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Abu Dhabi, UAESunday 16 December 2018

Stocks keep their calm as all about gets choppy

Since April 17, the Nikkei has gained 5 per cent, the euro STOXX 50 is up 2.8 per cent, and the FTSE 100 is up 7.5 per cent

Markets have so far remained immune from a range of potential volatility-causing issues. Bryan R. Smith / AFP
Markets have so far remained immune from a range of potential volatility-causing issues. Bryan R. Smith / AFP

US bond yields are the highest in seven years, the dollar is strengthening, emerging markets are wobbling, and oil is up to $80 a barrel.

Yet there is an unlikely oasis of calm out there: stocks.

There are many possible reasons for this, including: US tax cuts boosting earnings expectations and share buybacks, exchange rate moves, a sense a 3 per cent Treasury yield was already priced in, and a belief that the turmoil in the emerging world is and will remain isolated to certain countries.

Since the 10-year US yield and dollar really began to take off in mid-April, increasing the pressure already bearing down on emerging markets, the world's major equity indices have held steady or rallied.

There is a question mark over how long stocks can remain immune from this tightening of global financial conditions, bubbling inflationary pressures and geopolitical tension. But, for now at least, investors aren't interested in the answer.

Investors poured $11.9 billion into global equity funds in the latest week, mostly into US funds, according to Bank of America Merrill Lynch (BAML). That's the biggest inflow in two months and the fourth weekly inflow in a row.

Exchange rate moves have been a boon to Japanese, euro and UK stocks. Since April 17, when the dollar, US bond and emerging market moves cranked up a gear, the yen has fallen 3.5 per cent, the euro's down 4.5 per cent and sterling is off 5.5 per cent.

In that time the Nikkei has gained 5 per cent, the euro STOXX 50 is up 2.8 per cent, and the FTSE 100 is up 7.5 per cent. Euro zone stocks have also coped with yet another bout of messy Italian politics, which hit bonds hard, while UK stocks have ignored deteriorating economic data and growing confusion at the Bank of England.

Based solely on exchange rate differentials, these markets might have been expected to rise as much as they have. But Wall Street and Asia ex-Japan, which are most exposed to higher US yields and stronger dollar, are up, too. Albeit just.

The VIX index of implied volatility, still considered the benchmark measure of investor fear surrounding US stocks, has drifted to 13 per cent, its lowest since just before the "volmageddon" spike in early February.

Wall Street got a shot in the arm from first quarter earnings. They rose 26 per cent from the same period a year ago, in part thanks to the dollar's biggest annual decline last year since 2003.

US President Donald Trump's tax cuts, which were finally pushed through in December, have also boosted future earnings expectations and unleashed a wave of share buybacks and corporate merger and acquisition activity.

US stock repurchases in Q1 were $137bn, the strongest quarter in two years. Apple announced a $100bn buyback plan earlier this month, giving credence to research firm TrimTabs's view that buybacks in 2018 will "smash totals from all other previous years".

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In recent weeks, T-Mobile and Sprint agreed to a $26bn all-stock merger, and Marathon Petroleum agreed to buy rival Andeavor for more than $23bn in the largest-ever tie-up between US oil refiners.

It's not just US M&A activity that's taking off. According to Deals Intelligence, a Thomson Reuters company, global M&A so far this year has reached $1.85 trillion, up 67 per cent on the same period last year. Cross-border M&A has doubled to $836bn.

If buybacks and merger-mania are sweeping across developed markets, the same cannot be said of emerging markets. Argentina and Turkey, which boast two of the largest current account deficits in the world, have been hit particularly hard by the dollar and US yields.

There are country-specific factors at play there, like Turkish president Tayyip Erdogan exerting his influence over monetary policy. But investors are generally betting, for now at least, that these two crises will remain localised.

And while the 10-year Treasury yield's break higher to a seven-year high of 3.12 per cent is eye-catching, it hasn't taken anyone by surprise. Or at least it shouldn't have.

Last September the 10-year yield was close to 2 per cent. Bonds then embarked on a near-uninterrupted slide and the yield nudged 2.95 per cent in February, so the break above 3 per cent when it finally came a few weeks ago would hardly have spooked equity investors.

These are reasons why stocks have held up so far, but there's no guarantee they will remain supportive. The pain from increasing dollar strength and higher US yields could spread through corporate America. Emerging market turmoil could deepen. The positive impact from the tax cuts will fade.

Any one of these could alter investor sentiment towards stocks. And quickly.

Reuters