UK: Outlook – Smith & Williamson Investment Management - August 2010

Last Updated: 2 August 2010
Article by Smith & Williamson


Europe's window of opportunity

Markets have witnessed a significant rotation in expectations over the last few weeks. While the US has posted a sequence of weak industrial and consumer surveys raising concerns of a potential double-dip recession, the euro-zone (led by Germany) has produced a series of robust data. The admission from the Federal Reserve Chairman Ben Bernanke that the US is facing a period of 'unusual uncertainty' and that the Fed had considered the reintroduction of Quantitative Easing has compounded the view that the US has been losing momentum relative to Europe.

The euro has been a big beneficiary of this reversal in sentiment rising by almost 9% against the dollar from the lows of early June. The euro has also benefited from a decline in risk aversion as fears over a systemic seizure of the banking system dissipated. The announcement to undertake bank stress tests (even though the test requirements were not particularly rigorous) were psychologically important and produced the desired result of reducing peripheral market bond yield spreads relative to German bunds and getting the interbank market functioning again.

While the US economy is hitting a weak patch the risk of a double-dip recession look overstated. Instead the US is adjusting to a lower trend growth trajectory. Europe is undoubtedly enjoying a window of opportunity provided by the decline in the euro earlier in the year and strong export driven growth. The clear risk is that export markets start to weaken and the austerity measures sap domestic demand in peripheral Europe. In 2011/12 the US should have superior growth differentials to Europe which suggests the rally in the euro will not be sustainable.

Recent Q2 corporate earnings announcements have on balance been better than expected. This reflects continued margin expansion (cost containment) rather than improvements in revenue growth. Corporate balance sheets and free cash flow remain strong, providing scope for an acceleration in merger and acquisition activity. While equity markets have rallied in response to the recent earnings announcements it is important from a valuation perspective that analysts start to upgrade their 2011 earnings in order to allay fears that earnings have peaked this cycle.


'Unusual Uncertainty'

July saw the US 10 and 30 year bond yields break below the significant 3% and 4% levels respectively. This was a function of simultaneous declines in breakeven inflation rates and real yields signifying a contraction in both growth and inflation expectations. Recent economic data releases such as purchasing manager indices and consumer confidence reports have on balance been weaker than expected triggering concerns that the US was about to experience a double-dip in growth.

While the economy has undoubtedly been losing momentum and confronts a combination of high unemployment, a fragile housing market, fiscal contraction at the state level and uncertainty over the impact of potential tax hikes at the end of the year, fears of a double-dip look overdone.

The economy remains underpinned by strong corporate cash flow. This has been driving business investment growth and provides scope for a pick up in private sector job creation. Recent Q2 earnings releases so far have been significantly stronger than expected. Consumption growth which constitutes almost two-thirds of the economy looks set to deliver around 2-2.5% growth over the coming quarters.

While the Federal Reserve Chairman Ben Bernanke has acknowledged that the economic outlook is clouded by 'unusual uncertainty' and is set for several years of modest growth he remains of the view that the US is not weakening sufficiently to warrant additional monetary stimulus (another tranche of quantitative easing). He has however intimated that the Fed are ready to act if the economy does not improve and financial conditions deteriorate further.


Beginner's luck – stronger than expected growth

What a difference a quarter makes! The first GDP report released under the tenure of the new administration was much stronger than expected registering 1.1% QoQ growth for Q2 compared with market expectations of 0.6% and Q1 growth of 0.3%. While the surprisingly strong growth was distorted by a suspiciously strong surge in construction spending and will probably be subsequently revised lower, the UK economy appears to be in a stronger position to absorb the impact of the forthcoming fiscal contraction.

Another consequence of the GDP growth report could be the attachment of greater credence to the view of Andrew Sentence (an MPC member) that interest rates need to rise because the UK is running a much lower than assumed output gap. However, the rest of the MPC maintain the view that inflationary expectations will subside as fiscal consolidation starts to kick in and have even considered the prospect of restarting a Quantitative Easing programme the quantum of the Q2 GDP recovery will test their resolve. The key to the determination of monetary policy will ultimately rest on whether this is seen as a one off blip in growth or the beginning of a sequential shift in the growth trajectory. The MPC will need to see confirmation of at least another strong quarter before they reverse monetary policy.

The equity market has rallied from the lows established in early July. An important contributor to this move has been the rebound in the BP share price as confidence grows that the gulf oil spillage has been staunched and that they will make sufficient asset sales to fund the clear up and compensation costs. Aggregated corporate earnings per share have plateaued over the last few weeks and need to inflect upwards to lend support to a market that has seen its 12 month forward PE fall to10x having been at 12.3x at the start of the year.


German manufacturing is powering ahead

Europe has benefitted from two primary influences over the last few weeks. The first is that the economic powerhouse of Europe, Germany, is experiencing a dramatic surge in industrial production. Export orders have surged as demand from China and the US responded to the decline in the euro. While there has been a trickle down effect from the recovery in Germany to the rest of Europe the impact will be diluted because German consumption expenditure remains weak. The bifurcation in industrial performance between Germany and the rest of Europe is reflected in recent purchasing manager's surveys. Nevertheless, expectations for European economic growth and corporate earnings over the next couple of quarters have ratcheted upwards.

The second reason for the improved outlook has been the reduction in concern over the status of the European banking system. A few weeks ago the interbank market was showing signs of seizing up. The recently published European bank stress tests whilst not particularly robust, have on balance improved transparency and confidence in the banking system. As a consequence peripheral market bond yield spreads over the German Bunds have declined.

The reduction in risk aversion has seen the euro rally strongly against the US dollar and rise about 3% on a trade weighted basis. On a Purchasing Power Parity basis the euro currently is about 13% overvalued relative to the dollar.

Looking further out the principal risk is that fiscal austerity measures in peripheral Europe will create potential debt deflation resurrecting concerns over 'solvency' and the structure of the euro-zone.



The authorities in China have been striving to slow the economy to a more sustainable growth rate by tightening lending standards and restricting the growth in credit creation. The Q2 GDP release showed growth declining from 11.9% to 10.3% and inflation falling from 3.3% to 2.9%.This was the first tangible evidence that these policies could be achieving their objective. Having declined by around 27% between January and early July 2010 the Shanghai Composite equity market has started to rally in anticipation that the tightening phase is largely completed. The Chinese authorities are also aware that if the US economy is losing momentum they need to deliver rising consumption demand to act as a spur to global growth.


The Japanese economy is on track to deliver modest growth driven primarily by industrial production and exports. The latest quarterly Tankan survey reported an improvement in business conditions and confidence measures. However, anaemic household expenditure remains the core problem. Indeed there is a risk that once the temporary effect of stimulus fades consumer spending will decline. Excess spare capacity is still delivering persistent deflationary headwinds.

On the fiscal side the prospect of consolidation has been delayed by the failure of the DPJ led coalition to garner a majority in the recent Upper House election.

The volatility of global equity markets has seen the yen maintain its safe haven status. The trade weighted yen has risen by 11% so far in 2010.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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