Houston we have a problem

• Hurricane Harvey wreaks havoc in Houston but the US economy has ongoing challenges
• US 10 year government bond yield of 2.17% reflects market's view that growth and inflation will remain weak
• Near term technicals favour bonds over equities
• Medium term uptrend in is still intact
• Emerging market assets still favoured but look for a bout of relative weakness

As Hurricane Harvey wreaks havoc in Texas and most notably Houston the US 10 year government bond yield (2.17%) has again settled at the low-end of the 2017 range. You wonder when policy makers will realize that this could be the new norm rather than dreaming of significantly better economic growth, higher inflation and Fed rate rises. Recognising that we live in a low growth environment with limited inflation risk pushes you to a better balance of bonds and equities and alternative assets. 

I’m less worried about capital losses from bonds despite these government low bond yields, but I continue to be concerned with the level of developed market equity markets over the longer-term. I laugh to myself when commentators characterise current global growth as a pleasant surprise. To be sure global growth is solid with maybe more consistency in places such as the and the emerging markets than we have seen for some time. However, despite some better news in the US, economic data has continued to muddle along, on balance below market expectations. The Citigroup measure of the degree to which economic data is coming in above or below expectations is at an index level of -32.2 versus a June low of -80.0. Yes, better than June but still not good. 

At a global level, bond markets will take heart that there is still scant news of a build up of inflation pressures. Take the UK where last week’s inflation report came in below market expectations sending Sterling markedly lower. The UK has been one of the more inflation prone countries in the wake of the Brexit vote that sent Sterling sharply lower and pushed up the price of imported goods. Even UK producer price inflation fell back in July from 3.3% to 3.2%. UK inflation is high at the moment. However, it is hard to see it gaining any momentum given that indicators that still show very limited wage inflation. Recruitment firm Adecco said that they expected wage inflation over the next 12 months to hit no higher than 1%. Limited wage growth meeting higher than usual consumer price inflation usually leads to a buyers’ strike and consumer price inflation falling back. 

With limited signs of wage inflation, any burst of consumer price inflation is unlikely to persist. I’m very sympathetic to the academic arguments that summarised by the FT in an article published by the FT in July that laid out some very valid reasons why wage inflation was not going to prove a problem in the coming years. While labour has become more disaggregated due to the demise of trade unions, and more workers starting their own businesses leading employers have become more dominant and more capable of keeping salaries in check. 

This coming week sees the release of the Federal Reserve’s preferred measure of inflation the PCE deflator with the consensus view that it will drop back to 1.4%. Seriously why is anyone talking about the need for US interest rate rises? The market assigns a 35% chance of a rate rise by year-end but to be honest market pricing is for a 50-50 call on a rate rise by the end of next year. 

The medium term uptrend in still looks intact despite last week's setback on weaker than expected inflation. $1.28 proved to be the low point and some further recovery possible particularly given the coming challenges in the US, namely weaker inflation and debt ceiling deadlines.

Near term technicals still, favour bonds over equities. Technical analyst Bill Sarrubi points out that September October and November are not typically good months for equities, particularly in years with a 7. Possible catalysts for a setback remain geopolitical. While the rhetoric around North Korea appears to have gone quiet media speculation that the US Secretary of State Rex Tillerson could be next on Donald Trump’s hit list suggests that one of the true diplomats and calming voices at the White House could be on his way out. Meanwhile, the debt ceiling negotiations appear to be difficult with a deadline of the end of September/ first week of October still looming large on the horizon. Debt ceilings proved hard enough to solve under the Obama presidency, and now we have the dysfunctional Trump presidency to guide the negotiations. 

Over the medium term, there is still more to go for from emerging market assets despite recent good performance. Emerging markets equities have powered to the highest relative levels to global developed equity markets seen since mid-2015. However, that is 25% below where emerging markets stood relative to developed markets back in 2012. Low government bond yields in the US should continue to support the valuations of emerging markets where growth should be persistently and sustainably stronger over the long-term. 

Emerging market equities don’t have the same frothy dynamics as is the case amongst developed markets. Economic growth is still relatively early cycle, and currencies are good value. An analysis by Credit Suisse showed that of 10 emerging market stock metrics only two show signs of mid-to-late cycle behaviour. 

Investors should look for buying opportunities in emerging markets into weakness. Recent fund flows into emerging markets have not been so emphatically positive. Bouts of global risk aversion had investors taking some profits, particularly in early August when a large outflow broke a twenty-one-week streak of inflows into emerging market funds.

Weather disruption from tropical storms and hurricanes around the world is likely to wreak havoc with some of the coming economic data, particularly in the United States. Hurricane Harvey has hit Texas particularly hard. Texas accounts for 8.8% of US GDP. CNN reports that more than 24 inches of rain fell in 24 hours and more rain is expected. While the local economy gets an immediate hit as activity comes to a halt in the most affected areas. In the aftermath, the rebuild and often release of substantial public funds to help those affected should help the state and national data improve.