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.

To print this article, all you need is to be registered on

Click to Login as an existing user or Register so you can print this article.

In association with
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.


Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.


Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.


A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.


This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.


If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.


This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at and we will use commercially reasonable efforts to determine and correct the problem promptly.