Second quarter rally – Is the pesky blonde girl back ?

In the last investment blog I reported that global stock markets retreated in the first quarter of 2018. How things change! Half way through the second quarter there has been a marked improvement in investor sentiment and stock returns. The FTSE 100 index for example closed yesterday at 7,711, a significant recovery from its March 26th low of 6,889 and not far off the all-time high of 7,769 on January 15th. Other market indices have rallied albeit not to the same extent. So what is going on? My reading is there has been a combination of positive factors. One commentator from The Street suggested that in the US first quarter company earnings were impressive but investors have taken time to appreciate this. In the UK inflation fears have abated as economic growth has slowed and according to Charles Stanley & Co Ltd the Bank of England, expected to raise interest rates just a few weeks ago, voted to keep them at 0.5% p.a.

On theme of inflation various commentators including the Chief Economist of Invesco Perpetual, John Greenwood have noted the normal Phillips curve has broken down. The Phillips curve is an inverse relationship between the unemployment rate and inflation. The argument goes as unemployment falls inflation rises and vice versa. It is a very logical assumption borne out in the past by actual data. As unemployment falls not only are there more workers earning and spending but the shortage of skilled labour drives up wages. However in the US Greenwood noted that the tight US labour market has only had a modest impact on wages between 2009 and 2017 and the Phillips curve has been almost flat with a similar result in the UK, Germany and Japan. With inflation fears abating interest rate expectations are muted. This scenario is good for both bonds and equities.

Greenwood also concluded that fears of a US recession are misleading. He said there are three key indicators of recessions and all cases evidence is lacking:

1. The yield curve being inverted. The normal yield curve is based on interest rates on government bonds being correlated with the maturity date of the bond i.e. the longer the term the higher the interest rate paid. This is because investors in longer dated bonds demand higher interest rates to offset the greater risk of uncertain future inflation and interest rate rises. Greenwood noted the yield curve is not inverted and unlikely to become so in the near future.

2. A sharp slowdown in money and credit growth. These have been low and steady for several years.

3. Over-leveraged balance sheets; too much debt in plain English. Consumer balance sheets are in good shape and Greenwood reckons even if interest rates do rise US consumers should be resilient.

In conclusion Greenwood stated that in the US, Japan and the Eurozone low inflation will continue for the next few years and there is a low risk of recession. Greenwood is someone I respect and listen to. I find his analyses of the global economy to be measured, balanced and compelling.

Other factors have contributed to the recent market rally. The easing of tensions between North Korea and the US has been positive, although this has been followed by a deterioration in the Middle East, with the US pulling out of the Iran nuclear deal. The technology sector has recovered from its mauling earlier in the year. Charles Stanley’s Chief Investment Commentator, Garry White noted in a recent blog that Apple shares have climbed to a new high whilst Facebook has clawed back its losses from the Cambridge Analytica data harvesting scandal. Finally mergers and acquisitions are expected to spike in 2018, driving stock prices.

In the first quarter Goldilocks did a runner (see blog of 24/3/18). The bears ate their porridge in peace. However it seems Goldilocks was just being sneaky, hiding in the woods and is now ready to make another foray into the bears’ house in search of goodies. Perhaps the not too hot, not too cold economy is back. We shall see.

The content of this blog is my own understanding of the global economy and stock markets. My comments are intended as general commentary only. Nothing in this article should be construed as personal investment advice. You should seek individual advice based on your own financial circumstances before making investment decisions.