Hopes of an autumn resolution
Bond yields in Spain and Italy have fallen from the highs seen in mid-July due to speculation that the European Central Bank (ECB) is ready to step up its efforts and intervene once more in bond markets. Minutes of the recent Federal Open Market Committee (FOMC) meeting hinted at further quantitative easing (QE) in the US as the Federal Reserve keeps one eye on next year's looming 'fiscal cliff'.
As we enter an important few months that may settle the fate of the eurozone, we remain cautious in the near term, given the risk that policymakers will again fail to deliver. While many equity markets look attractively valued on a relative basis, our long-term focus remains on good quality companies with robust business models, global franchises and high and sustainable dividend yields. We are also focusing on a suitably diversified mix of index-linked, conventional and good quality investment-grade corporate bonds. Our stance is designed to combine a measure of insurance against further deflationary pressures with reasonable exposure to the assets most likely to generate sustainable positive returns in a fragile economic environment.
UK equity market surprisingly resilient
The upward revision to the second quarter GDP figure from -0.7% to -0.5% does little to change the bleak outlook for the UK economy and failed to provoke a positive reaction from financial markets. The UK economy remains a big underperformer among the major developed economies. According to the official statistics, GDP is still more than 4% below its precrisis peak, although employment has shown a surprising degree of resilience.
The Bank of England downgraded its growth forecasts from 1.3%, to closer to zero by the end of the year, with growth of around 2% expected in 2013. The Government and the Bank of England are pinning a lot of hopes on the funding for lending scheme (FLS) that was launched on 13 July, designed to stimulate more bank lending. Further QE and/ or another interest rate cut are likely to be delayed until the impact of the scheme becomes clearer. Although inflation picked up marginally in July, this looks to be the result of temporary factors. Consumer price inflation is expected to drop below the Bank of England's 2% target by the end of the year and provides further scope for a more dovish approach by the Bank's monetary policy committee.
Despite a backdrop of poor economic growth and an uncertain outlook for the eurozone, the UK equity market has remained surprisingly resilient. Seven of the ten major sectors have performed well year-to-date and the UK remains home to many good quality, nifty fifty companies with robust business models and global franchises (see the next article for more on the nifty fifty). However, given the continuing slowdown in China, the UK market's large weighting in mining companies will continue to be a drag on performance in the short term. A return to growth in many of the Far East's larger countries, should that materialise, would have a positive impact on the sector and the overall market.
US economy paints mixed picture
US equity markets hit four-year highs during August but continue to listen with anticipation to the Federal Reserve for hints that a response to the mixed economic data and potential fallout from the eurozone is just around the corner. The continuing fall in consumer price inflation to 1.4% in July remains well below the Federal Reserve's 2% target and certainly provides scope for further stimulus. However, while market expectations of further monetary stimulus are clearly high, for the Federal Reserve to act so close to the presidential elections in November would be politically contentious (see the previous article for more on the election). In addition to this, the real question remains whether the US needs further QE. There is little evidence to suggest that the previous two rounds of QE have had any lasting beneficial impact on the real economy. While equity markets have received a temporary boost, the impact has clearly been diminishing. With the S&P 500 and NASDAQ indices among the world's best performers this year, we expect the most certain ground for further monetary stimulus to come in response to a seismic shock from the eurozone, should this occur in the coming months.
Recent data releases continue to paint a mixed picture for the economy's progress. Unemployment and the housing market both now appear to have bottomed out, but look to be on different trajectories. The labour market continues to limp along with the unemployment level still a concern. This reflects a lack of confidence in the corporate sector, with companies unwilling to commit to large, labourintensive investment projects given the prevailing uncertainty. The outlook for the housing market, however, remains brighter and looks to be gaining significant traction. New home sales have increased around 36% since the trough in February 2011. With mortgage rates likely to remain low for the foreseeable future and a shrinking supply of housing, this could provide a genuine boost to the US economy.
Europe enters crucial period
Despite a continued equity market rally and optimism among investors that the ECB stands ready to react, second quarter GDP figures continue to show a deteriorating economic environment. Spanish and Italian equity markets have both rallied on the back of ECB president Mario Draghi's comments that the central bank will do "whatever it takes" to save the single currency. The future path of European equities remains closely linked to future decisions by the ECB and Europe's political leaders. A backdrop of deepening recession, rising unemployment and a lack of competitiveness across southern Europe is making it harder for policymakers to put together a credible plan for resolving the ongoing eurozone crisis. The divergence in performance between the troubled peripheral nations and stronger countries in the north, which is at the root of the eurozone's problems, continues to widen. The eurozone as a whole looks set to fall further into recession by the end of the year.
Some of this deteriorating outlook appears to have been priced into markets already. We are entering a potentially crucial period for the region with a Greek exit back on the agenda if an agreement to revise the terms of its bailout package cannot be reached at the next planned summit in October.
The German Constitutional Court dismissed complaints against the ratification of the European stability mechanism. It did, however, impose an EU190bn cap on Germany's liability, which cannot be increased without further legislative approval.
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