How is it possible for economic activity to be satisfactory if most industrial companies are struggling? Maybe it is just political uncertainties (Brexit, US presidential elections, political stalemate in Spain, referendum in Italy, uncertainty on central banks’ policies) delaying or pushing out some decisions and incentivising anyone to do destocking. If so, we should find out soon, because if these results do not improve fast in the first quarter of next year, it is going to be “Houston, we have a problem...”.
Setting aside political frenzy (high court decision in the UK, tight presidential race in the US, impending referendum in Italy which Renzi looks likely to lose), the most noticeable development in October was the rise in long bond yields. The US 10 year was as low as 1.36% in July. It is now 1.8%. Is it finally the inflection point that every sane man in the world should hope for (a return to normal rate environment, corollary of a return to a more “normal” world)? There is now clear tailwind for CPIs with commodity prices on the rise and wage inflation in countries with low unemployment rates (US, UK, Germany, ie 3 of the 4 largest economies in the world). With the Fed hinting at a hike in December and the ECB floating the idea of tapering, the trend may continue and there is still a long way to go (in a not so distant past, end of 2013, the 10 year rate hit 3%). This has clear consequences for the equity market.
First of all, indices will struggle to push up, if the bond market goes south. This is an event we will not try to capitalise on, as we never take a directional risk.
Second, bond proxies (staples) stand to lose, as their valuation should mechanically suffer. We don’t invest on the basis of valuation, but up to now we had failed to make a return shorting staple producers with a disappointing earnings profile, as valuation multiples expansion more than compensated for the drop in profits. This may change in a different rate environment. Some sub sectors might finally provide us with shorting opportunities.
Third, financials may finally hope to make a return on their capital. This is a game changer, especially for banks. We have already started to build positions in that space, though limiting ourselves to banks with a very solid balance sheet. Things seem about to change. I would welcome it.
However, the one thing I fear is that this change might be of a political nature rather than a monetary one. Next week we may wake up with a new US president who promises to rock the boat. In the UK we may head into early elections, if the Supreme Court does not over-rule the high court. Italy may start his search for its 66th prime minister since the end of the war. All these changes may take place before the next corporate reporting season starts. Investing is not getting easier.
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