The market ended last week in a cautious mood, with Florida in a state of emergency due to Hurricane Irma and the continued fears that North Korea would carry out another missile test over the weekend. Investors were wary and safe haven assets were well bid. As the worst case scenario for Irma failed to materialise and with inactivity on the Korean peninsula, the market emerged from the weekend on the front foot.
Cyclical assets performed well over the week with equities outperforming bonds. Once again currency fluctuations heavily influenced relative performance of equity markets. For example, the Japanese yen devalued by over 2% which helped the Nikkei outperform all other major equity markets. Conversely, the UK equity market suffered from the relative strength of sterling. Government bond markets performed poorly as risk appetite increased and inflation data in the UK and US was higher than expectations. Commodity market performance was mixed as energy did well but metals gave back some of their recent gains. However, the overriding theme was of cyclical outperformance.
There was a clear focus on the inflation data released this week. US CPI and core CPI came in higher than expected, printing at 1.9% and 1.7% respectively. After five consecutive months of below-forecast prints this data came as some relief to many market participants. Better inflation data, coupled with a strong NFIB Small Business Optimism figure of 105.3, increased the market-implied probability of a December rate hike from c.20% to above 40% over the week.
Chinese data was less encouraging with industrial production for August coming in at 6%, missing forecasts by 0.6%. The main drivers of this weakness were slowing domestic and foreign demand. Notably, medium to long-term bank lending to households, a proxy for mortgage demand, continued to slow, which suggests a cooling in the housing market. But inflation data was solid with a CPI of 1.8% beating estimates by 0.2%.
Turning to Australia, employment data was strong with 54,100 jobs created versus the 20,000 expected, along with greater fulltime employment of 40,100 versus the previous -20,300. With an increasing participation rate the Australian labour market seems in a stronger place than earlier in the year. Finally, touching on Europe, CPI data in Germany, Italy and Spain were all in-line with expectations printing 1.8%, 1.4% and 1.6% respectively. With industrial production in-line for Europe in aggregate, and Italy beating month-on-month at 0.1% versus -0.4%, the regional macro backdrop for economic activity in Europe is healthy.
In terms of central bank activity the main focus was on the Bank of England on Thursday. UK core CPI at 2.7% had surprised to the upside earlier in the week and the Bank of England was under some pressure to react. The balance of the Monetary Policy Committee (MPC) vote, however, remained the same as at the previous meeting, with seven to two in favour of no action. The rhetoric did become more hawkish, stating that some withdrawal of stimulus “in the coming months” would be appropriate. The Bank of England currently faces a dilemma: on one side there is a tightening labour market and accelerating inflation, but on the other there is modest wage growth and the fear of a Brexit-induced slowdown. Clearly the MPC is approaching the limit of its tolerance for inflation. The market reaction was to increase the probability of a November rate hike to 65% from 20% a week ago.
Portfolio review
Our broad asset allocation was held steady this week and we continue to believe the macroeconomic backdrop is consistent with maintaining a pro-cyclical bias. We have a number of positions in our total return strategy part of the portfolio that expire this month, and we have begun to selectively roll positions when presented with attractive entry opportunities. Within range-bound strategies, we added downside positions within the US, European and UK equity markets that could benefit the portfolio if these markets have underperformed at expiry.
Downside skew in the US equity market is elevated relative to historic levels, and we used this as an opportunity to add a breakout position which could benefit in a positive market environment. Although recent geopolitical tensions have caused brief pockets of modest pickup in volatility, we maintain a below average level of risk in our portfolio while we await better entry opportunities.
The portfolio made a modest loss over the period with underperformance from fixed income positions broadly offset by gains from equity holdings.
Outlook
The main event next week is likely to be the US Federal Reserve’s Open Market Committee (FOMC) meeting on Wednesday. Although interest rates are widely expected to remain unchanged, the Federal Reserve is expected to announce the start of balance sheet normalisation. The mechanics of this process have already been described in the June 2017 Addendum to the Committee’s Policy Normalisation Principles and Plans. Hence, it seems unlikely that there will be a significant market reaction if the start of the normalisation process is announced. Any debate, however, on the extent to which slower inflation is transitory or structural will be closely watched. We believe that the FOMC could still raise rates in December for financial stability reasons, even if inflation looks likely to remain below target. The Bank of Japan also meets next week although no change in policy is expected.
The German election takes place next weekend and it is widely anticipated that Angela Merkel will win a fourth term as chancellor. The chances are rising that Merkel will be able to form a ruling majority with just one coalition partner. The Free Democratic Party (FDP) looks to be in pole position as its programme is broadly compatible with the programme of Angela Merkel’s party, the Christian Democratic Union. That said, the FDP does take a harder line on eurozone reform and has called for a Greek exit from the single currency. It seems unlikely, however, that the German election will trigger any material market moves.
There is a reasonable amount of economic data to be released next week, although it is mostly second tier in nature. It is worth noting that the recent hurricanes will add considerable noise to US data in the months ahead. Next week will see the release of the preliminary Markit purchasing managers’ indices for September for the US and the eurozone. Other key releases include various housing-related data in the US, finalised eurozone CPI for August, UK retail sales and the European Central Bank’s economic bulletin.
The value of investments and any income from them will fluctuate and is not guaranteed (this may be partly due to exchange rate fluctuations). Investors may not get back the full amount invested. Past performance is not a guide to future performance. Unless otherwise attributed the views and opinions expressed are those of the fund manager at the time of publication and are subject to change. The content of this document is valid for one month from date of issue.