Equity markets appear to be stuck in a rut as participants find it hard to shake off prevailing negativity, says Instreet Investment managing director George Lucas.
“Markets are fixed on a view that oil and commodity prices will never rebound and that the bank model is broken due to over regulation and weaker economic growth compared to the first part of the century.
“But we think too much risk has been priced in and there is the potential for a surprise on the upside. A couple factors point to this; a weaker US dollar, signs of a rebound in oil prices and improving economic signals coming out of China with reducing fears of devaluation.
“Indeed, the latest major talking point is the strength of the Yen against the US dollar. It’s led many to tear up their currency forecasts for the year. It wasn’t so long ago that the consensus was that the US dollar would remain strong as the US continued to tighten while Europe and Japan continued to ease.
“But now the perception seems to be that US interest rates will remain low for a much longer period of time, while the European Central Bank and Bank of Japan are assumed to have scope for further monetary stimulus,” says Lucas.
“Other explanations for the strength of the Yen include its status as a safe haven currency; a large current account surplus that suggests that competitiveness can be maintained even if currencies rise; and the view that is close to estimates of ‘fair value’ based on purchasing power parity or fundamental equilibrium exchange rates measures, and hence still looks cheap on a real effective exchange rate basis.
“Ultimately, this is a problem for the Bank of Japan. The Yen needs to remain substantially ‘under-valued’ in order to overcome the headwinds of adverse demographics, low GDP growth and deflation. The strong Yen means the Bank of Japan will have to fight back with further monetary easing.
“Strength in the Yen and Euro significantly reduces the risk that China will need to devalue its currency. Receding fears over a sharp devaluation of the Renminbi, along with favourable exchange rate movements, has helped bring an end to the recent string of declines in the value of China’s FX reserves.”
Lucas argues that markets are pricing in the worst even though signs are improving.
“The US earnings season begins in earnest this week and it will be a breath of fresh air for fatigued markets. Any upside surprise in earnings or CEO outlooks could cause the rally we have seen in US equities since the 11 February to continue.
“As for the Japanese market, it will remain subdued until we see a turn in the Yen, which will either come from a Bank of Japan intervention or more monetary stimulus.
“European banks, which make up a large part of the European indices, may post earnings surprises that will translate into better performance for markets overall. Improving sentiment in emerging markets will also benefit European companies with significant EM exposure.
“Finally, the Australian market will likely remain subdued until equity markets fall in line with the reduction in fears associated with China and commodity prices. The banks, however, will continue to provide a headwind as will the general election and stronger Yen.”
