In this update we explore five themes of relevance to investors.

Please note the views expressed in this bulletin are those of the author and do not necessarily reflect AMP Capital’s house view.

Theme 1: Mixed signals from the economy, mixed opinions on the Fed and mixed leanings within the Fed

There have been some mixed signals on the US economy due to soft external demand, strong USD, and weak commodities, but these will likely prove transitory and should not stop the Fed from commencing policy normalisation.

If the Fed could focus on domestic indicators only, it would probably already be sending clear one-way signals that it will hike interest rates next week. But the Fed has to look at the economy holistically and as a result – along with most people – appears confused. The best example of this confusion from a data standpoint is the gap between the services and manufacturing PMIs. This gap is not unique, and there are several examples to support this. One consideration is whether this is a benign gap (where manufacturing falters for external reasons and the domestic economy holds up – and manufacturing eventually rebounds, e.g. 1998, 2011) or an insidious gap (where weak manufacturing reflects poor domestics and the economy goes into recession, e.g. 2001). The reasons manufacturing is weak are: soft global trade, a strong US dollar and weak commodities. A strong US dollar and weak commodity prices are generally positive for the consumer (in terms of real income/purchasing power). So in that sense the gap is easy to explain and should be transitory, as those factors will probably eventually dissipate (unless the US dollar rapidly appreciates further). So having made sense of the confusing economic picture where does that leave outlook on the Fed? Given monetary policy operates with a lag, by the time manufacturing comes back to the party the policy tightening will start to take effect. So my individual opinion would be that the Fed should begin policy normalisation now.

Theme in pictures

Source: AMP Capital, Thomson Reuters Datastream

Theme 2: What’s up with the Nikkei?

Following the correction, and despite being a consensus trade, Japanese equities still look good as Abenomics continues.

Japanese equities (along with most markets) have seen significant volatility lately, stealing headlines this week with a China-like one-day gain of 7.71%. Most notable is the -16% correction from top to bottom in the Nikkei (following the risk-off trading seen in most markets). Again, it’s a case of asking what has changed? While the USDJPY had come down a bit as the JPY saw safe-haven demand, it is still around the 120 mark which is helpful for Japanese companies – generally the rule of thumb is a weaker JPY (higher USDJPY) is helpful for Japanese corporates, and this can be seen as the Nikkei has tended to trade in step with the USDJPY over the past few years. Moving on to the economic policy front, the original reason why many people had piled into Japanese equities was because of BoJ QE and the lofty promises of Abenomics. The track record of Abenomics has been a mixed one, and arguably much more needs to be done if Japan wants to hit take-off speed and move sustainably away from its economic malaise of the past decade or so, and close competitiveness and profitability gaps with the likes of the US. While the data remains mixed in Japan, the inflation target of 2% is in doubt so there is a real risk the BoJ steps up or extends its easing program. At the same time our sources say that Abe is renewing his focus on the economy now; and the recent report around reducing corporate tax rates (an already planned 3.3% reduction to 31.33%, and pledge to cut “down into the twenties”) reflects this.

Theme in pictures

Source: AMP Capital

Source: AMP Capital

Theme 3: On the surface, China’s August trade numbers were awful

On the surface China’s August trade numbers look soft, but there are some signs things are turning the corner.

Looking at the trend in imports there are some signs that things are turning the corner. To be fair there were probably some minor temporary factors such as the accident at the Tianjin port (which does about 5% of foreign freight throughput), this impact will likely wash out in Q4. The most interesting aspect to my mind is the rolling quarterly year on year growth in imports (looking at it this way smooths out some of the month-to-month volatility). This had gone sharply negative, but has clearly turned the corner – lining up with my previous comments that the cyclical outlook is becoming more benign/positive in China due to a constrained upturn in the property market and ongoing stimulus measures.

Source: AMP Capital, Bloomberg, Thomson Reuters Datastream

Theme 4: Going with the flow on the S&P 500

US equities have seen notable outflows this year; which probably reflects a certain level of fear and pessimism and could be setting the market up for a rebound.

Looking at the flows helps to get a feel for how investors are playing their cards and also reflects investor sentiment. Recall, the way we think about sentiment is that when investors are particularly bearish and pessimistic, that’s usually the time to become bullish. And when investors are too bullish and excessively optimistic, that’s often the time to become bearish. A similar thing occurs in the flows as demonstrated in the charts below (the flows reflect how investors feel by capturing what they are actually doing). I previously pointed out the major outflows from the largest S&P 500 ETF, and it turns out these investors were on the money; and now outflows seem to be accelerating again – similar to 2011. The picture is similar on the mutual fund side of things. So at this point it would be fair to say that the flows do reflect a certain level of fear and pessimism and are close to being washed out.

Theme in pictures

Source: AMP Capital, Bloomberg, Thomson Reuters Datastream, ICI

Theme 5: The latte trade

Coffee futures have been falling, but now are well below trend, speculators are short, and there are potential weather risks. So the weight of risks are probably to the upside at this point.

While I was going to focus on coffee where the setup is quite convincing, I thought it would be worth adding a bit of milk and sugar to the analysis. Each of these commodities have come down significantly since peaking around 2011 (latte index down -55%), with the weakness more notable in the past 12 months (down over 30% on a rolling 12m basis). However, recently each of the commodities has begun to rebound. Agricultural commodities tend to see more rapid adjustment of supply, e.g. if coffee prices are high, farmers plant more coffee vs if coffee prices crash, they pull the trees out and use the land for something else. Focusing on coffee in particular, the trend reversion indicator suggests that coffee is ‘undervalued’ (well below rolling trend), while at the same time speculative futures positioning has come down a lot, making for a favourable risk/reward entry point. Additionally, the El Niño weather patterns are intensifying which can interfere with coffee crops; hence you would say at this point the weight of risks are to the upside for coffee prices.

Theme in pictures

Source: AMP Capital, Bloomberg, Thomson Reuters Datastream

Source: AMP Capital, Bloomberg, Thomson Reuters Datastream

 
About the Author

Callum Thomas, MMgt (finance), MMgt (banking), BBS (finance), Investment Strategist

Callum is an Investment Strategist in the strategy team of the Multi Asset Group at AMP Capital. Callum has a passion for global macro investment strategy and constantly strives to generate unique and innovative insights that help inform the strategy team's dynamic asset allocation process. Callum is responsible for researching a range of asset classes and global macroeconomic themes to aid in formulating investment strategies across the Multi-Asset Group. He also keenly collaborates with the global equity and fixed income teams. Callum originally joined AMP Capital in June 2009 as an analyst in the investment business of what was then AXA New Zealand. He previously worked in strategy at the New Zealand Stock Exchange.