UK: Outlook - February 2011

Last Updated: 7 February 2011
Article by Smith & Williamson


Focus of concern shifting from Europe to Emerging markets

Markets are juggling with a series of separate issues. In the UK the Monetary Policy Committee (MPC) has been under intense pressure to begin raising interest rates in order to restore their tarnished inflation fighting credentials. Although the futures market has discounted a reversalin monetary policy by this summer, the weak 2010 Q4 GDP report vindicates the view held by Mervyn King, that the UK economy is currently too fragile to absorb higher rates. Consequently, we expect UK interest rates to remain unchanged for the foreseeable future. Sterling initially rallied in response to the shift in interest rate expectations but could now be vulnerable to a move back to the 2010 year end level as the timing of rate hikes gets extended.

The surge in peripheral European bond yields in early January galvanized EU finance ministers into consideration of a plausible crisis management mechanism. The focus has centred on expanding the capability of the European Financial Stability Facility (EFSF). Indications that Germany will be willing to extend extra guarantees to the fund have seen the euro rally and bond spreads decline. While eurozone related risk has temporarily dissipated, the persistence of debt deflation in non core Europe is likely to maintain pressure on the eurozone over the coming months.

Surging food price inflation is exacting its toll on emerging economies. In response to rising inflation, regional interest rates have been ratcheting higher, most notably in, Brazil, India and China. Concern that growth might be hampered by rising rates has seen emerging equity markets under perform developed markets since November 2010. This is a correction from an overbought position and could persist until the interest rate cycle nears its end. At that juncture emerging markets could well provide an interesting opportunity.

After experiencing a sustained rally which had produced high levels of investor optimism we have decided to trim our equity exposure and raise a bit of cash. Were main constructive on markets longer term but want the ammunition to take advantage of any pull back. As in 2010 market returns are likely to remain volatile.


Bernanke has engineered a strong rally in the equity market

At his Jackson Hole speech at the end of August 2010 Federal Reserve Chairman Ben Bernanke identified the need to generate wealth effects via arising equity market as a counter to the drag on the economy from weak labour and housing markets. The US equity market has subsequently delivered a 23%return. Indeed, the US has been the best performing regional market since then. While liquidity (including corporate M&A) has been the primary driver behind the rally, earnings revisions have also been supportive. The quantum of the rally has however pushed the market into overbought territory and investor confidence has become elevated which is normally a good contrarian indicator. Consequently, we think the market is due a period of consolidation.

The combination of the rally in equities, are bound in confidence and the impact from fiscal stimulus has seen leading economic indicators such as the ISM rebound to levels consistent with 3% GDP growth for 2011.

Over the coming months markets are likely to focus on negotiations over the extension of the Federal debt ceiling and consideration of what will happen afterQE2 lapses in June if US unemployment remains above 9%.


UK monetary policy is 'not for turning'

UK inflation data continues to be problematic for the MPC. With a December headline CPI of 3.7% well above both market expectations and the peak projected by the MPC in its November inflation report the markets have lost patience and begun to factor in interest rate rises commencing as early as the summer.

Protestations from the MPC that the reason for the spike in CPI are due to transitory factors such as VAT hikes(CPI ex indirect taxes is a benign 1.9%), and the delayed impact of the 25% decline in sterling in2008 are falling on deaf ears.

The markets are likely to be wrong in their estimation of the timing of rate hikes. The key question is not what rate of interest is required to restore credibility (the market fixation) but what rate of interest the UK economy can absorb? The only way to counter current inflationary pressures and restore credibility would be to let sterling appreciate sharply. This would kill off then ascent recovery in the manufacturing sector. In terms of the broader economy the combination of negative M4 money supply growth, negative real average earnings, a fragile labour market unlikely to produce wage push inflation and a housing market extremely vulnerable to higher mortgage rates are all ultimately disinflationary forces. The recent - 0.5% Q4GDP estimate vindicates Mervyn King's(the bank governor) view that UK rates must remain low for longer.

After a strong rally the UK equity market has started to retrench from over bought levels. Concern that China will have to continue raising interest rates to counter inflationary pressures has seen profit taking in mining stocks. While earnings revisions have been positive there is growing concern that corporate profit margins are vulnerable to rising input costs. We would wait for oversold signals before considering topping up positions.


Eurozone – more muddle through than melt down

It didn't take long for the markets to renew the pressure on peripheral European bond markets. With the yields on Portuguese and Spanish bonds establishing new highs in the second week of January, EU finance ministers were forced to respond. They appear to have identified a change in the remit of the European Financial Stability Facility (EFSF) as the principal mechanism to deliver a solution to the crisis. In order for this to work the EFSF has to be able to lend more of its allocated funds. To maintain its 'triple A' rating the EFSF will therefore require increased guarantees from Germany. The German shave been extremely reluctant to accept greater involvement, but it appears they will eventually acquiesce. The EFSF would then be permitted to purchase government bonds providing a counterweight to the markets. In response to signs of greater urgency and coordinated action peripheral market CDS and bond yield spreads have started to decline. The euro has also appreciated against the dollar. It increasingly looks as though the eurozone is edging towards a muddle through rather than a chaotic melt down scenario (a rapid disintegration of the euro).This would afford more time for the consideration of'Plan B's' as debt deflation exerts pressure on the peripheral economies.



China continues to confront rising inflation by pushing up reserve ratios, increasing lending rates and imposing property –purchase limitations. While most of the rise in inflation is due to surging food prices, the authorities are anxious to rein in loan growth in order to curb speculative property building. Although M2 growth has bounced from 17.5% to 19.7% it is well below the 30% growth rate seen in2009. Consequently, it would appear that the authorities only need to tap rather than slam on the monetary brakes to achieve their target loan growth of 15-16%. The risk of an overshoot that ends up pushing GDP growth projections below the key8% level looks remote. The equity market is unlikely to outperform until it starts to think the tightening is almost over, this turning point is a little way away.


The prospect of tighter fiscal and monetary policies in the rest of Asia has sparked foreign investor interest in Japan (where monetary policy remains unchanged).It is a market in which regional managers have had structural underweight positions. At a macro level Japan still confronts deflation and low nominal GDP growth. However, export volumes have so far not been negatively impacted by the strongyen. The catalyst for a period of sustained out performance from Japan resides with conviction that corporate Japan could narrow the differential in ROE with the rest of the world (Japan ROE of 8.7%compares with world ROE of 12%) and whether the yen will weaken substantially which boosts export earnings. Neither of these looks imminent.

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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