UK: Investment Outlook - October 2012

Last Updated: 15 October 2012
Article by Jonathan Davis, Michael Quach and Christopher Bates

A monthly round-up of global and local market trends

Investment review

Central banks take the strain

Global equity markets have enjoyed a solid run through the summer as central banks around the world have stepped up their efforts against the global headwinds of sluggish growth, low confidence and the continued uncertainty over the outlook for the eurozone.

World

The Federal Reserve exceeded market expectations by announcing its plans for a third round of quantitative easing (QE) and reaffirmed that it would continue its ultra loose monetary policy until mid-2015. In Europe, the European Central Bank (ECB) helped lower bond yields in Italy and Spain as President Mario Draghi stated the bank would purchase bonds of peripheral nations on a large scale, subject to governments agreeing to economic reforms and strict conditions. The potential stimulus has succeeded in improving investor sentiment and restored some confidence in the financial markets. Japan also announced new monetary stimulus measures.

While these developments appear to have reduced the risk of an immediate eurozone break up, a large number of issues still need to be resolved ahead of the next planned summit of European leaders on 18-19 October. Anger about the ongoing austerity in Europe has spilled into the streets of Madrid and Athens with rioting and social unrest dominating the headlines. Deteriorating economic data continues to highlight the severity of the crisis facing the region and the core, underlying issues that remain unaddressed.

As we enter the final quarter of 2012, the focus in the US will be on the build up to November's presidential elections and the impact of the Federal Reserve's latest round of stimulus on the economy. Markets will be looking for further commitments by policymakers to follow through on their past pledges of action.

UK

With the prospect of central bank action in the US and Europe providing a boost to investor sentiment in the last few months, domestically the focus may now shift to what the Bank of England and the Coalition Government can do to help stimulate a still sluggish UK economy. Inflation, which fell again in August to 2.5%, has continued its gradual downward trend and looks set to fall back down towards the Monetary Policy Committee's 2% target by the end of the year, providing oil prices don't rise any further. The fall in consumer prices index inflation will certainly give policymakers at the Bank of England scope to provide the economy with further stimulus.

While QE and the funding for lending scheme launched in June should provide the UK's banks with funds to lend to the wider economy, the question remains whether, with consumer and business confidence at low levels, there is the demand for borrowing while uncertainty surrounding the outlook for the economy remains so high. A revival of 'animal spirits' still looks distant for the UK consumer and many small businesses. The latest public sector borrowing figures show that the budget deficit year to date is well ahead of official projections, putting more pressure on the Chancellor to modify his fiscal plans.

There are however some positives to consider. The UK labour market remains resilient and employment has continued to grow, rising by 236,000 in the three months to July. With inflation continuing to fall, we expect real wage growth to move back into positive territory by the end of the year. Industrial production rebounded 2.9% in July, more than enough to recover from heavy falls in April and June. Unfortunately, the UK equity market, despite its resilience, remains highly skewed towards the mining sector which is vulnerable to the continued slowdown in the global economy. This is likely to remain a drag on performance in the current economic environment.

US

After several weeks of speculation the Federal Reserve did not disappoint the market with its announcement of an open-ended programme of money printing (QE3). The immediate reaction was a lift to the price of risk assets and investor sentiment in the US. The Federal Reserve's third round of QE will centre on the purchase of $40bn worth of mortgage-backed securities (MBS) each month, a change from previous QE measures, which have aimed to bring down bond yields through purchases of US government bonds. The central bank also said it would extend its commitment to keeping near-zero interest rates until at least the middle of 2015. While house prices recorded their sixth straight month of increase, the Federal Reserve made clear that its primary concern from now on will be to improve the struggling labour market, with unemployment still uncomfortably high at 8.1%. While down from the 9.1% level of a year ago, non-farm payroll figures have continued to disappoint. The labour market will remain a key topic for debate for Barack Obama and Mitt Romney as we approach November's presidential election. Whether QE is anything but a short-term palliative remains a matter of lively dispute in the economics profession.

One encouraging sign is that there appears to be hints of confidence returning to the corporate sector. The most recent flow of funds accounts show that non-financial companies are no longer building up cash reserves, a theme that has reflected corporate uncertainty for the past three years. The US needs to see firms starting to make positive commitments to large investment projects, capital spending and recruitment drives if corporate America is to make a bigger contribution to the economic recovery. The looming 'fiscal cliff ' and upcoming elections are likely to move further into the spotlight as we enter the final quarter of the year.

Europe

European equity markets have been buoyed by the ECB's plans to cap bond yields for troubled countries in the eurozone. ECB president, Mario Draghi, announced that the central bank was ready to make potentially unlimited purchases of short-term bonds in an attempt to bring down borrowing costs in peripheral countries, principally Spain and Italy. The ECB plan will effectively bypass opposition in Germany to granting a banking licence to the eurozone's new bailout vehicle, the European Stability Mechanism (ESM). The banking licence option has now been ruled out, although other ways to increase the ESM's potential firepower are still on the table. While Mr Draghi's announcement brought an immediate reduction in Spanish and Italian bond yields, as with previous eurozone plans the devil remains in the detail. Before bond purchases can commence, countries will have to apply to the ESM and agree to a strict set of conditions and economic reforms, making further austerity measures likely. This will be a contentious issue for countries such as Spain, where further austerity would prove highly dangerous politically for Prime Minister Mariano Rajoy and could lead to further social unrest. Nevertheless, this is a step in the right direction for the eurozone and the plan may also lower bond yields in other affected countries, including Portugal and Ireland.

While recent announcements have helped stem the fear of an immediate eurozone break up, the core structural and competitiveness issues remain unaddressed. Growth in the region remains non-existent and third-quarter GDP figures are more than likely to show the region is moving into a technical recession.

The growing divergence between Germany, where growth also remains sluggish, and the troubled peripheral nations is likely to continue. Although European equity markets remain attractively valued on an historical basis, many companies will continue to find it difficult to thrive in the low growth environment. The ECB has provided a summer boost to risk assets and helped improve investor sentiment, but fears over the outlook for growth and the inability of governments to carry public opinion with them as they unveil yet more austerity measures will continue to hang ominously over the region. Both the Spanish and French Governments unveiled a new round of budget cuts and tax rises as the month ended.

Asia

August's trade and industrial production figures continue to point to a slowdown in China and increased market expectation that policymakers in the world's second largest economy will introduce further stimulus. China's official manufacturing PMI slipped below the 50 expansion/contraction level for the first time since November last year and signals a further decline in GDP growth in the third quarter. China's exports continue to be a victim of the low demand in the eurozone. More worrying still is the rapidly declining trade with Japan, China's main trading partner. Recent data shows Japan's exports to China fell 9.9% in August. Tensions between the two nations are threatening the trade relationship further after Japan announced it planned to buy the disputed, potentially oil-rich islands in the East and South China Seas. With output falling and inflation now looking under control, further monetary easing and stimulus in the coming months is likely. However, investors and the rest of the global economy may have to begin adjusting expectations of China, as growth of 6-7% in the region may now be the new normal.

The Bank of Japan joined the global central bank action by expanding its asset purchase programme by Ą10tn ($126bn) as Japan faces slowing export growth and weak domestic demand. Given the continued slowdown in Europe, exports are likely to decline further while confidence remains at low levels. As a result we could see further stimulus from the Bank of Japan before the end of the year. Appetite for Japanese equities remains low, mainly due to the unrelinquishing strength of the yen against most major currencies, a theme that is likely to hold Japanese growth back this year, forecast to come in at around 2.3% but still well above most developed countries. However, we are unlikely to see investors rush into Japanese equities until we see a notable depreciation in the currency.

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