5 June 2015
L O T H A R M E N T E L
C H I E F I N V E S T M E N T O F F I C E R
S A M U E L L E A R Y
H E A D O F I N V E S T M E N T C O M M U N I C A T I O N S
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Asset Class
Equities
Bonds
Inflation
Index
FTSE 100 (UK)
FTSE4Good 50 (UK Ethical Index)
Dow Jones Euro-Stoxx 50 (Euro-Zone)
Standard & Poors 500 (USA)
Nikkei 225 (Japan)
MSCI All Countries World
FTSE Gilts All Stocks
IA Sterling Corporate Bond Index
Barclays Global Aggregate Bond Index
Goldman Sachs Commodity Index
Commodities Brent Crude Oil Price
Spot Gold Price
UK Consumer Price Index (annual rate)
Cash rates Libor 3 month GBP 0.05%
2015 May and year to date asset class returns; Source: Morningstar Adv. Work
Station, all returns in £ - GBP
0.2%
May
0.7%
0.5%
-1.6%
2.0%
2.3%
0.5%
0.5%
0.1%
-1.1%
-1.3%
-1.1%
-0.5%
0.0%
2015
8.3%
5.9%
6.9%
5.5%
16.3%
6.9%
0.5%
1.7%
-0.5%
2.1%
16.9%
1.4%
-0.2%
V O L A T I L I T Y I S B A C K – M A Y ’ S T R E N D S C A R R Y O N I N T O J U N E
While the FIFA turmoil found a very sudden and perhaps satisfying end, (?) other European trouble spots, namely the bond market gyrations of late and the Greek debt ‘drama’ continued to be centre stage. Oil came into the limelight again, with OPEC assembling once more in Vienna for their quarterly meeting.
With these topics at the forefront during the first week in June, they are also the ones which characterised the month of May. As the generic May 2015 asset class returns table (at top) shows, May has panned out very close to what we had anticipated in April: Disappointing bond markets and considerable stock markets fluctuations as the period of low volatility appears to have ended for now.
The beginning of May had seen one of the most extreme reversals in government bond markets in recent times. Yields shot up and the reversely correlated bond values fell considerably. This came about when
European growth trends were confirmed and the rebound in the cost of oil, reversed price trends from towards deflation, to mildly inflationary. Speculative investors took this as the signal that the positive momentum in bond valuations due to central bank bond buying (ECB’s QE), must rapidly be coming to an end and liquidated their positions en masse. The ensuing negative momentum was strong enough to push bond values so low, that mid-month bond markets witnessed a mild bounce back, before this past week the selloff resumed after growth and inflation expectations were reconfirmed.
After a particularly strong first quarter, long term investors have therefore not seen much further return over the past 2 months. The exception being the US, Japan and China stock markets. The US is in the process of catching up with Europe after their Q1 growth slump had been confirmed as merely another winter weather induced temporary scare. Japan is in a similarly positive monetary environment as the
Eurozone nations, minus a Greek problem. China has had by far the highest 2015 stock market returns so far (nearly 100%!) as the Chinese government is promoting stock market investment over residential property ‘flipping’. The stock market valuations that have been reached are frothy to say the least,
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particularly all the while Chinese economic growth continues to slow. Local investors seem to realise that ‘the party’ may be nearing an end. This was evidenced in the past week by intraday falls of more than 6%. While this is slightly worrying, the most significant headwind to markets over the month of May has become Greece. Regular readers of the Weekly have read about the Greek tragedy regularly and the brinkmanship with which the populist left Syriza government is attempting to avert the countries’ bankruptcy is breath-taking. Capital markets continue to ascribe a higher probability to a last minute
Source: Financial Times resolution than any political observer can identify. The combination of the markets’ near ignorance of what is likely to become a politically messy and financially painful resolution to the Greek Eurozone challenge and the recent sell off in bond markets has in my opinion built up a formidable potential for another bond market correction. This time though it is in the other direction, i.e. a flight back to the safety of government bonds. This is likely to be only temporary because there is indeed a strong logic that suggests, the main Eurozone countries will want to prevent an ultimate Grexit, however, they may not want to grant this success to the extremists of Syriza. With this perspective, government bonds may well now be undervalued in the shorter term, even if they are not the asset class of choice for the medium to long term. The stock market declines of the past week have shown that equities are not immune when bond markets swing wildly. On this basis it would appear advisable to focus on the short term and rebalance investment portfolios from a longer term pro-growth stance to a shorter term risk reduction stance. At least until the uncertainties of this summer with Greece and the likely first rate rise timing in the US are behind us, I believe there to be value in increasing risk counterbalancing assets in portfolios. This applies even if their historically low yields, compared to the dividends of risk assets, constitute somewhat of an insurance premium.
B O N D M A R K E T T U R M O I L C O N T I N U E S – G R E E C E O R I N F L A T I O N T H E
C A U S E ?
Government bonds are usually considered “safe”, even potentially dull and boring. However, that image may for now have well and truly vanished. If the 2 bond sell-offs in the past five-weeks were any signal, then we may be in for another wild ride.
After the first Bund flash sell-off in early May we had another truly exceptionally large move in bond yields this past week. As recently as April 7 10-year Bunds yielded just 0.07% (7 basis points in ‘bond
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speak’), but we have moved from 7 to 99 basis points in the space of 15 trading sessions and now look to be close to breaking 1% (See red line in the graph below). To put these moves into perspective, in just 2 days this week, Bunds leaped 34 basis points, which is the largest 2 day jump in nearly 20 years -
October 1998 to be precise, when investors were dealing with the Russian financial crisis and collapse of
Long-Term Capital Management (LTCM). Similarly, US Treasuries rose 19 basis points over the same period as Bunds this week.
While some had thought that the sell-off in bonds was more a reflection of hopes that the Greek debt drama was essentially sorted – bar some last moment negotiations. However, we would observe that it most probably has more to do with the unwind of short positions, which speculative investors put in place when the yields jumped at the beginning of May and Bunds appeared oversold. The more recent confirmation of rising inflation (see blue line in the chart above) and improving economic growth is normally a strong signal that the economy is growing. This tends to very positive for stock prices, while bonds suffer selling pressures as investors seek participation in the upside of growth and are less worried about limiting risk exposure.
But in this case, equity markets appear to have been unsettled by the sheer speed of bond yield rises.
Once again the shakeout of the Eurozone bond market dominated investor sentiment on the fear that the sudden spike may lead to disorderly bond markets, or at least push up borrowing costs for both businesses and consumers so quickly that it may crimp economic growth in the shorter-term.
We expect that volatility in both, equity and bond markets is here to stay, at least while central banks continue with unprecedented monetary stimulus. European Central Bank (ECB) member, Erkki Liikanen, said that fellow central bankers had some concerns about the “Frankenstein’s monster” unleashed from quantitative easing programmes, as they had “changed the whole way of looking at assets across the world”.
E C B ’ S D R A G H I : “ G E T U S E D T O V O L A T I L I T Y ”
Following on from the story above, the ECB’s President, Mario Draghi, warned investors that they should
“get used to” higher levels of bond market volatility. Some economists had expected that Draghi would attempt to sooth investor fears in the wake of wildly fluctuating bond yields and prices, by announcing further intervention measures. The fact that he did the opposite by stating that he is relaxed about
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rapidly moving yields and even said volatility is something to get used to, suggests to us that he is perhaps trying to declare a ‘new normal’ and focus on the longer term. Thereby soothing investor fears by alternative means?
The sheer size of ECB bond buying, at €60 billion a month, means that the ECB is holding more and more of the so-called free flow of bond issues available for trading in the Eurozone bond markets, thereby draining liquidity from the market. This is likely to amplify movements so much so that sharp and sudden price changes can be interpreted as a by-product of QE, rather than as drastic changes in market expectations.
Much like Japan and its QE, the ECB’s own programme appears to be bearing fruit. The ECB raised its full year inflation forecast, while indicators of future growth look increasingly optimistic.
Eurozone inflation increased more than expected in May, rising to +0.3% (+0.34% at two significant figures) versus the 0.2% predicted by economists. Encouragingly, the core measure (excluding food and energy) also improved by 0.3 percentage points to +0.9% year-on-year (0.91% at two significant figures).
Digging into the data, we see energy price (dis-)inflation rising from -5.8% year-on-year to -5.0% year-onyear during May, which reflects some of the 2.9% increase in European oil prices during the month. Rises in food, alcohol and tobacco prices also helped boost the headline rate, increasing from +1.0%yoy to
+1.2% year-on-year. On a regional basis, the data showed meaningful price increases only in Germany,
Italy and Spain, while all other regions remained flat or negative.
The forward looking business sentiment measure of the Composite Purchasing Manager’s Index printed at
53.6 in May, which was stronger than the initial flash estimate and squarely in expansion territory
(anything above 50). In comparison to April, the composite PMI eased 0.3pt. The stronger final composite
PMI was driven by flash/final upward revisions within the French composite PMI. Interestingly French sentiment is no longer lagging German sentiment materially, which may indicate that France is also emerging from their recent downturn. Given the relative size of their economy in the European context this is a significant development.
In terms of this week’s large bond moves, we are reminded of the ‘taper tantrum’ in the US from 2013.
Here bond investors were similarly spooked into a more volatile state by the mere mention that the
Federal Reserve would scale back and end its QE programme.
We would argue that while QE does have some “unintended consequences”, Mr Draghi is “looking through” these developments in order to maintain a steady monetary policy stance, one that should ultimately benefit the Eurozone economy and boost growth. It could be viewed therefore as a “necessary evil”. Alas, don’t expects an apology from the central bankers to frightened, elderly bond investors!
B A N K O F J A P A N R E M A I N S P O S I T I V E A S “ E X C E S S I V E ” Y E N S T R E N G T H I S
“ C O R R E C T E D ”
Peter Pan; that’s who Bank of Japan (BoJ) Governor Haruhiko Kuroda cited as guiding current Japanese monetary policy as the country looks to be turning into a more positive corner. Economic data released this week shows that the country is on better footing, with both wages and business investment improving. The combination which should underpin consumer spending and further economic growth.
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That Kuroda-san would draw upon the words of J. M. Barrie’s Peter Pan may not be as bizarre as it first seems. Conviction and self-confidence underpin Japan’s unprecedented monetary stimulus. This finally seems to be promoting economic growth after nearly 20 years of near stagnation. In this context Kurodasan’s reference to Peter Pan’s “moment you doubt whether you can fly, you cease forever to be able to it” makes sense.
This underscores the positive attitude that the BoJ has taken as it feels it can “overcome problems by conceiving new solutions”. The stimulus provided by the BoJ has effectively sought to weaken the Yen so that Japanese exports become more price competitive, along with boosting domestic inflation in order to prevent counterproductive consumer behaviour.
On a trade-weighted basis, the Yen is now back to the level that was last seen before the financial crisis, which may signal that officials will not be seeking further weakening of the Yen for now. Indeed, BoJ spokesman, Yutaka Harada, said that the “abnormally strong Yen has been corrected” and moved into a
“good place”. Since the high of ¥75.35 (per US dollar), the Yen is down 40% to around ¥120-¥125.
We believe that the BoJ may still provide further monetary easing via its quantitative easing programme, as officials recently moved back the date by which they thought the country would achieve the 2% inflation target by six-months to September 2016. With last April’s VAT increase now washing out of the inflation picture, prices in Japan may begin to retreat back towards deflationary territory. However,
Kuroda-san believes that cheaper oil should help accelerate consumer spending in the medium-term. An increasingly tight labour market may also play into the BoJ’s hands, as companies compete for skilled workers, which boosts pay and helps underpin both consumer spending and improves inflation expectations.
Wage data for April, revealed that nominal pay growth accelerated to +0.9% year-on-year, while business investment spending increased strongly in Q1, rising +8.1% year-on-year (see chart below, MOF line). This strong reading for capital spending, particularly in the manufacturing sector may even lead to upward
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Source: Goldman Sachs

revisions in GDP.
We believe one of the key themes in Japanese equities for the longer-term is domestic companies increasing focus on improving returns to shareholders typically measured through returns on equity (RoE) or dividend yields. Domestic firms returned a record ¥12.8 trillion ($108 billion) to investors over the past year, a 78% rise in the 12-months to March. Japanese firms had long been thought of as lagging western peers in shareholder returns, but we expect companies to be eager to catch up and this will drive further interest in Japanese equities.
U S : B E I G E B O O K S H O W S C O N T I N U E D E C O N O M I C E X P A N S I O N
Compared to the previous week, the picture from the US this week was a little more mixed, until the a much better than expected monthly jobs report on Friday (non-farm payrolls) confirmed recent growth acceleration. Reported economic data continued to be fairly solid, although the Federal Reserve’s Beige
Source: Bloomberg
Book struck a far more confident tone, which suggests further expansion of the world’s largest economy.
Kicking off the choppy data were factory orders which were marginally weaker than forecast, despite a rise in inventories. The ADP Employment report printed in line with estimates, rising +201,000 in May helped by increasing employment in the transport and utilities sector. The ISM non-manufacturing index was softer than estimated, declining from 57.8 in April to 55.7 in May. This is the lowest level in over a year. Encouragingly, new export orders improved more than expected, rebounding back into expansion
(+6.5 points to 55).
On the positive side, car sales in the US reached a new 10-year high, driven by increased credit availability. The average loan term for both new and used cars also reached all-time highs to 67 and 62 months, respectively. A longer term loan helps consumers keep their monthly payments manageable, while allowing them to purchase a new vehicle without breaking the bank. We also highlight the crosselasticity of demand for cars with that of its complimentary good – petrol – in negative territory. Given that energy prices have fallen, this means a rise in car sales can be partially explained by the above data point.
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Despite this rise in car sales, personal spending was unchanged. Interestingly the savings rate jumped from 5.2% to 5.6%, which suggests that consumers are saving the price difference on petrol prices rather than spending it. This goes against what economists had been expecting; namely a big spending boost.
We believe Milton Friedman’s Permanent Income Hypothesis may partly explain this anomaly, as it posits that people generally spend at a level that is consistent with their long-term average income, but tend to stash away what they deem temporary savings. Given that real incomes are typically lower than precrisis levels, it is not difficult to see why individuals would prefer to squirrel away any temporary shortterm savings for a rainy day. This still doesn’t explain why retail consumption (ex oil) even fell when the oil price was at its lowest. We suggest that this may have to do with recent US consumer experience correlations. That is that last time the oil price was at similarly low levels (2009), they experienced the worst recession in living memory – therefore creating a feel-bad, rather than feel-good factor.
Moving on to the Fed’s assessment of economic conditions. The Beige Book prepared for its June FOMC meeting was largely in line with comments from April, but noted that weakness in the energy sector had proved a drag within some districts. In line with the ADP numbers, both employment conditions and wages improved.
When we look into the detail of the report, we see that 7 out of the 12 districts said that the economy was expanding at a "modest" or "moderate" rate, down from 8 recorded in April.
The Fed noted that retail sales had improved in a majority of districts, while the outlook for consumer spending was still healthy. Manufacturing activity remained robust, however, activity in the oil and gas sector contracted, while the impact of a stronger dollar hurt exports.
Encouragingly, the Fed saw a recovery of activity in both residential and commercial property, with much of the US seeing higher real house prices. Limited inventories were cited as a key driver of recent price increases.
There were a number of regions that had begun reporting tighter labour markets and even shortages in some cases, with staff retention cited as an issue. We see this as a positive development, as it means individuals are more able to switch to better job offers meaning that friction in the labour market is declining.
When we track the composition of the Beige Book and highlight the number of positive versus negative words, there was a clear improvement from April, suggesting the Fed are seeing more rapid growth in the underlying economy.
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O I L P R I C E S L I K E L Y T O R E M A I N U N D E R P R E S S U R E
$60-70 a barrel in the price of oil, has been called the ‘new normal’. Even though better economic growth would suggest a higher price through higher demand. However, there is still a fairly significant supply overhang that needs to be absorbed before prices are able to move higher, not to mention continued record US shale oil production, which means that prices are more likely to fall than they are to rise.
With the members of OPEC (Organisation of Petroleum Exporting Countries) meeting in Vienna over the next few days, analysts are expecting some movement from its largest member, Saudi Arabia, to provide the oil market with some direction. The biggest question is, will Saudi officials cut production or not?
The answer on Friday was no, they will not. Ali al-Naimi, Saudi’s oil minister said he saw the supply slowing but demand growing. Not because of the Saudis we may add, the country is the world’s largest oil exporter and has increased crude output to a record 10.3 million barrels per day, equating to
Source: Bloomberg approximately 1 out of 9 barrels used worldwide.
Oil analysts largely anticipated that OPEC would maintain its production ceiling of 30 million barrels per day. US (non-OPEC) oil inventories are sitting at 80 year highs, but crucially American production expanded the most in 19 months, with the average of 48 states rising by an average of 209,000 barrels per day. To put US inventories into perspective the chart below illustrates this.
We believe one of the big swing factors in the oil market that is rarely discussed, is that of Iraqi oil production. Iraq is predicted to expand output to a new record of 3.75 million barrels per day this month, or an extra 800k barrels per day.
Another data point that may have been overlooked is that from the oil tanker market and the message here is that the recent rally in prices due to expectation of tightening supply could be under threat.
There has been a sudden jump in demand for supertankers, which has increased charter rates by 57% in
May. Daily rates on the Baltic Exchange rose from $52,987 to $64,710, which is a 7-year high.
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Such supertankers – with capacity for 2 million barrels – can earn $45,000 a day, which is 69% higher than in 2014. Shares in Belgium-based Euronav have surged 22%, while Frontline Ltd, with a fleet of 24 supertankers are up 25%.
Analysts estimate that about 20 million barrels is currently stored on ships and the world is pumping about 1.9 million more barrels/day of oil than it needs, according to Paddy Rodgers – CEO of Euronav.
With few signs that the supply side will begin to expand at a slower pace than the demand is growing
Source: Bloomberg tells us that prices could end up lower, but very unlikely go higher in the shorter-term.
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P E R S O N A L F I N A N C E C O M P A S S
GLOBAL EQUITY MARKETS CURRENCIES COMMODITIES
MARKET
FTSE 100
FTSE 250
FTSE AS
FTSE Small
CAC
DAX
Dow
S&P 500
Nasdaq
Nikkei
CLOSE % 1 WEEK
6804.6
1 W TECHNICAL
-2.6 -179.8

17931.3
3711.1
4796.3
-1.2 -223.1
-2.3
0.1
-86.0
5.8



4920.7
11197.2
17879.7
2094.8
4484.6
20460.9
-1.7 -87.2
-1.9 -216.7
-0.7 -131.0
-0.6
-0.5
-12.6
-23.7
-0.5 -102.3






SPOT RATE
GBP/USD
EURO/USD
JPY/USD
EUR/GBP
GBP/JPY
FIXED INCOME
GOVT BOND
UK 10-Yr
US 10-Yr
French 10-Yr
German 10-Yr
Japanese 10-Yr
LAST %1W CMDTY
1.53 -0.20
OIL
1.11 1.10
125.56 -1.12
GOLD
SILVER
0.73 -1.27
COPPER
6.20 -0.08
ALUMIN
TOP 5 GAINERS
COMPANY
RBS
ASHTEAD GROUP
DIRECT LINE
KINGFISHER
INTERTEK GROUP
TOP 5 LOSERS
% COMPANY
3.4 NATIONAL GRID
2.6 MONDI
2.0 ROYAL MAIL
1.9 ABERDEEN ASSET
1.8 IMPERIAL TOBACCO
SOVEREIGN DEFAULT RISK
DEVELOPED
UK
US
France
Germany
Japan
CDS DEVELOPING
18.8
Brazil
16.2 Russia
30.8 China
14.6 South Korea
38.3 South Africa
CDS
240.3
345.0
87.6
47.5
210.0
%
-8.2
-6.4
-6.0
-5.6
-5.5
UK MORTGAGE RATES
MORTGAGE BENCHMARK RATES
Base Rate Tracker
2-yr Discount Rate
2-yr Fixed Rate
3-yr Fixed Rate
5-yr Fixed Rate
Standard Variable
GLOBAL RESEARCH TEAM
Lothar Mentel – Chief Investment Officer
Lothar.Mentel@tattonim.com
Steven Kesh – Economist steven.kesh@tattonim.com
Sam Leary – Strategist
Sam.leary@tattonim.com
For any questions, as always, please ask!
For anybody to be added to or taken of the distribution list, just send me an email.
LAST %1W
61.8 -5.8
1168.2 -1.9
16.1 -3.9
269.4 -1.3
1743.0 -1.9
%YIELD % 1W 1 WEEK
2.1 14.6 0.27
2.4 11.8 0.25
1.2
0.8
0.5
46.7
74.1
24.6
0.37
0.36
0.10
RATE %
2.6
1.6
2.0
2.6
2.9
4.5
L O T H A R M E N T E L
D I S C L A I M E R :
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