or stocks are right to read the very short term prognosis for prices of such instruments or securities - mindful of the power of computerised trading to rapidly respond to any break in critical support levels - irrespective of fundamental events or subjective views. Often positions will be forced to close prematurely, as traders reach their threshold of indebtedness-driven 'pain'. Such high volume trades, typically prompted by previously arranged limit orders, can lead to distorted valuations (applies on the upside, as well as the downside) and an opportunity for the more considered, grounded investor with a longer term time horizon to take advantage of an anomalous price.

The difference between 'being early' in calling the bottom of the market's current dip, or 'being wrong' will only be revealed, of course, some time after the event. Capturing the actual low point is a near impossibility, and so this writer would encourage the prospective investor to have courage in their own convictions as they endeavour to read the current state of the various factors that contribute to determining fair value for a particular asset. In the case of equity investment, the following consideration of the downside risks and positive returns drive, and define, this writer's unbiased view on the UK equity market.

Global economic growth, taken overall, is clearly positive. An update of US economic growth, due later this week, is set to show an acceleration in GDP despite inflation slipping back to a negligible pace. The latter persuaded markets that the Fed (Federal Reserve Bank, America's central bank) was now less likely to raise interest rates next month, causing the US dollar to slide against the Euro (by 2.5% to 1.1386) and sterling last week. Economic activity in certain parts of Europe is sluggish, but positive performances from the bigger contributors like Britain, Germany and France deliver near-trend levels of growth. For all the 'noise' surrounding Asia - and China in particular, over the past two weeks - growth remains very healthy, with a slower pace being a natural consequence of a larger starting base.

An absence of inflation (and, in places, evident deflation) in a number of business-critical cost components - notably the price of oil and finance - represents a major positive. While a lower oil price is not good news for the industry (especially the upstream explorers and the allied service companies: noting that Wood Group plan to lay off 5,000 staff, including 1,000 in its North Sea operations), the rest of industry and consumers, worldwide, will benefit. Higher inventories - featuring a further 2.6 million barrels of oil being added last week, to take the US crude total to 456.2 million - suggests that the oil price appears set to remain in the doldrums (please excuse the pun) for longer. A number of headwinds suggest that global and domestic economic growth will be less than robust - but nevertheless, comfortably within positive territory. That the cost of borrowing appears stable and unlikely to rise - in either magnitude or in the immediate timescale - should encourage consumers to spend, and corporates to invest.

The long term investor in company stocks and shares should be heartened by a reasonably benign outlook for profits - mindful that earnings are the prime determinant in valuing the asset. In particular, a more mobile cross-border workforce, lower direct corporate taxation burden, low inflation and cost of finance provides a supportive framework for successful businesses to flourish. Single digit paced progress in the turnover of UK plc can be progressed, via efficiently engineered balance sheets (as gearing kicks in), to deliver very respectable (high single digit) profits and - in a steadier domestic environment, post the election - increase the proportion of such earnings paid out to shareholders in the form of a dividend.

By contrast with the above mentioned suggested improvement in the corporate landscape (which, in itself, could be debated), there appear to be new and perhaps greater geo-political or macro financial uncertainties for corporates, and their investors, to contend with. An increasing pace of change in the world's political 'hotspots' (noting recent tensions in Turkey, amongst other countries) and the prospect of negative shocks - from sporadic terrorist atrocities to cyber crime - makes it difficult for markets to 'price in' the risks of an escalation and an eventual outcome, if not solution. The financial problems include the health of public finances, with many so-called developed countries' levels of debt being so high, as to necessarily result in huge eventual write-offs, and the threat of deflation (and its impact on both the worth of debt and associated assets).

The investor in real (here defined as the prospect of delivering inflation-beating income or capital returns), cum risk assets has to determine the relative weight they wish to place on the apparent risks (and price in some unknown, to say nothing of 'black swan events') as well as the potential rewards (set against the background of the alternate means of storing value, such as the bank account) before deciding how comfortable they are with their current allocation of assets. This writer believes that UK company shares currently appear significantly undervalued or erroneously priced, but accepts that the fear of another deterioration this week and the prediction by some commentators of further weakness can prove to be a self-fulfilling prophecy.

It is going to be an interesting week for markets.