UK: Outlook – May 2011

Last Updated: 26 April 2011
Article by Smith & Williamson


Markets and uncertainty are uneasy companions

While global equities have exhibited admirable resilience – rebounding from the Japanese earthquake/tsunami induced sell off in mid March – they are struggling to find direction and remain below the recent high established in February.

The principal driver behind this resilience has been liquidity. At a corporate level, strong balance sheets and free cash flow generation have delivered a pick up in dividend payouts, stock buy backs and merger and acquisition activity. While these drivers should remain in place the markets are facing several headwinds over the summer months.

The first concerns the ending of QE2 in June. The expansion of the Fed's balance sheet has been highly correlated with equity market performance and also appears to have had strong connectivity to the recent rise in commodities. This obviously creates uncertainty over what will happen once the liquidity injections cease.

Another concern is that with US and UK earnings back to prior peak levels consensus forecasts will start to inflect lower as rising input costs impact margins. We are mindful that at this stage of the cycle value traps emerge.

The US bond market is starting to fret about the status and scale of the US federal deficit and the lack of a credible long term austerity programme. The potential for horse trading over the forthcoming debt ceiling and long term deficit reduction negotiations, adds to the political risk premium over the summer.

Lastly, the tightening financial conditions and potential debt rescheduling in the periphery create uncertainty over the health of the capital base of the European banking system.

In the face of these mounting uncertainties volatility could well start to rise with more downside than upside risk. We advocate holding enough cash to take advantage of any down drafts that might arise.


Pressure building on politicians

There is a good chance that politics dominates the headlines over the next few weeks. The last minute settlement between the administration and the Republicans on the federal budget for the next two years has focused attention on the outlook for longer term deficit reduction. With the debt ceiling rapidly approaching, yet more brinkmanship, and commensurate fears of a government shutdown, can not be ruled out. The backdrop to all of this is that the US has been the one significant economy that has not so far instigated any form of fiscal austerity. Now that the economy is showing signs of traction the bond market vigilantes have started to voice concerns that a plausible austerity package is now required. Failure to do so runs the risk of a considerable risk premium being factored into bond yields. The politicians appear to have got the message, with President Obama proposing $4tn worth of budget cuts over the next 12 years. At the moment the markets are giving the politicians the benefit of the doubt but any sense of slippage will see the vigilantes and credit ratings agencies turning the screw (S&P have already put the US on a negative outlook).

Market attention is focused on two things. The first is whether the forthcoming Q1 earnings releases provide any clarity over the outlook for peak margins. There is mounting concern that rising input costs cannot be passed through indefinitely and that analyst forecasts are not yet factoring in sufficient margin compression. The second focus concerns the ending of QE2 in June and what consequences this will have. All of this suggests the markets face a period of uncertainty and increased volatility over the next few weeks.


Is demand shortfall to replace inflation as the key concern?

The decline in March CPI from 4.4% to 4% was the first positive news for the doves on the MPC for many months – markets have become conditioned to inflation data continually exceeding forecasts. Whether or not this is the start of a trend is debatable but it has alleviated pressure on the MPC to raise rates. The forthcoming Bank of England May Inflation Report was perceived as the occasion at which the MPC would provide clarity on rate hikes. Instead we are back to a wait and see mode.

Interest rate futures have pushed the timing of the rate hikes out from this summer to the final quarter of the year.

The CPI decline was attributable to aggressive discounting by the food retailers in response to mounting consumer price sensitivity. This lends support to the view that consumption expenditure which is 2/3rds of the economy is finally being impacted by the negative real disposable income growth. This heightens the focus on the initial Q1 GDP growth estimate which will be released towards the end of April. While it is expected to post a rebound from the weather impacted Q4 -0.5% level, consensus forecasts have been nudging lower over the last few weeks. A higher than consensus number would confirm inflation fears and resurrect tightening concerns – essentially a move back to where we were a month ago. However, we think far too small a probability is being attached to consideration of what will happen if Q1 GDP is lower than expected. There is a real chance that a sub 0.3% reading would see demand shortfall replace inflation as the principal market focus. If this were to occur it implies a preference for defensive over cyclical sectors and bonds.


The second act of the Greek tragedy

As expected the ECB increased interest rates by 25 basis points in April. They justified the need to tighten by referring to their narrow inflation targeting remit, pointing out that EU headline inflation at 2.7% is well above their 2% target and that the German economy is operating with a positive output gap. The markets expect The ECB to raise rates again this summer. The interest rate differential with the US has continued to drive the euro higher, leaving it about 22% overvalued on a Purchasing Power Parity basis.

Unfortunately, while the ECB can justify the rate hike from a pan European perspective, the combination of an appreciating currency, rising interest rates and rising bond yields is creating even more headwinds for the peripheral economies. The effective tightening of overall financial conditions is occurring precisely at a time when Portugal is seeking an IMF/ EU bailout and concerns about sovereign debt restructuring are reappearing. Indeed, Standard & Poor's has recently warned that investors might suffer haircuts of between 50-70% on their holdings of Greek debt. With Greek 2 year bond yields at 18.4% the market appears to be taking the view that the restructuring could well occur before the introduction of the European Support Mechanism in 2013.

Over the coming months the markets will have to balance the positives of rising bank margins (Sweden has shown how higher interest rates actually boost margins) against macro concerns over the potential damage to tier one capital from a debt restructuring.



China continues to confront rising inflation and property prices by raising reserve ratios, increasing lending rates. 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. While M2 money supply growth at 16.6% is above the 15% target level it has fallen from the 19.7% rate seen last December. The rebound in the Shanghai composite index in Q1 could be a tentative signal that local investors think the end of tightening cycle in China is closer than we think.


The triple whammy of an earthquake, tsunami and nuclear reactor melt down came as a heavy blow for an economy that was showing tentative signs of recovery. It now looks as though GDP will contract 1-3% in 2011. For 2012 the rebuilding stimulus should then produce between 2-3% growth. Initial concerns that supplychain disruption would be significant now look overdone. After the G7 initiated a concerted intervention the yen weakened by 8%.However it has subsequently started to rally – possibly reflecting a repatriation of capital.

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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