AOTW 2014 1031

Anson Capital Article of the Week
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Article of the Week  

Our article this week comes from The Economist.  The author discusses why the equity markets are retreating, commodity prices are falling and investors are shifting towards the safety of government bonds



Bears, but no picnic 

From Buttonwood's Notebook

Fears of deflation may lie behind recent weakness

The mood in financial markets has turned gloomy again. Equity markets are retreating, commodity prices are falling and investors are stampeding for the safety of government bonds (see chart). Volatility has soared: the VIX, a measure of how much investors are willing to pay to insure against sharp market moves, has more than doubled since July.

Perhaps the most remarkable development is the strength of government bonds. At the start of the year, a survey of fund managers by Towers Watson, an actuary, found that 81% were bearish on government bonds. Many commentators were talking about the end of a 30-year bull market. But the yield on 10-year Treasury bonds (which moves in the opposite direction to prices) briefly dropped below 2% on October 15th, having stood at 3.02% on January 1st.

This fall in yields has occurred even though the Federal Reserve has been steadily reducing its bond purchases, just as it said it would. Private-sector buyers have been eager to step into the breach. After all, yields on Treasuries are substantially higher than those in most of Europe (German 10-year yields dropped to 0.72% on October 15th) and American inflation is low (1.7% in August).

But probably the biggest reason why yields have fallen is that global growth has been disappointing, with the partial exception of America (where GDP fell in the first quarter, but has since recovered). The IMF recently revised down its global growth forecast for the year from 3.7% in April to 3.3%. Recent data from the euro zone have been particularly weak; industrial production fell 1.8% in August.

Worries about the euro area’s stability are resurfacing. Greece has been an exception to the government bond rally, with 10-year yields climbing back over 7%. The Greek stock market is down nearly 24% so far this year. Investors worry that Syriza, a left-wing opposition party, may take power next year and demand a reduction of the government’s debt.

A sluggish economy has also affected commodities. While oil has captured the headlines, food prices have dropped 15.5% over the last six months and industrial materials have fallen 3.4%. These drops are good for Western consumers (and help explain why inflation is so low), but are bad for commodity-producing countries.

Equity markets have wobbled three times this year in the face of disappointing economic news, not to mention the political turmoil in the Middle East and Ukraine. But those tumbles have so far been modest by the standards of past bear markets. Recent experience has taught many investors that good news can equal bad news: the more uncertain the outlook, the more supportive central banks are likely to be. The Fed may be reluctant to tighten monetary policy until the recovery is better established (markets are not now expecting a rate rise until March 2016) and the European Central Bank may feel obliged to loosen policy further.

The other big hope for equity investors is that profits will remain strong, despite economic weakness; after all, the cost of raw materials is falling, borrowing is cheap, and wages are subdued. The third-quarter results season is under way in America. Once again, analysts have gone through the charade of reducing profit forecasts (by more than four percentage points) ahead of the season so that companies are able to “beat” forecasts by a small margin. American companies are expected to report annual earnings growth of 4.5%, according to FactSet, a data company. But investors will probably concern themselves less with the details of firms’ performance in the third quarter, and more with what they say about the outlook, particularly for those with big foreign operations.

Investors’ underlying fear seems to be that the developed world is slipping into a deflationary spiral; hence the falls in commodity prices and a sharp drop in expectations of inflation, as measured by the Treasury-bond market. The recent weakness in the euro and the yen may be a sign that those regions are exporting deflation to the rest of the world, as their exporters cut prices to seize market share.

Deflation can cause severe pain in the corporate sector; a further sign of trouble is that the spread (or excess interest rate) paid by the riskiest bond issuers has widened by one-and-a-half percentage points since June. This deterioration is seen by Julien Garran, an analyst at UBS, as the “fourth horseman of the apocalypse”, signalling that deflation is on its way. If investors lose faith in the Fed’s ability to rescue them from that fate, the recent market weakness may be only the beginning
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