Stockwatch: Keep powder dry for summer jitters

Is playing equities nowadays little more than out-guessing the moves of central banks? And have their stimulus measures reached diminishing returns, coinciding with a traditional sense of "sell in May"?

Stock indices just fell after the Bank of Japan opted not to make any additional stimulus, as if market hopes were ahead of reality. Consequently, the US dollar slid against the yen, which in turn pushed up commodities (generally priced in dollars), helping oil continue its remarkable turnaround - rising to $47 a barrel. Individual stocks will continue to appeal on specific criteria, but beware these tensions in the macro trend.

Has the US Federal Reserve lost the plot?

A chief reason US stocks have recovered since February to within 2% of their May 2015 highs is the relatively liberal chair of the Federal Reserve Board, seeking to protect what gains the US economy and jobs market show, leaving interest rates ultra-low - currently at a Federal Funds rate of 0.5%.

First-quarter US corporate profits haven't revealed enough nasty surprises to hit overall sentimentThis contrasts with a conservative minority on the board with a hawk-eye to the inflationary risks and a need to reasonably normalise monetary policy before the next cyclical downturn, or else have no effective scope for rate cuts then. Markets had begun 2016 expecting a series of small rate rises, which now appear deferred - hence stocks rallying. But mind how US macro data is indicating mild "stagflation" i.e. stagnating growth with inflation.

Overall figures for employment, GDP, durable goods orders etc. show slow growth at around two-year lows, while areas of the labour market are tight, which squeezes wages higher. First quarter US GDP has, for example, come in at 0.5% versus expectations of 0.7% and expansion of 1.4% in fourth quarter and 2.0% in the third. Core indicators of inflation have risen near the 2% level and leading inflationary indicators are at a seven-and-a-half year high - potentially over-shooting what a prudent central bank should allow.

Rising oil prices quelled fears indebted energy firms could create another 'sub-prime' crisisScare stories about a tight US jobs market have persisted for a few years, but it does need watching, given a risk that inflation forces interest rate rises to come sooner. Stagflation provides fresh meat to bears who have warned the Fed's response to the 2008 crisis was justified, but stimulus has continued far too long, "borrowing from the future" and creating asset bubbles. Companies have been tempted to raise debt at artificially low interest rates, which has further pushed up stock values via buybacks and takeovers. Balance sheets are, therefore, exposed to rate rises, a more fundamental economic risk.

First-quarter US corporate profits haven't revealed enough nasty surprises to hit overall sentiment. There's a hope that the dip in corporate earnings will be overcome, hence reason to anticipate further gains in stocks later this year. Rising oil prices have also quelled fears that over-indebted energy firms represent another "sub-prime" crisis. But the US stock indices' latest fall in response to a lack of further stimulus in Japan shows central bank policies remain key.

China embarks on yet another credit binge

Since January 2015 I have argued against warnings by Crispin Odey that equities "will get devastated" by another financial crisis, in particular a Chinese hard landing. There are plenty of strong equity yields to inhibit a major sell-off, but certainly the risks need watching. His problem has been premature timing, quite like Jim Chanos, the US hedge fund manager who has predicted a Chinese crash since 2010.

Lately, China has engaged another round of debt-driven stimulus: by end-March total credit had soared 58% year-on-year to 7.5 trillion yuan (£792 billion), quite like the 4 trillion yuan stimulus in 2009 that led to inflation and excess capacity.

A recent forecast predicts global investors will pull £369 billion out of China in 2016Property values are soaring again, up 30-60% in key urban areas. You wonder whether the Chinese authorities really know their game, against a promise to rebalance the economy. Meanwhile, Apple has reported a 26% drop in sales there, probably not all down to currency factors and smartphone sales maturing.

The dilemma - where Chanos and Odey may yet be vindicated - is higher debt running into diminishing returns, now imbalances have got even bigger. Chinese capital outflows were high-profile in January and early February, when global equity indices would twitch according to the Chinese central bank's daily yuan fixing (officials denying any competitive devaluation goals to help exporters).

Lately, the outflows have somewhat reversed, but a recent forecast still predicts global investors will pull $538 billion (£369 billion) out of China's slowing economy in 2016, i.e. an additional $420 billion during the rest of this year. There is risk, at least, of another round of jitters.

Oil markets tip from one historic extreme to another

As if reflecting the modern power of speculation, the crude oil market has seen an incredible swing over barely two months: from the highest net short positions ever-recorded to the highest net longs, hence a 70% rally from a 13-year low last February at around $27 per barrel.

Sentiment has shifted from expecting chronic low prices, amid over-production and a weak global economy, to hopes that a two-year production glut is abating and that a shortfall will eventually arise due to "structural supply destruction" in the US, with Chinese demand strengthening.

The inverse correlation between oil and the US dollar has eased sharply in the last six weeksA very few traders reading such shifts have profited immensely, while analysts focused on relentlessly growing stockpiles have had their cautions brushed aside. With oil seen as a proxy for risk appetite, its rollercoaster has also benefited stocks, but mind the aspect of possibly artificial Chinese demand. Besides involving credit, China appears to be taking advantage of the overall price downturn to stockpile, likewise a transitory feature.

Notably, the inverse correlation between oil and the US dollar has eased sharply in the last six weeks, with oil up about 25% and the dollar down only 2.5%. Quite whether oil's direct link with equities will ease - most global indices being a simple overlay of the crude oil chart - remains to be seen. Theoretically, it makes little sense, given the most influential factor is energy costs, low oil mitigating the risks of secular stagnation.

Do risks imply a jittery summer ahead?

Pumped-up US equities, over-borrowed Chinese and capricious oil are nothing new. Since the start of 2015, for example, it has paid not to be swayed, instead focusing on companies well-established in their industries with robust earnings and dividends. That remains so; just keep these risks in mind and cash to exploit the drops.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.