Is it time to reassess the correlations?

Wednesday, 19th September 2018 08:30 - by Shant

As ever we continue to watch the inter-asset relationships in order to get an idea of what the main drivers in the market are and whether they are undergoing - or starting to undergo a change in some of the broader themes in the market.  Off the back of US economic superiority, we have seen a chain of events led by Dollar strength, hurting the commodities and linked enterprises which have pushed investors through the various channels to their limits.  Emerging markets have suffered from Dollar shortages with heavily debt ridden economies such as Turkey also hit and this has provided yet another boost to US equities as the function of a flight to quality.  

Allied to this have been months of US repatriation prompted by the tax cuts initiated by the Trump administration, with talk that further measures are being considered in a fight to (effectively) reclaim some of the globalisation which the president and his cohorts believe has been to the detriment of the US economy.  True as it may or may not be, we are not here to discuss politics - perish the thought.  What we do look to is the impact and dynamic this is having on sentiment and as we have noted in previous blogs, the lure of the Dollar and Treasuries based on yield alone.  

There is, however, the upcoming mid term elections in the US - in early November to be precise.  This has long been earmarked as a potential hiccup for US$ based assets including the greenback, with the president's rating the lowest of any predecessor in history, pointing to a divided populus who could turn Congress into a real battleground for future policy decisions.  The Senate is widely expected to maintain a Republican majority, so focus will be on the lower House of Reps, where (Republican) 39 incumbents are standing down - some in protest against Trump (so they say).  The Democrats naturally smell blood and if they can take advantage then Trump policy will be harder to enact. 

As it stands, the trade war with China has yet to be felt in its consequences.  Economically, the inflationary impact may take time to feed through into the real economy, but the markets will - or are - ahead of this and have already started to trim down Dollar positioning in the meantime. Given this dynamic has been central to market drivers lately, we could see a propensity to veer back towards the commodity sector outside of the US.  If one has been bypassing Gold as a hedge in a their portfolio, then now may be the time to start reassessing its value based on risk in relative terms, as we have (for some time now) lauded the safety of tangible (precious assets) in what are undeniably uncertain times. 

Trade wars have historically been a lose-lose situation, and economists and market pundits are not shy in re-emphasising this point.  While president Trump is banging the drum to make America great again, the Fed have consistently highlighted this as a material risk to the economy, as have all other major central banks around the globe. 

On this point alone we are looking for markets to start repricing Fed rate profile beyond the FOMC meeting next week, when the Fed are widely expected to lift the Fed Funds rate by another 25bps to 2.25%.  Ever closer to the neutral rate, we expect to see December's meeting to be a little more fraught with uncertainty than it currently is.  With odds of close to 70% of seeing the Fed funds rate at 2.50% by end of year we see this as a case of over-confidence at this juncture, and again, this is central to the broader view dictating the flow in the financial markets as a whole. 

While a softer rate profile may again add fuel to the Wall Street rocket, we revive the view that equity markets away from the US may well outperform over coming months, with the focus sticking with major producers of raw materials our favoured destination given the Dollar dynamic covered above.  You only have to look at Brazil's opportunities in soybean production and export (to China) to get a taste for what can spread through to other industries as a result of US protectionism.  No surprise then to see a healthy recovery in the Bovespa this week, outperforming the major US indices which are already struggling at their record highs. 

The Writer's views are their own, not a representation of London South East's. No advice is inferred or given. If you require financial advice, please seek an Independent Financial Adviser.