Issue No. 1 December 2009 Financial Forecast Inside this issue Key Investment Thoughts 2 Macro Thoughts 3 Equity Markets 5 Fixed Income 7 Currencies 9 Commodities 11 Conclusion 12 Indices / FX Rate Price (prices as at 1 st December) FTSE 100 5,312.17 DJ Eurostoxx 50 2871.75 S&P 500 1,108.86 / $ 1.6610 Crude Oil 78.37 Gold 1,196.60 This report is written to place global financial markets into perspective and to draw together the future themes that we are formulating and subsequent trade ideas. Our sister publication, the weekly report, will pick up on specific trade ideas. RMG Wealth Management LLP 13 Austin Friars London EC2N 2HE Tel: 0207 256 4960 Fax: 0207 374 6448 Email: info@rmgwealth.com Website: www.rmgwealth.com Stewart Richardson Chief Investment Officer RMG Wealth management LLP RMG Wealth Management LLP is authorised and regulated by the Financial Services Authority Registered in England No. OC346813. Registered office is at 13 Austin Friars, London, EC2N 2HE
Key Investment Thoughts Stock Markets Developed markets appear to be tiring in their upward trend established in March 2009. Although headline indices in the UK and US have hit new recovery highs in recent weeks, fewer individual stocks are achieving new highs, showing that the advance is becoming more narrow which is not healthy. Furthermore, volume has generally been declining in recent weeks as markets edged to new highs which is again an unhealthy condition (less volume during a market advance is indicative of lack of participation and therefore a lack of conviction). All told, although equity markets are achieving new highs in the rally since March, the undertone is not as healthy as it should be which makes the market vulnerable to a correction. Interest Rates Bond yields remain within ranges that have been in place all year, indicative of both the huge liquidity support that central banks have provided and also the tug of war between the move towards risky assets by investors and the weak structural backdrop to developed economies. We expect the sideways trend to prevail. Currencies The headlines suggest that the US Dollar is on the precipice although we view things a bit differently. Currency markets are like a beauty parade where only ugly contestants may enter. Although the US Dollar has many warts that we could discuss at length, it is as under-owned and under-loved as it was near previous lows, so the conditions for a rally are in place and one could start at any time. Commodities The undertone to the commodities market is that when the US Dollar goes down, commodities go up. Of course, some commodities are more equal than others, and Gold has certainly been centre stage in recent weeks. If the US Dollar does rally as I suspect, commodities should go through a period of correction. I have highlighted the positive divergence between momentum and price at the March low, and also the current negative divergence that has been building since August. Although the trend is clearly higher since March (see the green line which is the 75 day moving average and has worked well recently as a trend indicator) the market does not feel as robust as it was in late Summer and the conditions that should be seen prior to a correction of note are falling into place. I believe that the upside in developed markets is limited, although so long as the 75 day moving average is rising and the S&P 500 trades above the 1029 November low, the medium-term trend must be graded as bullish. 2
Macro Economic Thoughts Financial markets have recovered strongly since March with most major economies now growing again. The economic recovery does appear to be of the fragile variety, inflation is unlikely to be a problem for major economies and most central banks are unlikely to tighten policy aggressively. The economic turnaround reflects four primary considerations; 1. A significant easing of financial conditions 2. A strong cyclical pick up in the emerging market world 3. A turnaround in the inventory cycle 4. Various fiscal stimulus initiatives The turn in the inventory cycle and the fiscal stimulus initiatives are transitory in nature and the emerging economies are not large enough to become the locomotive for global growth, leaving the unprecedented stimulus as the major supporting factor of the recovery. The US and the UK in particular are so over leveraged, and with the financial intermediation process still quite fragile, it remains to be seen how long the easing of financial conditions can support growth if the private sector truly embarks on a deleveraging trend. The chart below shows the level of debt here in the UK relative to Gross Domestic Product, which is genuinely worrying. Broadly speaking, total debt to GDP has risen from 300% to 500% in the last decade. This debt binge is similar in the US and to some extent in other countries. What is likely to happen in the next few years is that the private sector will shrink their balance sheets (outstanding consumer credit has declined four consecutive months in the UK and 11 of the last 12 months in the US) which will be offset by an expansion in the Government s balance 3
sheet. Overall, however, it is likely that debt levels relative to GDP will stagnate and possibly even decline. History suggests that economic growth should remain subdued in such an environment. Balance sheet repair is too large a subject to cover off in our financial forecast, but I will return to this and other subjects in one off reports in the next few months. The major macro thoughts that I believe relate to markets are not limited to but do include; Markets are pricing in a V shaped economic recovery, which I believe is too optimistic Correlations between risky assets is high; a sign that liquidity and herding are major driving forces Investors are being encouraged to take risks with interest rates at or near zero Private sector balance sheet repair continues and will be a major drag on future growth Western Governments are both lender and spender of last resort; this cannot continue Inflation unlikely to be a problem due to massive spare capacity Major Central Banks are contemplating exit strategies and the scope for policy error is extraordinarily high 4
Equity Markets The chart on page 2 highlights how the current upward move in equity markets (as depicted by the S&P 500) is losing momentum. Not only that, but the bullish sentiment of small traders has recently hit levels that were last seen at the highs in late 2007, the number of bearish advisory newsletter writers has also reached a level last seen at the late 07 highs. In other words, when all are bullish, who is left to buy? Sentiment is generating a bearish signal on equity markets today. Simply put, the technical and sentiment landscape of the developed equity markets is very similar to that seen at past market highs, and is the opposite of that seen when the markets were establishing their lows in March of this year. The above chart is of the FTSE 100 on a weekly basis with momentum in the lower panel. I have illustrated a bullish divergence (new price low that is not confirmed by momentum) that developed during late 08 and early 09. Bullish divergences on both daily and weekly charts, as occurred in March this year are extremely powerful signals that better times lie ahead. As well as these bullish momentum divergences, other market based indicators were signalling similar positive signals around the March lows. The chart below illustrates the S&P 500 with the daily bullish sentiment of small traders (sentiment being a contrary indicator at turning points). As can be seen, bullish sentiment was almost non-existent at the March low, whereas being bullish is now the consensus call amongst this investor group. These market and sentiment based indicators are not outright bearish at the moment, but their current construct indicates that markets may suffer a reasonable price correction, or possibly a lengthy sideways movement. Either scenario would alleviate the current overbought and tiring condition apparent today. The outlook for emerging markets and Asia will be broadly similar to that of the developed or western equity markets. Although economists may argue that the long-term trend for emerging economies is a decoupling from the West, investors should remember that emerging markets have remained a high beta play during both the bear market and the subsequent recovery. I do not expect anything different in the months ahead. 5
Although it is clear from this chart that it is better to buy when other investors are bearish and vice-versa, it is important to combine this with other tools such as momentum and fundamental analysis. I employ a small arsenal of tried and tested indicators that help in keeping us on the right side of the market. The FTSE 250 recently pulled back and found support at the bullish trend-line formed by connecting the lows in March, July and now November. The mid caps are beginning to under-perform the large caps, which is yet another sign of how the market is becoming more selective which is consistent with the view that the rally is tiring. Support in the 8750 area must hold for this index in any correction. 6
Fixed Income Markets Government bond yields have tended to move sideways in a range since risky asset markets bottomed in March. The record supply of Government bonds around the World are being soaked up by the aggressive liquidity being pumped into the system (Quantitative easing in the U.K. and U.S.). The big question facing the Government bond markets is what happens when the authorities begin exiting their stimulus programmes. Typically, supply is not a major driver of performance in Government bond markets. However, with the amount of supply in the West totalling gargantuan proportions, this time it may be more of a problem. We suspect that the heavy supply will broadly be offset by weak economic performances in the West and that yields will drift mostly sideways, especially if our low inflation outlook proves to be correct. With 5 year gilt yields currently at 2.58% and 10 year yields at 3.55%, there does not appear to be much value unless we expect yields to move lower in the months ahead. Indeed, it is very hard to know where the value in any fixed income markets lies. 7
As noted above, I do not expect reported inflation to become a problem in the next few years. The chart above shows the breakeven inflation rate as measured by Government bond prices, or in other words, the bond markets best guess at what the average inflation rate will be for the next five years. Despite the unprecedented stimulus and quantitative easing in place, the bond market s best guess is that inflation will average about 2% over the next five years. This is consistent with the Government s inflation target and at the bottom of the range that the bond market priced in prior to the financial collapse. The chart above shows the yield premium of 5 year investment grade bonds in Europe compared to 5 year Government bonds. It is clear to see that the recent recovery has seen yield premiums contract back to levels near those seen back in 2007. I believe that this is very much a reflection of the liquidity that has been pumped into the global system, and in line with the V shaped recovery now discounted by the equity markets. 8
Currencies Currency markets have been dancing to the risk seeking trend apparent across all asset classes, with the US Dollar declining against all major currencies since March. We can predict that major currencies will go up against the US Dollar if equities and commodities go up, and down if they go down. As with the argument I have put forward with developed equity markets, there are a number of negative divergences in place throughout the currency markets, and sentiment, as shown in the chart below, is solidly bullish on the Euro versus the US Dollar. Of particular interest to me in the months ahead is the general performance of Sterling, not only as many of our clients are based in the UK, but also because Sterling may be one of the worst performing currencies. This represents an opportunity. The chart below is of Sterling against the US Dollar, and I have illustrated a clear sideways trend that has been in place for 6 months now. The fact that Sterling can only move sideways when the investment world can only talk of impending US Dollar disaster is testament to Sterling s own problems. The second chart below shows the weekly chart of Sterling versus the Euro, and it is clear that both the long term and also the short term trend is very much in favour of the Euro. 9
10
Commodities At the risk of sounding like a broken record, Commodity markets as with Currencies, are dancing to the risk seeking theme. The key for driving force for commodity markets in general has been the performance of the US Dollar, in that when the Dollar declines, commodities have risen and vice-versa. The first chart here is of WTI Oil. Although Oil has rallied smartly from $45 to $80 since March, it remains well below the all time high near $150 set in 2008. This picture is similar in most other commodity markets. One commodity that is going it alone on the upside is Gold. The media is painting a win/win situation for Gold, in that under all scenarios (ie inflation, deflation or increased status as a new reserve currency) Gold must rise in price. This may be true in the longer term, but for the next few weeks, it appears to me that there is just too much bullishness surrounding the yellow metal, and the technical and sentiment backdrop is too similar to March 2008, just before the price fell from $1000 to $700 over the next 7 months. 11
Conclusion Risky asset markets (equities, commodities, currencies and corporate bonds) have performed exceptionally well since the lows in March. There is no doubt in my mind that although this rally represents a natural recovery from a deeply oversold condition in March, it has been aided by the extraordinary liquidity support that central banks have enacted in the last 12 months. Now, the weekly picture looks overbought, the daily trends appear to be very tired and sentiment is too bullish. The odds of either a sideways move or a deeper correction have grown, and we would not be holding aggressive long positions at the moment. That said, the upward trend since March is still intact, and with the ultra low interest rates encouraging investors to seek out higher returns in risky assets, we have to respect this trend, and any correction is to be viewed as an opportunity to position for higher prices. Disclaimer RMG Wealth Management LLP is authorised and regulated by the Financial Services Authority (FSA). This report is for general information purposes only and does not take into account the specific investment objectives, financial situation or particular needs of any particular person. It is not a personal recommendation and it should not be regarded as a solicitation or an offer to buy or sell any securities or instruments mentioned in it. This report is based upon public information that RMG considers reliable but RMG does not represent that the information contained herein is accurate or complete. The price and value of investments mentioned in this report and income arising from them may fluctuate. Past performance is not a guide to future performance and future returns are not guaranteed. 12