Most equity markets were down last week with the Dow, the SP500 and the NASDAQ losing steam and the MWXO World index ending marginally lower. Some profit taking took place in Asia and Japan succumbed to the sharp rise in the value of the Japanese Yen, losing 2.5 % in value. Europe was stabler with the German Dax being one of the very few markets closing up on the week. Brazil and Vietnam were the best performers while Japan was the worst.
Equity markets are richly priced, having rallied for 9 years now. Their rise has been fueled by exceptionally accommodative liquidity injections by Central banks and lately by a powerful recovery in earnings following the global pick up in economic activity.
In the US, the story is all about valuation extremes and the end of easy money. Many institutional investors and strategists have started to worry about the elevated valuations but individual investors have adopted a buy-on-dips mentality that has prevented any significant correction to develop since February 2016. The FED timid management of the normalization of the structure of interest rates and their prudent approach to reducing their bloated balance sheet is keeping bond markets happy and bond yields abnormally low at this stage of the cycle.
The consensus has not yet embraced the prospects of rising inflation and keeps worrying about an economic slowdown.
But the reality is actually quite different.
The world economies are now growing in sync and the survival of Europe is no longer a question mark following the victory of Emmanuel Macron last May and the expected victory of Angela Merkel in next month’s German elections.
Far from it. As we wrote back in January 2016, when we predicted its outcome, BREXIT will be good for Europe and calls for a more integrated and more powerful Europe have already started.
The real danger to the financial markets ahead are not political. We do not expect the North Korean situation to develop into a situation of war.
The danger comes from the msipricing of bond markets worldwide following the artificial driving of bond yields to negligible levels over the past few years. This will reverse one day and when it happens, equity markets, and the US equity market i the first place will suddenly look extremely overvalued, leading to a significant correction.
But we do not expect this to happen just right now.
Our view is that the US markets have probably entered a shallow correction that will end in September or mid-october, paving the way for a new rally into the year-end and the beginning of 2018. For the time being, equity markets are supported by stronger growth and the total absence of monetary tightening as the FED increases in interest rates barely match the rise in inflation, keeping REAL rates of interest still in stubbornly negative territory.
Moreover, we expect the Trump administration to succeed at passing a revised tax reform that will boost optimism and economic activity even if it fails to deliver on the campaign promises.
It is only by the end of the year or the beginning of next year that the markets – and the Central Banks – will realize that they are way behind the curve and that they have allowed inflation to develop a sustainable momentum upwards. By then, the need will be to raise interest rates by much more than currently expected and bond yields will probably shoot up to 3 or 3.5 % form their current 2 % level.
In Asia, we saw some profit taking last week and emerging markets are not faring that well. But the trend in China and Hong Kong remains extremely positive and the recent rise of the Yuan and the Hong Kong Dollar combined with the upcoming Communist Party Convention in October bodes well for equity markets there.
Global investors will also be attracted by a stabilization or even rise of the Chinese currencies and be more willing to add structurally to their long term weightings to the Chinese markets that are trading at deep valuation discounts to their Western counterparts.
In Europe, the correction has already happened as the EUR was rising agains all currencies. Equity markets are giving signa that the correction is over and any reversal in the EUR will be a catalyst for a significant advance. Moreover, important developments are taking place in France, Spain and Italy where, finally, the structural problems of the labor laws and taxation are being addressed. We have started re-building positions to Europe and expect the European markets to outperform the US in the coming six months.
We would avoid the UK market and privilege large cap exporter and the German, French and Spanish Equity markets.
The situation in Japan is complex. The technical picture of the Nikkei 225 is the only one that is truly negative at the moment and there is no doubt that a continuation of the Japanese currency strength would be a negative for the market. However, history tells us that the Japanese never hesitate to intervene in the currency markets when they start worrying about the economic impact of the strength of their currency. We may have reached this tipping point last week.