Investment review
Signs of faltering momentum
For each of the last three years both the global economy and equity markets have moved through short seasonal cycles, with a dip in economic data and market performance in the second quarter, followed by an upturn midway through the summer months. These cycles have tended to be triggered by specific global events – in 2010 by the first Greek crisis, in 2011 by the tsunami in Japan and last year by renewed fears about the future of the eurozone. Could suggestions that the Federal Reserve may begin to taper down its asset purchase programme 'within a matter of months' produce the same result in 2013? It looks possible after stock markets faltered and bond yields rose in many developed markets at the end of May.
UK
The Bank of England's latest 'Inflation Report', released in May, painted a slightly more optimistic outlook for the UK economy. The Monetary Policy Committee raised its growth outlook for this year to 1.1%, with a further modest rise expected in 2014. Recent economic data has looked encouraging. The manufacturing Purchasing Managers' Index (PMI) rose for the third successive month and services output continues to expand. While inflation fell back in April, it is expected to peak in the third quarter. The main issue for policymakers is whether economic data is still sufficiently weak to justify further stimulus while inflation remains stubbornly above the 2% target. Although the new Governor starts work in July, we don't expect any radical change in policy until at least the release of August's 'Inflation Report'. Against a backdrop of global currency debasement, anchoring sterling will be key to the UK's competitiveness on the world stage. However declining real wage growth will continue to act as a drag on demand.
Despite the sluggish economy, UK equity markets remain resilient. Excluding the financial sector, the wider FTSE All Share index has broken through previous highs and valuations do not look stretched by historic standards. The more defensive sectors of the market, mainly telecoms and utilities, remain the best performers' year to date, although investors are paying a notable premium to the rest of the market. Demand for good quality corporate debt remains high. While offering little in the way of capital growth, investment grade corporate bonds still offer an attractive yield spread over gilts. The UK market's wealth of international companies with high exposure to areas outside the eurozone will continue to be its trump card. However signs that the domestic economic picture may begin to be turning a corner could favour the more cyclical sectors as we enter the summer months.
US
The hints from the Federal Reserve that it may begin to taper down its asset purchase programme as early as the second half of this year jolted some of the complacency in global financial markets about the durability of its monetary stimulus. Minutes from the most recent Federal Open Market Committee (FOMC) meeting suggested a number of committee members favour moving sooner rather than later to reduce the size and pace of the Fed's $85bn a month liquidity injection. As liquidity has been the main driving factor driving risk assets higher in recent months, investors have begun to focus on the implications of a change in Fed policy, should it materialise. With equity markets in the US having reached new all-time highs, margin debt at record levels and sentiment indicators looking stretched, it would be no surprise to see a cooling off period in the markets. The Fed has committed itself to remain accommodative until unemployment falls below 6.5%. It is worth bearing in mind however that if the unemployment data is adjusted for the fall in labour market participation since 2008, the unemployment rate today would still be 11.5%. With this in mind, we think any significant change in the scale of asset purchases is unlikely before next year, though the markets may seek to anticipate such a change. The positive signs of recovery in the US economy are encouraging. The housing market continues to strengthen, consumer confidence is back to pre recession levels and optimism amongst small and medium size firms, the engine of the US economy, has started to rise. From an investment standpoint, this may encourage a switch in market leadership towards growth sectors. We are already seeing some signs of a rotation, with telecoms and utilities falling over the past month, and technology, industrials and materials gathering momentum.
Europe
Continued concern over the lack of economic growth in the eurozone prompted the European Central Bank (ECB) to take action in May by cutting interest rates to a record low of 0.5%. The region has fallen further into recession, with first quarter GDP contracting by 0.2%, the sixth successive quarter of economic decline. Growth in Germany, the eurozone's flagship economy, came in below expectations. With the yen continuing to decline against all major currencies, there is a risk that German exporters will be among the biggest losers from the Bank of Japan's aggressive monetary easing. While leading indicators appear to have stabilised, the region's growth prospects look poor. Any further deterioration will increase pressure on the central bank to take further action. Unlike the central banks in Japan, the US and UK, the ECB has seen its balance sheet shrink as many of the banks who took advantage of the ECB's LTRO funding support start to repay loans. European companies obtain around 75% of their funding from banks, so a healthier banking system would help to kick start the flow of credit through the region. The ECB's Outright Markets Transactions programme is proving successful in easing concerns over the fragility of the sovereign debt markets in the region's peripheral nations. Yields in Italy, despite several months of political uncertainty, have fallen to sustainable levels once again. Some European equity markets have also improved, with the Dax and France's main index, the CAC 40, among the best performers. In its search for new measures to stimulate growth, the European Union has given a number of countries more time to meet fiscal deficit targets, with many having fallen short of their original targets. The lack of growth in Europe remains the biggest threat to global economic recovery, but given the political sensitivity of cross-border transfer payments, no lasting changes in eurozone policy are likely until after the German Federal elections in September.
Asia
After six months of spectacular gains, Japanese equity markets finally felt the force of gravity during the month with the Nikkei experiencing its biggest single one-day loss for over two years. Suggestions from the Federal Reserve that it may taper down its asset purchase programme was followed by a brief but sharp market pull back. The Bank of Japan's ambitious plans to use monetary stimulus to help pull the country out of deflation meanwhile ran into its first major challenge as long run government bond yields rose towards 1%. The scale and speed of the turnround in Japan's financial markets since the change in Government means that a reaction was inevitable at some stage. Domestically it is a case of 'so far, so good' for Prime Minister Shinzo Abe's new regime. First quarter GDP rose at an annualised rate of 3.5%, with an encouraging jump in consumption, which contributed over 65% of the headline figure, no doubt aided by the 65% rise in the equity market over the last year. Mr Abe's next political hurdle comes on 21 July as Japanese voters go to the polls to elect the Upper House. Success there would open the way for the government to tackle the "third arrow" of Abe's radical plans, the implementation of much-needed structural reform. For now at least, unless the yen reverses course, the momentum behind the recovery in the Japanese stock market may soon resume, albeit at the cost of continuing volatility of the kind we have seen in the last month.
The latest data coming out of China suggest that the economy remains in a difficult position. The most recent PMI showed manufacturing output contracting for the first time since October 2012 and points to a further slowdown in growth in the second quarter. Despite the high expectations which followed the change of leadership last year, the evidence points to the Chinese economy losing steam. The rapid growth in the shadow banking sector has reinforced concerns that China's financial system may be hiding some unpleasant surprises. The planned shift to a more balanced economy remains the primary objective of the new leadership and will inevitably be a gradual process. Investors expecting a more rapid transition may be disappointed, but the fact that consumption contributed more than 55% of economic growth in the first quarter is an encouraging sign. Higher consumer spending will continue to benefit western companies with exposure to the Chinese consumer market. With inflation running below the government's target level, policymakers have monetary and fiscal tools at their disposal to stimulate domestic demand further.
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