This article is intended to give a short insight into the rationale behind some interesting articles I have recently read on different market topics. The first idea is that major stock markets like the S&P 500 in the US or the DAX in Germany are only looking good on the surface, while a deeper look inside reveals major problems that might lead to a turnaround in the near future. The second bit is about the ever debated EUR/USD with some interesting argumentation coming from JP Morgan, which sees the currency pair back at 1.13 at the end of next year. Finally, I want to shortly sum up the theory of why terror attacks like the one in Paris earlier this month seem to not affect financial markets (any more).
A Bad Year For Equities
In his article for the FT last week, author John Authers points out how the now 7-year lasting bull market in the US has recently focused on less and less companies who actually drive the rally further (or at least maintain the current status quo near the all time high). While the past has taught market participants that smaller companies tend to dominate during market rallies, what we see today is a handful of big players who have taken the lead. In the FT article these companies are referred to as the FANG (Facebook, Amazon, Netflix, Google) and the “Nifty Nine“, which adds Ebay, Starbucks, Microsoft, Priceline and Salesforce. Both FANG alone and the “Nifty Nine“ would have given investors a return on of over 60% since the beginning of the year, while the S&P500 returned a poor 1%.
Why is that?
One possible explanation might be the new economic environment that is focussed on services rather than manufacturing. Maybe the “Nifty Nine“ are receiving some kind of advance praise for their prospective leading roles in this new economic environment. However, it should be noted that the “Nifty Nine’s“ collective P/E ratio is around 45, which is double the ratio of the overall S&P. Investors being excited about a handful of big companies is a classic sign of a bull market top, so caution is needed while observing this trend further.
Similar Picture In Europe
The issue of a stock market looking good only on the surface is not restricted to the American side of the pond. The DAX, for example, has seen a rise of around 20% since its plunge in August (+15% since the beginning of the year), although DAX profits are decreasing. Conventional market wisdom says that one of the key factors influencing share prices is corporate profits. Who ever follows this concept at the moment, will have a hard time explaining some of the current DAX share prices: DAX companies Q3 profits have fallen a tremendous 69% YoY.
In all fairness though, what should be taken into consideration in the DAX example is that the decline in Q3 profits stems to a large extent from three big players, namely Deutsche Bank, Volkswagen and EON. While the reasons for Volkswagen’s figures need no further explanation, Deutsche Bank announced a €5.8bn write down for the third quarter, only topped by energy giant EON declaring €8bn of impairment charges. It is important to note that the reasons for these enormous write-offs (corporate scandals, write-offs) have nothing or little to do with the operative business of these firms, making the outlook for them slightly less worrying than it seems at first sight.
However, markets are based on expectations and so the future outlook is more important than the status quo. Considering concerns about the global economic development, and the fact that many of the seemingly attractive European corporate profits are strongly influenced by currency effects through the weak Euro, the question remains how long the developed market stock market rally can last.
EUR/USD Back On The Rise In 2016?
In terms of the main currency pair, EUR/USD, it is admittedly hard to even determine what the mainstream currently is. While some say, the Euro has fallen enough so that it is not worth entering into the short any more, others could not be further away from this opinion.
As the title of a recent Goldman Sachs research paper suggests, the Euro might go “to parity and beyond“, implying that the bottom is far from reached. This thesis is reinforced by the fact that the dollar is still not very strong on a historical basis and right now, the EUR/USD is not even at its lowest in 2015.
However, voices have become louder stating that the Euro short might not be as safe as it appears to be. After Bank of America warned of the crowdedness of the trade a couple of weeks ago, JP Morgan now comes up with some interesting additional thoughts on the issue. Their research division suggests that the US economy looks good but not great and that it only takes on weak quarter for the FED to end the highly expected tightening cycle, which it is assumed to begin soon.
Another interesting thought on the EUR/USD is the status of the Euro as a funding currency. I already mentioned in my July article “Quo Vadis Euro – What Europe’s Currency Will Be Worth In A Year“ how funding currencies tend to do better in times of crisis (back then the Greek saga). In short, the ECB’s aggressive easing has effectively turned the Euro into a funding currency for a carry trade, meaning investors borrow (go short) Euro (at the near-zero interest rate in Europe) and go long a currency with a higher interest rate to profit from the rate divergence. One important feature of such funding currencies is that in times of crisis, triggering risk-aversion, the market tends to “cut“ such funding, making the funding currency appreciate. Some people argue that this has made the Euro an anti-cyclical currency, which was observable during the Greek crisis, when it was reluctant to leave its tight range no matter how bad the news from Athens and Brussels were. In conclusion: An unexpected crisis or shock has the potential to put a sudden end to the EUR/USD decline.
Why Terror Attacks Do Not Affect Financial Markets
Uncertainty affects market prices negatively. This is another idea hardly anyone would argue against. If that is to hold though, how come that a recent event like the Paris terror attacks, which made media (rightly so) report about nothing else for a series of days, and which made some of the most powerful states overthink their current military strategies, seem to have no effect on the markets?
To understand this phenomenon, it is important to have a look in the past, as what we see today is not what is used to be like. After the terror attacks of 9/11, stock markets in the developed world fell by as much as 25%. US firms massively increased their cash reserves (+ 60% over three years) to be well equipped in case a similar event would have occurred again, which had major implications on investment. While effects on macro economic factors like the latter are difficult to assess so shortly after the Paris attacks, the financial markets have shown an almost defiantly seeming disinterest in the attacks, quickly getting back to higher prices than before the 13th November. Experts see two main reasons for that.
Firstly, despite putting the world in shock for a couple of days, the attacks in Paris do not come nearly as unexpected as those in New York in 2001. Though low, and as horrible as it sounds, it is not new to Europe to have one of their capitals attacked by terrorists. This thesis is in line with something one could call a trend: While the German DAX fell by more than 20% after 9/11, it only fell 8% after the Madrid attacks in 2004, and showed almost no reaction to the London attacks in 2005.
Secondly, the attacks in Paris were, from an economics perspective, conventional attacks. Some market participants believe that once terror attacks aim at a country’s infrastructure, use chemical weapons or even a series of terrorist attacks rather than one concentrated attack would provoke a more extreme market reaction because of its new quality and potential political consequences.
However, what should not be forgot is that markets not showing much of a reaction does not mean there are no economic effects of terror attacks. Considering implications on tourism (if we think further than Paris, for example North Africa, Middle East), trade or investment are areas that will probably see negative effects from the recent attacks. And with regards to that, an economy like the European one, that is already struggling, might be even more vulnerable to such unforeseen events, be they more or less expected due to similar experiences in the past.