INVESTMENT REVIEW
More positive momentum
Fears of Federal Reserve tightening and slower economic growth receded in July after two months of nervousness, with many equity markets producing strong rallies to claw back their earlier losses, despite bond yields resetting at higher levels.
US
While speculation about the Federal Reserve's timetable for tapering its quantitative easing (QE) programme continues to provide the most important focus for investors, away from the noise US equities have resumed their rally, with the S&P 500 index breaking through to new highs in mid-July, reversing all the losses of the previous few weeks. Although the picture painted by recent macroeconomic data has been mixed, second quarter GDP came in better than expected, suggesting an economy growing at an annualised rate of 1.7%. The figure will no doubt give the Fed food for thought as it debates the timing of its next move. Chairman Ben Bernanke has reiterated the official line that there is no pre-determined course for slowing the pace of QE. It will be dependent on the economic data. Should labour market conditions improve on a consistent trajectory, we expect the Fed to begin tapering its asset purchases in the fourth quarter. Treasury yields have continued to back up by almost 30% since Mr Bernanke's speech on 22 May and now yield significantly more than either UK gilts or German bunds. If the Fed eases its foot off the pedal, Treasury yields could well drift gradually higher. Mr Bernanke has been at pains however to emphasise that scaling back QE should not be seen as a tightening of monetary policy, insisting that a rate hike is highly unlikely until at least mid 2015. With inflation remaining below the Fed's target level, and economic growth still nowhere near pre-crisis levels, monetary policy will remain accommodative.
Although some uncertainty remains, for now at least much of the dust appears to have settled and US equities have gone from strength to strength, even in the face of rising bond yields, with the S&P 500 delivering around a 20% total return year to date. The sharp sell-off in bonds in May and June has finally prompted some significant flows out of bond funds and into equities. Our view is that investors still need to focus carefully on company fundamentals in assessing the scope for further gains after such a strong first half showing. With more than half the S&P 500 companies having reported second quarter earnings, most sectors have beaten both sales and earnings estimates, although the overall year-on-year gain is only around 3.5%. Financial stocks, notably banks, have produced the biggest positive surprises, helped by higher interest rate margins and improved investment banking returns. In absolute terms, valuations of US equities are starting to look stretched, but positive momentum shows no sign of easing up for now.
UK
The second quarter GDP data confirmed that the UK economy continues to turn a corner. The 0.6% quarterly rise in economic activity, while far from astounding, was another step in the right direction and is consistent with a somewhat brighter outlook for the UK. The breakdown showed a pick up across the board in manufacturing, construction and services, pointing to a more balanced recovery. Recent employment figures continue to show a steady improvement in job market conditions. Job vacancies are now at their highest level for almost five years with the ratio of jobseekers to jobs falling to 4:1. With Mark Carney's feet now under the table at the Bank of England, the minutes from his first meeting in charge of the monetary policy committee showed a unanimous vote against any further QE. This may be an early indication of Mr Carney's powers of persuasion, or perhaps an intriguing pointer to the fact that some new policy initiative lies around the corner. A mixed strategy that employs a wider range of policy tools is a possibility going forward. Mr Carney's past experience of using forward guidance already seems to have gained him some credibility in the gilt markets, where yields, while higher than earlier in the year, remain below those of equivalent US treasuries.
With a new governor at the helm, a slowly improving economy and the door open for something beyond gilt purchases, the UK equity market is becoming more popular with international investors, comfortably outperforming the global market over the year to date. The cyclically adjusted price/earnings ratio for the market as a whole is well below its long-run average since the late 1970s. Economically sensitive sectors such as personal goods, travel, leisure and financials all have projected double-digit earnings growth for the next three years. With the eurozone apparently on the mend, the defensive qualities of the UK market may mean it underperforms in the near term. However with an economy gaining traction and monetary policy accommodating, we remain positive on the medium term outlook for UK markets.
Europe
A year on from Mario Draghi's now famous 'whatever it takes' speech, the eurozone is finally showing signs of wakening from its long recessionary nightmare. At this month's meeting of the European Central Bank's (ECB) policy committee, Mr Draghi indicated that the ECB too would be moving towards a fashionable 'forward guidance' approach, stating that interest rates in the region will remain at lower levels for an extended period of time, a statement that pleased European equity markets. A steady flow of encouraging economic data over the quarter continues to improve investor perceptions towards the region. July's Purchasing Managers Index (PMI) reading climbed into expansion territory for the first time since late 2011, suggesting that there has been a modest return to growth in the second quarter.
On the surface, political risks in the periphery also appear to have eased in the near term. The Portuguese government pledged to stick to its plans to complete a Troika-led bailout programme after narrowly avoiding the collapse of its coalition earlier in the month. Financial conditions have improved too, with the average eurozone government bond yield declining by around 200 basis points since late 2011. However the region is not out of the woods yet, as many important structural issues have yet to be addressed. Germany's reluctance to agree to a comprehensive banking union remains a contentious issue, but won't be clarified until after the upcoming Federal election on 22 September. We don't expect further flare-ups in the region before then and hope for signs of further progress towards normalisation towards the end of the year. Many of the eurozone's equity markets have rebounded since the sell-off in May and June, and continue to look good value, given the many high quality global companies based in the region. Further positive surprises in the economic data can only help to improve investor perceptions towards the region.
Asia
As expected, Prime Minister Shinzo Abe's Liberal Democratic Party swept to victory and took control of the Japanese parliament's upper house for the next three years, a relative eternity compared to the recent high turnover in Japan's political leadership. The victory reduces the political headwinds and paves the way for Japan to start implementing structural reforms, the so-called 'third arrow' of Mr Abe's radical economic plan. While this is what investors are looking for, enthusiasm for 'Abenomics' has waned a little in the last few weeks. Cooling investor sentiment is evident in both the recent performance of the equity market and the stubborn strength of the yen. Supply-side reforms are vital if Japan is to compete more effectively on the global stage and awake from economic hibernation. A key test of Mr Abe's post-election resolve will come when the Government makes its final decision on how quickly to implement a proposed rise in sales taxes. Despite the profit-taking, there are still reasons to remain upbeat on the Japanese equity market. Economic growth prospects are strong relative to its G7 peers, and the rise in consumer confidence is already translating into positive retail spending figures. Consumer price index inflation, excluding energy costs, has continued to rise and is on track to meet the Bank of Japan's 2% target within the next two years. Reflationary policies should continue to benefit the Japanese banks, which have performed strongly so far this year and remain attractively valued. As markets await more details of Mr Abe's plan of action, they are likely to remain volatile. The movements in the yen against the dollar will continue to drive the performance of equities.
Meanwhile in China, policy reform has also shifted to the forefront. The emergence of so-called 'Likonomics', named after Chinese Prime Minister Li Keqiang, has caught the eye of investors as growth concerns continue to weigh on sentiment towards the equity market. Unlike the expansionary aims of Abenomics, Likonomics includes a range of policies aimed at aiding China's shift towards a more laissez-faire economy, while reining in growth in the shadow banking system. We saw evidence of this with the recent squeeze on credit conditions in China's money markets. Mr Li has also announced a number of new economic objectives, including a floor to GDP growth, an inflation ceiling and targets for urban unemployment. While the economy remains in a gradual slowdown, policymakers in China are sending a message that they still believe they have the necessary tools to fine-tune a rebalancing of the economy. China's position as a net commodity importer makes it less vulnerable to the recent slowdown in commodity prices than many of its emerging market peers. While slowing growth in China is inevitable, the growing importance of the Chinese consumer remains a potential source of reward for overseas investors.
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