Investors remained in a cautious mood during June as concerns over events in Europe, a sharp slowdown in China and the looming US 'fiscal cliff' continued to weigh heavily on sentiment.
World
Recent events in Europe, including the victory of Antonis Samaras and his pro-bail-out party in the rerun Greek general elections, have done little to reassure global financial markets. Political developments have so far failed to address the underlying debt, growth and competitiveness issues facing the region, and hopes of an improvement going into the latest summit meeting of European leaders on 28-29 June were not high. The European crisis has clearly begun to impact on the world economy, as well as, equally disturbingly, on companies' sales growth. Danone, the French yoghurt maker, for example, issued a surprising profits warning as consumers cut back on what are normally staple products. World markets responded positively, however, at the end of the month to a provisional agreement by Europe's leaders at their summit to introduce new bail-out funding arrangements for Spanish banks.
UK
A further fall in inflation in May was a welcome surprise in a continuingly bleak economic environment. The headline consumer prices inflation rate has fallen to 2.8% from over 5% in September last year, driven mainly by a sharp fall in oil and commodity prices. A recent spike in retail sales was primarily attributable to petrol sales returning to normal levels; we have yet to see any real confidence returning to the high street. With inflation heading back towards the Monetary Policy Committee's (MPC) 2% target level, policymakers are beginning to see the need for further monetary stimulus. Four members of the MPC, including Sir Mervyn King, the Governor, voted for another £50bn of asset purchases at the most recent meeting. Further quantitative easing (QE) is likely in the next month or two. Chancellor George Osborne announced plans for a scheme designed to help cut bank's funding costs, claiming it could support around £80bn new loans to the wider economy. The concern for investors is whether UK equity markets have already factored in these positive signs of more effective policymaking. With banking and mining stocks making up a large proportion of the UK market, the ongoing Spanish banking crisis and the continued slowdown in Chinese growth, make the UK equity market vulnerable on the downside the short term. We continue to believe that the poor GDP growth figures reflect some fundamental problems in the UK economy which remain largely unaddressed and cannot be solely blamed on the problems in the eurozone.
US
Another month of patchy economic data from the US has continued to signal that the recovery across the Atlantic is beginning to lose steam. Poor housing and employment data, combined with another fall in inflation, initially buoyed US equities at the beginning of the month, on speculation that another round of QE was on its way. Instead, the Federal Reserve shied away from full scale monetary easing and decided instead to extend its 'Operation Twist' until the end of 2012, disappointing those investors who had been hoping for a more aggressive response. Markets tailed off accordingly towards the end of the month. The Federal Open Market Committee announced plans to purchase $267bn of longer-dated treasuries, while simultaneously selling an equivalent amount of shorter dated government bonds. While this move supports the Federal Reserve's commitment to keep interest rates low for the foreseeable future, it remains less clear whether this will have a significant positive impact on the real economy or push down longer-term interest rates as the Federal Reserve expects. The decision to extend Operation Twist does not rule out further QE. If the economic data continues to deteriorate further we could see the Federal Reserve spring into action once more with a more aggressive stance.
As we enter the second half of the year the potential impact of next year's looming 'fiscal cliff' is now firmly on investors' radars. US companies are beginning to delay hiring and remain unwilling to commit to new investment projects, in part because of growing concerns that Congress won't reach a compromise in time to halt automatic tax increases and spending cuts that are due to come into force at the beginning of next year. Vulnerable stocks include those in the defence and healthcare sectors where potential spending cuts will be felt the most. US equity markets are likely to remain choppy in the short term until the political landscape becomes clearer.
Europe
Following the drama of the Greek electoral crisis in May, it was the turn of the Spanish banking system to move into the market spotlight this month as the Government sought up to €100bn in EU bail-out funds to rescue the nation's ailing banks. Spanish government bond yields soared above 7% on fears that the country itself may need a bail-out as well. Spanish woes also pushed Italy further to the front line of the debt crisis. Although it has not experienced a housing boom and bust like its southern European neighbour, Italy has more than €2trn of debt and is perceived by some as potentially an even greater credit risk than Spain. With Spain becoming the fourth eurozone nation to seek an international bail-out (after Greece, Ireland and Portugal), very little has been done to address the underlying issues facing the region. A more coherent policy response from eurozone leaders is needed before any kind of confidence can be restored, but there remain deep differences of opinion between the zone's 17 member countries as to the best way forward. Top of the agenda at the latest EU summit was a push towards greater integration, with the Commission proposing a European-wide banking union and ultimately, a single treasury and banking supervisor with the power to intervene in national policies. While this would help the development of a more effective monetary union, banking integration remains a contentious proposal that challenges the desire of many European countries to retain national sovereignty over their tax and spending decisions. Many European equities appear very cheap on historical valuation measures, but despite an immediately positive market response to the latest summit agreement on 29 June, European equity markets are likely to remain volatile and subdued for some time. Yields on German bunds fell to new lows during June as investors moved further into safe haven assets. Spanish and Italian bond yields ended the month down from their mid-month highs, but seem set to continue yoyoing up and down in reaction to political developments.
Asia
After months of speculation, China cut interest rates for the first time since 2008. Policymakers in Beijing have become increasingly concerned about the knock-on effects of slower growth and uncertainty in the western world. The People's Bank of China is worried about sluggish loan growth becoming a drag on the economy and confidence in the region. A surprising rise in M2 money supply in May (+13.2% YoY) may point to a pick up in economic activity. With inflation seemingly now under control, we expect policymakers to concentrate on stimulating domestic demand as China looks to make the transition to a more balanced economy. Despite last month's sharp rise in exports to 15.3% YoY, China's economic slowdown remains a key headwind to global economic recovery.
Further signs of Japan's vulnerability to the eurozone crisis were highlighted during the month when the economy posted its first ever monthly trade deficit with the EU. Although trade with the US and the rest of Asia remained positive, the recent trade data is likely to put more pressure on the Bank of Japan for easier monetary policy. There are now genuine concerns over the sustainability of Japan's trade surplus. Its equity markets remain heavily reliant on foreign investment while domestic demand remains at low levels. The same headwinds that are posing a challenge to policymakers in the West, eurozone uncertainty and a slowing US economy, remain a challenge to policymakers. When coupled with the yen appreciating against all major currencies (around 4% versus the dollar), further central bank intervention is likely in Japan sooner rather than later.
Conclusions
The flight to safety by many investors drove the yields on US, German and UK bonds, to lows that were last seen many generations ago – indeed 200 years ago in the case of the US and UK. With little income available from conventional government bonds, the global search for yield continues. Equities continue to be shunned by many institutional investors and trading volumes remain very low by historical standards. On a more positive note, there is scope for monetary policies to be loosened further, and for investor sentiment, which has been poor, to rebound given the slightest encouragement. Equities appear inexpensively valued in many markets, the balance sheets of many companies outside the financial sector are robust and the recent notable fall in oil prices and a number of other commodities will have a positive impact on input costs, corporate margins and disposable incomes. Given the global uncertainty, and in a risk-on, risk-off trading environment, our focus remains on good quality companies with robust business models, global franchises and high and sustainable dividend yields, while maintaining suitably diversified portfolios for protection should further evidence of global deflationary pressures materialise.
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