UK: Investment Outlook - April 2013

Last Updated: 16 April 2013
Article by Jonathan Davis, Michael Quach and Christopher Bates

Investment review

Completing a strong first quarter

Equity markets continued to power ahead in March, shrugging off the latest eurozone bailout crisis (in Cyprus) and completing a strong first quarter for returns.

UK

The Chancellor, George Osborne, released the details of the eagerly anticipated budget in March with many wondering if last month’s UK debt downgrade would be the catalyst for a new pro-growth agenda under the coalition government. It appears not. Given the debt constraints, the government has little room for manoeuvre, with the key takeaway being that Mr Osborne is broadly sticking to his austerity plans, though public sector borrowing is not now expected to fall until after the next election. The most striking statistic was the Office for Budget Responsibility’s growth forecast for 2013, which has fallen to 0.6%, half what was forecast as recently as December. There is a £3bn per annum increase in capital expenditure projects from 2015; these will largely be financed through departmental spending cuts over the next two years. This could be positive for growth prospects in the medium term, but does little to alter the poor outlook for this year.

The other striking feature of the Budget was Mr Osborne’s announcement of a new mortgage guarantee scheme to help homebuyers purchase cheaper properties, scheduled to take effect from next year. With the new Governor, Mark Carney, scheduled to start work in the summer, the Chancellor is likely to rely on the Bank of England to boost the economy. Mr Osborne announced a more flexible approach to monetary policy with the Bank, while keeping its broad 2% inflation target, having more leeway to miss that target in the interests of the wider economy.

Despite the economic backdrop, the UK equity market has remained remarkably resilient while bond yields have fallen, in part as the beneficiary of safe haven capital flows following renewed turbulence in the eurozone. Historically the UK stock market has been negatively correlated with sterling; shares do better when sterling weakens. With around 60% of revenues coming from outside Europe, the weaker pound should have a positive impact on first quarter earnings. Although it has lagged behind other markets over the past six months, the breadth and depth of the corporate sector within the UK, combined with favourable valuations and solid dividend yields, have started to make the market appear more attractive when compared to other developed countries. However lower bond yields are still signalling the need for caution.

US

US markets have largely shrugged off initial concerns over sequester spending cuts and continue to focus on the many positives coming out of the economy. Major US indices have broken through their all-time highs. The housing market continues to gain traction; new home sales are up 50% from the trough in 2011, while house prices rose 10% in 2012 and should continue on a similar path this year. The Federal Reserve, who has set its sights on an unemployment rate below 6.5%, will be encouraged with the progress made so far. The latest non-farm payroll figures expanded by 236,000 beating expectations, with the unemployment rate falling to a four-year low of 7.7%. Wage growth, which has been in decline for the past five years, looks to have turned a corner and has been expanding since late last year. Despite a backdrop of tax hikes agreed earlier in the year, retail sales figures have remained robust while homeowners have benefited from refinancing their mortgages.

Against a backdrop of currency debasement elsewhere in the developed world, the relatively upbeat outlook for the US, combined with its safe haven status, means that the dollar is likely to remain strong. The resulting impact on imported input costs, combined with rising wages, have begun to fuel concerns about a squeeze on corporate profit margins, which remain at historically high levels. Earnings growth estimates have been lowered since the last quarter to around 7.5%. However a pick up in consumption should increase top-line gains and offset any margin compression. The Fed’s liquidity programme and ultra loose monetary policy remain the key drivers behind markets, with the economic climate elsewhere in the developed world remaining fragile. We expect a gradual reduction in the pace and size of its asset purchase programme over the next 12 months. While US valuations remain expensive relative to Europe, we are a long way from the highs experienced during the tech bubble and the ‘Nifty Fifty’ rally of the late 1960s and early 1970s.

Europe

The Eurozone returned to the headlines in March, but sadly for the wrong reasons as another round of ill-tempered bail out negotiations, this time with Cyprus, raised new question marks over the stability of the currency union. The Cyprus economy accounts for less than 0.3% of eurozone GDP, but became the fifth country to receive a bail out after a last minute deal was agreed to save the island from imminent bankruptcy. After the Cypriot Parliament voted down the troika’s initial terms for the bailout of its banking system, an eleventh hour deal was reached which will involve haircuts for both junior and senior Cypriot bank debt holders in the country’s two largest banks, as well as sizeable levies on bank deposits over €100,000. This was the first time in the eurozone’s history that bank depositors and senior bondholders have been asked to pick up the tab for a bank rescue.

Suggestions by the Dutch Finance Minister, Jeroen Dijsselbloem, who recently took over the leadership of the Eurogroup, that the Cypriot rescue package could provide a template for other troubled banks in the eurozone caused a sell-off in peripheral bank shares in Spain, Italy and Greece. The greatest fear is that bank depositors in other countries with big debt problems, such as Greece and Spain, will start to move their money out of their domestic banks for fear of receiving similar treatment. The ugly atmosphere surrounding the negotiations is further evidence of the divergent views across Europe about how best to contain the continuing debt problems of southern Europe.

European markets may have stiffened their resilience to negative news compared with a year ago, but it is clear that significant risks remain. Portugal has been given an extra year to meet its fiscal targets, while there is no sign of a resumption of economic growth, which is necessary for the lingering debt and public spending pressures to ease. The next key date for Europe is likely to be the German federal elections in September, after which Germany’s long term resolve to continue bailing out other parts of Europe should become clearer. In part because of the greater risks, European equities remain attractively priced relative to most developed markets. Companies with greater exposure to high growth areas such as Asia and parts of South America offer superior earnings growth and will be less vulnerable to further shocks within the eurozone.

Asia

The latest data from China continues to show the economic recovery moving along at a modest pace, below the high expectations of some global investors. March’s Flash Purchasing Managers’ Index suggests manufacturing output remains robust as the seasonal impacts of Chinese New Year begin to fade away. Exports have continued to expand at a healthy pace, increasing by 21.8% over the year to February, while domestic consumption has lagged. Disappointing retail sales figures may mean policy makers hold off on tightening rates, as inflation remains relatively benign. Chinese equity markets have cooled. Increasingly regulated sectors such as financials, real estate and telecommunications have underperformed growth-focused sectors such as technology. Healthcare remains the standout performer. Despite the recent pull back, Chinese equities remain attractively valued with price relative to forward earnings well below the historic average. However, efforts to improve market accessibility and stamp down on corruption have so far proven short-lived and for the equity market to gather pace again, sentiment towards the economic recovery will need to improve.

The momentum behind Shinzo Abe’s new regime in Japan is showing little sign of waning. Japanese equity markets have driven on further, as we expected. With opinion polls suggesting that Mr Abe’s popularity amongst the general public continues to rise, his party has its sights on winning the summer’s upper house election, which will give it more freedom to pursue its pro-growth, inflationary policies. Currency hedged investors have continued to benefit from the weakening yen, which has fallen around 8% year to date against the dollar. Earnings at Japan’s large export firms are likely to reflect the improved backcloth when the first quarter reporting season begins in the coming weeks. Software and electronics, which generate large amounts of revenue from overseas, have been amongst the top performing sectors since the yen started to depreciate. Speculation that the Bank of Japan, led by its new Governor, Haruhiko Kuroda, will begin purchases of longer-term bonds (JGBs) has pushed 30-year yields down to their lowest level in nearly two and a half years. With high expectations of what Mr Abe can achieve with his quest to abolish deflation, there is clearly room for future disappointment, but for now confidence remains high.

Outlook

Equity markets have remained resilient despite the Cyprus crisis and the lower than hoped for rate of Chinese economic recovery. The loose monetary policy of the Federal Reserve and other central banks is an important support for markets in the near-term, though it would be no surprise to see the normal midyear correction as we move into the second quarter of the year. Within fixed interest, safe haven assets such as gilts offer little in the way of income or capital growth, but provide a measure of protection against unfavourable outcomes. Corporate bonds issued by good quality, large cap companies continue to offer attractive yield spreads over gilts without additional risk. With inflation pressures apparently on the increase in the UK, our view is that the environment continues to favour inflation-protected assets, including index-linked gilts and US treasury inflation protected securities. Investors may find better value towards the longer end of the curve. With large amounts of cash on the side lines, confidence remains the key missing ingredient. Recent events in Europe are a stark reminder that risks still remain. Any rotation out of cash and bonds into growth oriented assets is likely to be gradual as the global economic environment stabilises further.

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