A monthly round-up of global and local market trends
Investment review
Waiting on Europe
Equities rallied mildly in July as investors entertained hopes that policymakers might respond more effectively to mounting evidence of a slowing global economy. Bonds and gold also made gains on fears of a new eurozone crisis – a schizoid response that faithfully reflects the fragility and polarised nature of investor sentiment in current market conditions.
World
Global financial markets recovered somewhat from their midsummer doldrums on speculation that central banks might be able to help orchestrate an effective policy response to the deteriorating eurozone crisis. The European Central Bank, the Federal Reserve and the Bank of England buoyed equity markets temporarily with hints of further monetary stimulus and statements suggesting that they are willing to act to prevent a disorderly breakdown of the European single currency. The period of denial last year, when hopes that the developed world could simply grow its way out of the ongoing debt crisis, in many developed countries now appears to be over. Expectations of future growth have been lowered in the face of deteriorating economic data from Europe and the US, and clear evidence of a slowdown in China. The survival of the eurozone in its current form continues to hang in the balance, investor sentiment remains fragile and yields on 'safe haven' sovereign bonds remain at record low levels. Although many companies have beaten analyst earnings forecasts, earnings in aggregate have fallen and top line revenue is down even more sharply in the face of declining economic growth.
UK
As London prepared to host the Olympic Games, there was little to cheer about on the economic front. According to the Office for National Statistics, the economy plunged further into recession in the second quarter, with GDP contracting by a worse than expected 0.7%, following a 0.3% decline in the first quarter. Although seasonal factors, including poor weather, hurt high street sales and the extra Queen's Jubilee bank holiday in June also contributed to the weaker growth figure, economic recovery is likely to remain elusive until some core structural issues, including excessive debt, are addressed.
Despite the poor economic backdrop, equity markets proved resilient. One reason may be that investors had already pencilled in lower growth expectations. Another is that markets have started to anticipate a further easing of monetary policy, as urged by the IMF in its latest report on the UK economy. The dovish tone of the most recent Monetary Policy Committee meeting minutes, combined with a further sharp fall in consumer prices index (CPI) inflation to 2.4% in June, certainly leaves the door open for further stimulus. Policies to stimulate economic growth are also being encouraged by the Government. The funding for lending scheme, a joint plan between the Bank of England and the UK Treasury, will offer banks the opportunity to borrow money cheaply provided they lend the money on to households and small businesses. Ministers will hope that it is more effective than Project Merlin and other similar measures to boost bank lending. On a more positive note, dividends in the UK increased by 18% in the second quarter to a record high, and while the economic climate in the UK continues to be overshadowed by fears of a eurozone collapse, the seasonal effects that hurt growth in the second quarter seem unlikely to be repeated.
US
Patchy economic data in the US continues to leave investors pondering whether it will produce another response from the Federal Reserve. The 1.5% annualised increase in GDP in the second quarter underlined that the US economy is failing to generate the traction which many had hoped for at the start of the year. The issue for the Federal Reserve is whether the data is sufficiently bad to warrant immediate action. Consumption growth, the key driver of the American economy in the modern era, continues to lose steam, rising by just 1.5% year-on-year in the second quarter. Consumer confidence remains at low levels, households continue to pay down debts in preference to spending elsewhere, and company investment remains at low levels, although a 7.2% rise in business investment in Q2 suggests that some confidence may finally be returning to the corporate sector.
The underwhelming growth figures are likely to form the main area of attack for Republican candidate Mitt Romney as the presidential election campaign gathers pace. While equity investors appear to be expecting further action from the Federal Reserve, possibly in the form of another round of so-called 'quantitative easing' (QE), the Federal Reserve has to steer a careful course for fear of being accused of acting in a partisan way during the extended American election campaign. With unemployment still standing at more than 8%, and CPI inflation below the official 2.0% target, the central bank does have room to pursue a more expansionary monetary policy. That is certainly our expectation. Previous rounds of QE, in 2010 and 2011, have boosted equity and commodity prices, albeit only for a short period, and the same pattern may repeat itself again if the Federal Reserve does decide to act. Economists however remain divided about the wisdom and effectiveness of such unorthodox monetary policies.
Europe
Equities and other 'risk assets' in Europe rallied sharply towards the end of the month after Mario Draghi, the president of the European Central Bank, promised to step up its efforts to save the euro. Mr Draghi's pledge to do 'whatever it takes' to preserve the single currency came after bond yields in Spain had risen to 7.5%, a record high, and one widely seen as being unsustainable. Italian bond yields also rose to new highs. The Spanish economy, weighed down by excessive debts in its banking system, mainly property-related, sunk further into recession in the second quarter. Fears that the country's banks – and possibly the country itself – will need a further massive injection of bailout funds has led to more than €150bn of private sector capital being pulled from the country since the start of the year. The money has gone into other assets perceived as safer havens, such as US, UK and German bonds, London property and gold, helping to driving up their price. Whatever monetary stimulus measures the European Central Bank may wish to introduce, its freedom to manoeuvre is even more constrained than that of the Federal Reserve, which has a broader mandate and is not confined in the same way as the European Central Bank is by the treaties which set up the euro as a single currency.
Many analysts argue that the deepening crisis in the eurozone could be averted by mutualising its debt and moving towards a common supervisory regime for the region's biggest banks. Political opposition to further integration of this kind is growing in Germany and other northern countries which in practice would have to shoulder most of the burden of financing these measures. With political leaders still some way from agreeing on their next steps, the sense of crisis circling the eurozone is likely to persist.
The economic climate in Europe continues to deteriorate, with leading indicators pointing to negative growth in an ever greater number of countries. Unemployment, especially in the over-indebted southern nations, rose to a new high of 11.2% in June.
Greece meanwhile remains perilously close to running out of money and is behind schedule in delivering the reforms and cuts demanded by other eurozone countries as a condition of agreeing the second bailout for the country earlier this year. The recent depreciation of the euro is one welcome development for Europe, but the risk that financial markets will eventually force the partial disintegration of the single currency remains a significant headwind.
Asia
Much to the disappointment of Japanese equity markets, the Bank of Japan once again shied away from more aggressive monetary easing, instead opting to increase its asset purchasing programme by $63bn while reducing its special lending facility by a similar amount. The move pushed yields on ten year Japanese government bonds to their lowest level since 2003 and reaffirmed their safe haven status as investors continue to seek safety from the ongoing uncertainty and volatility in Europe. With CPI inflation slowing to -0.2% year-on-year in June, even further below the country's 1% inflation target, the Bank of Japan is likely to face further political pressure to help stimulate the economy by easing policy further. Domestic demand remains weak. Retail sales growth fell to just 0.2% year-on-year even after government measures such as subsidies for eco-friendly cars. The strength of the yen is hurting exports and raising input costs.
Growth in the Chinese economy has also been slowing, with second quarter GDP coming in at just 7.6% year-on-year according to official statistics. This was the first time since mid-2009 that growth has fallen below the psychologically important 8% level. Evidence that the Government is starting to shift towards pro-growth policies, combined with the effects of last month's interest rate cut, may have a positive impact in due course. A 20.4% increase in investment in the year-to-date and a substantial rise in new bank loans in June suggests that the authorities are already reacting positively to the slowdown, but the markets will remain on the lookout for further evidence of success before counting on a stronger contribution from the Chinese economy. The price of commodities which are dependent on Chinese growth, such as platinum and copper, did show some signs of picking up in July after a poor first half.
Conclusions
Markets are likely to remain range bound in the short term as the 'risk on, risk off' environment continues. There has been little change in our investment strategy in this 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 with index-linked, conventional bonds and real assets for protection, should further evidence of global deflationary pressures materialise. While talk of a political solution in Europe has attracted attention in the last few weeks, we have yet to see actions follow words, and the continued uncertainty is clearly now affecting economic confidence in other parts of the world.
Important note: This article summarises Smith & Williamson Investment Management's current assessment of recent developments in the global economy, but our investment managers have discretion to tailor individual portfolios to the specific needs and risk profiles of clients rather than follow a specific model.
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