Explaining Seemingly Incongruent Cross-Asset Investment Patterns Thus Far This Year

Since the advent of the new year, anomalous developments in asset market performance make for intriguing speculation regarding the tendency in risk appetites and general sentiment among investors in relation to flows into various investment classes.

For instance, why are the Russian and Saudi Arabian stock markets atop the worldwide equity performance league so far this year when the price of oil – a key revenue-generating export of both countries – has slumped to lows not seen in more than six years?  Further, what can plausibly explain the 1.9 percent rise in the price of gold during the past six weeks amid US dollar appreciation on both nominal and real effective trade-weighted bases and persistent disinflationary-to-deflationary patterns across dollar bloc and Western European economies?  Finally, what could conceivably account for the modest outperformance of the Japanese yen vis-à-vis the US unit in light of the divergent outlook for economic growth, monetary policy and international trade in both countries?

Russia’s and Saudi Arabia’s enduring dependence on sales abroad of domestic crude oil output for generating much-needed foreign exchange revenue should proceed to weigh bearishly on the stock markets of both nations.  However, unlike their performance last year when the former posted the worst loss among all shares markets globally and the latter sold off to the tune of 2.5 percent, Russian and Saudi equities are compositely outscoring their emerging and developed market competitors with double-digit returns of 13.3 and 11.9 percent, respectively, so far this year.  In the context of all the negative circumstances facing Russia on top of the precipitous decline in petroleum costs ill-affecting both economies, how could the returns of the Moscow and Riyadh stock exchanges still be outracing the performance of their rivals worldwide?

Despite the worsening fall-out from the financial sanctions imposed on Russia by Western powers in retaliation for Moscow’s annexation of the Crimean peninsula last year and continued prosecution of an insurrection on its border with Ukraine, ruble stability of late – in response to a resurgence in interest rates – should have aided in perhaps moderating the depressed state of the domestic equity market, not instilling a renewed sense of bullishness among investors.  Moreover, recent evidence of a bottoming of crude oil prices should not have fostered a recuperation of investor enthusiasm precipitating a correspondingly baseless equity market rally, but conveyed a moment of feeble stability to the Moscow stock exchange.  If anything, in fact, the six-week run-up in Russian share prices appears entirely counter-intuitive from a fundamental standpoint.

Nothing convinces us that the rally in Russian equities has much durability in the period immediately ahead considering the nation’s deteriorating macroeconomic and political prospects.  Virtually every statistic displays a pattern of increasing economic weakness.  Real wages and retail sales are plunging as is capital spending accompanied by rising joblessness.  Furthermore, policymaking seems to have been hijacked by President Putin and his intimate circle of advisors, who categorically support him – at the ostensible expense of the domestic economy – in his determination to destabilize former Soviet satellites and Socialist Republics that favor closer ties with the West.  Needless to say, we believe the Moscow stock market upturn will prove short-lived once risk-avid investors regain consciousness of Russia’s long-term demerits and liquidate exposures.  As has been GMI’s position for quite some time, Russian shares compositely deserve no more than an under-weighted exposure in well-diversified portfolios.

Saudi Arabia stocks, meanwhile, have also been performing well beyond anyone’s expectations of key fundamental factors driving earnings growth in 2015.  While a consensus in the market anticipates moderating economic activity of 3.6 percent (a full percentage point drop from last year’s expansion rate of 4.6 percent), S&P Ratings Services is projecting a considerably weaker Saudi expansion with real GDP advancing at just 2.5 percent this year and next.  The sharp fall in petroleum prices will diminish government revenues and lower business fixed investment, the detrimental consequences of which to macro-economic and budgetary patterns prompted S&P Ratings earlier this month to revise its credit outlook for Saudi Arabia to negative, but affirming its AA-/A-1+ debt ratings.  GMI recommends no exposure to the Saudi Arabian stock market for the foreseeable future, advising investors instead to focus on Panama as the frontier market of choice.

What has made gold a preferred investment in the past three months if living costs pose no proximate threat of re-accelerating anytime soon?  Even though the price of gold has already lost six percent of its value after peaking at $1,302.25 on January 22, the yellow metal is still the fifth highest performing commodity year to date, lagging silver’s top performing return of 7.3 percent by only 4.3 percentage points.  Until then, the cost of gold had risen 14 percent from its November 5th low of $1,140.54.  As an inflation hedge, investments in the precious metal have made little, or no, sense since most of the developing and advanced world had witnessed their living costs recede into disinflationary, or – in a few cases – into deflationary territory.

However, what has made exposures to gold attractive has been its property as a safe harbor in times of exacerbated risk countered by rising aversion among investors – most notably under current circumstances, with respect to potential credit and ongoing political events as well as heightened foreign currency volatility.  The dire financial straits of Greece amid political squabbling between Athens and Berlin, and Moscow’s military support of a spreading insurrection in Ukraine’s eastern province will keep the lure strong for gold exposures as will elevated volatility among G-20 currencies in reaction to central banks’ de facto weakening of their national currencies via either interest rate reductions or quantitative credit relaxation.

Another oddity since the end of last year has been the Japanese yen’s appreciation against the euro and US dollar.  Ranked fourth strongest in year-to-date cumulative spot market returns of 7.1 and 0.7 percent vis-à-vis the euro and US unit – correspondingly, the yen’s gains would appear to have little, or nothing, to do with the projected trend in economic fundamentals.  Economic inertia last year is forecast to accede to a modest revival of 1.0 to 1.4 percent in the tempo of the rate of expansion of the world’s third biggest economy, but – with the domestic cost of living expected to abate to just above one percent – investors appear to have little reason to enlarge their exposure in Japanese shares irrespective of the 5.4 percent US dollar-denominated return registered by the Nikkei 225 since the end of 2014.  In fact, we reiterate our advice to retain a solid under-emphasis of the Japanese equity market in globally diversified portfolios.

So, if outside investment in Japan’s stock market to any extent has not been the principal source of the yen’s firmer tone, to what is its new-found strength attributable?  Refuge demand for Japanese sovereign debt explains as much as, if not more than, the modest single-digit, year-to-date upturn in domestic stocks for the appreciation in the Japanese yen.  Government bonds (JGBs) ranging from short- to intermediate-duration remain the target of investors regardless of their paltry fractional yields.  In reality, though, investors, in stressing the front- and medium-term tenors of the JGB maturity spectrum, are presumably apprehensive about the long-term outlook for Japan, whereas their simultaneous emphasis of long- to intermediate-term debt of the Swiss Confederation and US Treasury markets validates their relatively greater confidence in American and Swiss policymaking climates.

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