Looking for clouds on the horizon

Begin by placing your market telescope to your eye the right way around so as to magnify distant objects of interest. It is surprising how many people you observe with the wrong end of the telescope stuck in their eye. Investment banks actually pay staff large salaries and bonuses to perform this task in the name of specialisation and liquidity. (The equity market, being a place of specialists understandably induces myopia.) Moreover, telescopes whether used properly or not, involve the use of one eye only, thereby providing another example of that old saying that in the land of the blind: the one-eyed man is king.

So with your one eye engaged with the right end of your telescope, what tiny clouds – no larger than a man’s hand as the saying goes – can we spy on the distant horizon? Investment involves, amongst many other things, keeping a weather eye open. As Jack Hawkins famously says as the idiosyncratic special services major on the film “Bridge on the River Kwai”, “Now for the things we haven’t thought of”; those things that a once strange US secretary of state called the “unknown, unknowns”, as distinct from the “known unknowns”.

The current clouds of great known unknowns include of course the market implications of the tapering down of the great money printing operation called, to make it sound obscure, ‘quantitative easing.’ The latest yields on 30 year Gilts (which represents the market’s expectation of future inflation because you are locked into the “coupon’s” rate of interest) may allow some insight into this conundrum.

Currently, the average yield on UK Gilts is 2.54%. A year ago that Gilt yield was 3.37%. It has come down with a growing realisation that inflation is not what many had feared it might be and what had been expected longer term. In consequence, the market is currently discounting a modest amount of inflation in historic terms, even though we are heading towards QE tapering in the near term – or least that is the expectation. That makes those of us who have lived through the last thirty years of market history cautious. A redemption interest yield of only 2.54%, represent a small cloud to be watched.

The fact that oil prices are rising, despite a daily global excess supply for oil in relation to demand is another curiously shaped small cloud passing in front of us. Does it imply that demand for oil is greater than economists claim it to be or is there funny stuff going on somewhere? It is now highly fashionable as well as streetwise to suppose the latter.

Another small cloud that has drifted into sight is that of a mutating bird flu virus, which is being watched hawk-like by world health authorities. Its significance lies in the possibility that this virus could mutate so that one human infected by it could then pass it on to other brother and sister homo sapiens. If that were to occur, the disruption to equity markets would be palpable. However, experience shows that we are well equipped to address such problems, although it would be stretching things to suggest that modern medicine is infallible, despite the apparently successful containment of Ebola. That was not easily passed on. This one, should it ever occur, would be infectious between humans by definition.

FTSE 100 index earnings are currently valued at sixteen years purchase or 16 times price to earnings ratio and on a dividend yield of around 3.4% – still ahead of the redemption yield on 30 year government gilts at 2.54%. A 1% difference shows how an alteration in inflationary expectations, should it occur, could undermine the current valuation of equities. So are we entering a new deflationary world or shall we be returned to a world of rising inflation. That is now the question…