Momentum momentum

• Equity markets likely to maintain their momentum in the absence of materially higher rates
• Central banks are withdrawing QE but for now markets show no fear
• Only a sharp rise in bond yields can end the party
• Watch for other central banks raising rates - UK sterling supported... for the moment
• Mr Abe gets a stronger mandate - Japanese equities well supported
• Europe watches Catalonia
• How about a cave on the moon?

As central banks continue to push on with withdrawing some of their quantitative easing and raising interest rates, equity markets push higher. Although you would expect the equity market to take the thought of tightening badly, to date bond yields have remained low supporting sentiment. As long as the 10-year bond yield remains in recent boundaries, equities may continue to push on irrespective of whether there are serious doubts about value. 

The momentum alone of equity markets is drawing more and more investors deeper into the market. As a CIO, I’m more than aware that making the observation that something is cheap or expensive is not always useful when trying to judge when the market will turn. It was sobering to read one technical analyst @Bill Sarubbi at Cycle Research observe that similar dynamics of the current run in the US equity market have occurred on 18 previous occasions. Going back to 1928 there are only two time periods that can match this year’s momentum, in 1964 and 1995. History suggests a further 5%-15% gain over the next six months. 

 How could the market make further gains when it has already gone up so far? Well for one some surveys such as the Yale’s showed a dip in investor sentiment since the middle of the year. With the markets on the rise again it is possible that a fresh wave of buying by retail investors who feel they are missing out reinforces the rally. Indeed there are some signs of this happening. The Michigan consumer survey of investor views on stock market returns spiked to an all-time high, and new subscriptions to equity-based ETFs have reaccelerated to $31.3 billion (Deutsche Bank estimate).

The key to the equities market maintaining their momentum is the good behaviour on the bond markets. To-date the US 10-year government bond yield has remained range bound. However, a break above 2.40% would at least present a headwind to the market, as the fear would be, that this is ‘the’ big break out of yields. I sense however that the US 10 year government bond yield would need to move above 3.0% to break the back of the recent run-up in equities. 

The growing group of central banks that may raise rates also provides a challenge. The US, Canada, UK, Korea are countries thought likely to raise rates before the end of the year. Not that the prospect of a rate rise has helped sterling much. The UK remains beset by significant political problems with the government struggling to find support even within its own party for its approach to Brexit negotiations. While in the near term there is scope for a sharp rally on the decision to raise rates but that would probably provide a selling opportunity on a one year view. 

The key event of the coming week is likely to be the announcement of the tapering of European Central Bank’s Quantitative easing (QE). The market is anticipating a drop in the pace of purchases from Euro 60 billion a month, down to Euro 20 billion through to the middle of next year. 

The ECB, like the Fed, will be keen to distinguish QE policy from that of interest rates. A tightening of QE and rise of policy rates are not likely to go in lock-step; rather the pace will be quite independent. Indeed should the central banks see that the reduction of QE has too dramatic an impact, they may go slow on rate rises. At this stage, the market still sees very limited rate rises from the Fed and nothing from the ECB before 2020. 

Investor appetite for Japanese equities is likely to be reinforced by the results of the election that has given a strong mandate to Mr. Abe as he forms a new government. Prime Minister Abe’s Liberal Democratic Party and a small coalition have secured at least 312 seats taking them through the crucial 310 barrier that allows them to push through some structural reforms. The coalition already holds a two-thirds majority in the upper house. 

The stock market will probably shrug off the fact that Mr. Abe is likely to use the new powers he has to push through changes to what is termed the “pacifist” constitution drafted by the United States in the wake of the Second World War. The changes are likely to see Japan more active militarily in the geopolitics of the region. 

The new government is likely to push ahead with some reforms that the government will hope will tackle the problem of a declining population. Reducing the cost of education and childcare are aimed at increasing the birthrate. 

In Spain, the move by Catalonia to seek independence has created the inevitable response from the centre with a move to take direct control of the state. How the centre deals with the crisis and how successful it is in defusing the fallout will set precedence for likely other protest movements around Europe. In my view, although there has always been a deep-seated separatist movement in Spain for some considerable time the reason it has gained greater traction now is the context of the broader theme of protest votes across Europe. People are still unhappy with the political elite and are thrashing around for an alternative. The previous week’s developments in Austria where an extreme right-wing candidate has won through only showed how much peripheral parties are penetrating mainstream politics. The political challenges of the 1930s and 40’s were a direct result of the depression years in the last 1920’s and 30’s. The world is still making its way through the aftermath of the world financial crisis. 

A final thought for the week. We may all need to go back to being cavemen. It seems China is genuinely worried that the North Korean’s will bring down a mountain with their next nuclear test leading to massive nuclear fallout. All hope for the human race is not lost With fear of nuclear fallout from the next North Korean nuclear test that may bring down the 4000ft tall mountain; the good news is that Japanese scientists believe they have found a massive cave on the surface of the moon. The scientists have estimated that the cave is 100m wide and 50km kilometers deep.