Tuesday, December 15th, 2015

Unfinished Business

There are just 10 days till Christmas and we are still waiting for the main event(s) of the year as far as investors are concerned. This week’s FOMC is one of them. The other is the Spanish parliamentary elections, which will be held on Sunday December 20th. Most investors would agree with our first choice, even though the decision has been much discounted, but many would be surprised that we accord equal significance to the second. Yet it has dominated our thinking about the Eurozone and the ECB for the last six months. As we say in the week’s summary notes, “Everything in Europe flows from this result.”

If the current centre-right government is re-elected, we believe that the Southern European anti-austerity revolt would be finished. Greece would remain a special case, the Italian government would pursue labour market reform and the new socialist-led coalition in Portugal would have no allies with whom to protest. If there is a centre-left coalition, anything is possible. Much would depend on how many ministries Podemos, the new, leftist party, controlled and whether Ciudadanos, the new right-wing but anti-corruption party, was also part of it. The PP, led by Prime Minister Mariano Rajoy, has 27% of the vote according to the latest opinion polls, enough to be the largest single party, but not enough to govern without a coalition. The most market friendly combination (PP + Ciudadanos) may also be the least likely because it would involve the anti-corruption party doing a deal with the government they were formed to eject from office. Look what happened to the UK Liberal Party after it went into coalition with the Conservatives. The most likely outcome is that there will be a long period of negotiation (and possibly the need for another election). This is not normally a recipe for stable markets.

Our normal recommendation would be to avoid as much of this risk as possible. However as argued above we think there are links with many other countries in Europe. There is also a significant difference between our bond view and our equity view. Spain is #3 in our bond model, but #9 in our equity model, suggesting that equity investors are more concerned about the downside than bondholders. It’s normally the other way around. To us, this indicates that investors simply don’t know what the result is going to be or how to analyse its consequences. Similarly Italy is #1 in bonds, but #5 in equities.

Turning to Fed, we assume like everyone else that the FOMC will raise interest rates by 25bps and that they will pledge to be gradual in future moves. The trouble is that we are not sure about the gradual bit. Our fixed income models suggest that the high-yield market is under real strain (a view which is unlikely to change even if there is a rally this week). Our equity sector model suggests the equity market has become overly-dependent on leadership by the Technology sector and that this could also come under strain towards the end of the first quarter. Neither of these developments would be compatible with any significant increase in US rates next year, let alone a consistent and gradual uptrend. In the US, as in Spain, investors have turned a view of what they would like to happen into a forecast of what actually will happen. They may be right, but in our view the consensus is too complacent. January could be difficult.

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