JP#Capital#!Perspective!is!everything!

August 20 2015

Global Equity A bit of doom and gloom with global markets this week as every single market has taken a step back ranging from 0.5% to 2.5%. The monthly to date figures continues to show red and does not seem to show any signs of reversing. Fixed Income Traditionally, as equity goes down fixed income goes up and this is exactly what happened last week. Even though the movement has only been minor, the bond market is showing signs of greener figures to come. Currencies The important news that came in this week was by far the devaluation of the Chinese Yuan, which was devalued further than what was expected. The GBP also gave up ground against the Euro, as did the USD. Commodities All been affected by the Chinese devaluation, especially Copper, which has reacted very quickly to the devalued currency. The Bloomberg commodity index accurately reflects the loss of value in the so called “commodity currencies.

Market roundup

Source: BoAML research, As of August 19, 2015

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EQUITIES

VALIDATING VALUATIONS

1

European equities appear to be more attractive relative to the United States. We say this from a bottom up valuation basis and from a narrative perspective. Trailing Price to Earnings (“P/E”) in the MSCI Europe ex- UK trades at 16x versus its 30-year average of 18x. This is in stark contrast to the U.S. where the S&P 500 trades at 27x versus its long term average of 16x. One argument in favour of these lofty valuations is that as wage growth picks up in to 2016, consumer demand, both domestically and abroad, will increase corporate cash flows. If this turns out to be the case, valuations will be validated causing the market to track higher. 25% of the S&P 500 companies are export led meaning overseas demand is a big driver of earnings growth.

2

That said, on two key counts, we feel that the S&P 500 faces inevitable headwinds resulting in a decrease in the benchmark index. As the Fed raises rates, the dollar over the medium term will rise, causing competitiveness to fall and earnings to be dragged down with it. We already saw this in second quarter of this year's earnings season. Secondly, as the effective discount rate goes higher, cash flows will be reduced at a greater rate, leading to a contraction in the bottom line. The “taper tantrum” back in 2013 took its toll on equities in both emerging and developed markets. Although it has been almost a decade since the last rate rise, history has shown (see Exhibit 1) that equities, at least in the U.S. tend to benefit from a rate rise. Fundamentals eventually take over amid a stronger economy, supporting higher borrowing costs.!

Next- FX update: Yuan tumbles to record low

Exhibit 1: Equity Markets buoyed by higher interest rates

Source: Credit Suisse

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FX & COMMODITIES

Chinese Yuan The Peoples Bank of China (“PBoC”) decided to devalue the Yuan after disappointing export figures. Indeed, the figures were not meant to be great, with an expected decline of around 1.5%, but they were far worse than expected with an 8.3% decline. The PBoC therefore wanted to devalue the Yuan by 1.8% against the USD on Tuesday and global markets did not welcome this devaluation with the Yuan falling an extra 1% by the end of Wednesday’s trading session. GBP/EUR Sterling has declined against the euro for two straight weeks. That is not great news for the British pound as the CPI figures are to be released on the 18th. If the CPI figures are bad, then it would more than likely reduce any chances of a rise in interest rates by the Bank of England before the end of the year. A survey by Bloomberg estimates that Britain is currently already in an environment of stagnating inflation. EUR/USD With the Euro area showing sings of stabilising, it has not only gained against the GBP, but it has also gained

versus the USD, beginning last week at 1.1019 and finishing at 1.1109. It is likely that EUR strength versus the USD will not persist, as Europe will be more exposed to the ongoing events in China. The Chinese devaluation is affecting the commodities market substantially. The Bloomberg commodity index went from 186 to 182 by the end of the week, the lowest point of last year. Copper took a serious hit on Monday (see Exhibit 2) and for the remainder of the week, it slowly started to stabilise towards Thursday and Friday. As the value of the Yuan stabilises, the value of commodities will follow and will increase accordingly. The oil price has lost approximately 60% year on year and has lost around $1.3tn for investors. OPEC is still standing its ground and will not reduce supply; this only suggests that the price of crude oil is going to head south and is likely looking at less than $30 a barrel by the end of the year.

Exhibit 2: Copper continues to fall amid a China slowdown Markets buoyed by higher interest rates

Source: Bloomberg

Trading band vs. Trade war

Next- Bond update: FED Liftoff

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FIXED INCOME The U.S. economy is slowly gaining traction. Unemployment is falling, wage growth is accelerating, yet inflation remains elusive. The latest Purchasing Managers’ Index for manufacturing (July) ticked up slightly to 53.8 from 53.6 in June. This, coupled with a slight increase in the labour force participation rate should give the Federal Reserve license to move in September. But because inflation remains low and due to some external headwinds, we feel the Federal Reserve (FED) will likely remain accommodative until December and possibly through into Q1 of 2016. That said, during the crisis years, the U.S. economy lost 8.8 million jobs but has since created 12.8 million (private sector). With two thirds of U.S GDP coming from consumption, if consumer confidence returns leading to increase spending, this will drive GDP growth in Q3 of 2016. The Bank of England may be forced to go for a rate rise earlier than the Fed, yet the Gilt forecast (see Exhibit 4) indicates

lower rates in the near term. This is likely due to the lack luster performance in the U.K’s largest trading partner. Sterling will continue to remain weaker, aiding the export sector to the U.S. In contrast, the market anticipates higher rates in the shorter term, with the 10-year benchmark reaching 3% by year-end. However, this is predicated on the notion of a positive inflation outlook, which at current levels will not be sufficient for a hike in the Fed funds rate. As expected the higher duration maturity (2-year) has the steepest ascent, touching 1.5% by December 2015. The most likely scenario is that the FED goes for its first interest rate rise in December with an extremely shallow path and a considerably lower longer-term rate than we are accustomed to seeing.

Exhibit 3: U.S. Treasury Yield Curve Forecast continues to rise amid Fed rate hike

Exhibit 4: U.K. Gilt Yield Curve Forecasts

Source: Credit Suisse

Source: Credit Suisse

Liftoff or Lowflation

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JP#Capital#!Perspective!is!everything!

Jonathan Taubert FX and Commodities

Pete McCarthy Equities and Fixed Income

JP Capital Team