INVESTMENT REVIEW - MARKETS TAKE FRIGHT AGAIN
The prospect of the Federal Reserve slowing its asset purchases, combined with the threat of military action in Syria, hung heavily over financial markets in August. Oil prices were sent up and both bond and equity prices down, most notably in emerging markets, overshadowing the encouraging signs of economic recovery in the UK and Europe.
US
After reaching new highs in July, US equity markets have pulled back in recent weeks as the prospect of Fed 'tapering' edges towards reality. The yield on Treasuries, probably the single most important price in global financial markets, continues to rise in anticipation of an imminent change in monetary policy. That in turn has helped to send the dollar higher and the currencies of weaker economies in the opposite direction. Capital has flowed steadily out of many emerging markets, especially those with large current account deficits. A key question for investors is whether equities can continue to rally at a time when bond yields are rising, given that the current bull market is already mature by historical standards. That question will become clearer after the September meeting of the Fed's open market committee, when we learn whether it is in fact ready to start tapering, as the markets now appear to expect. The evidence of economic recovery in the US remains solid. The revision to second quarter GDP was greater than the market was expecting and underlines the economy's resilience despite the fiscal headwinds this year. US corporations remain well financed. Pre-tax earnings rose 3.9% in the second quarter and there are some early signs of a pick up in capital expenditure. This should favour sectors such as IT, which accounts for a large proportion of investment spending in the US and where earnings have scope for a rebound. Sales of cars and light vehicles are on course for their best year since before the recession in 2007, although valuations in the consumer discretions sectors of the equity market now look stretched.
As corporate profits as a percentage of GDP are at a 60-year high, it is open to question how far earnings can remain on their upward trajectory as the economy recovers. Stronger economic growth is likely to produce greater competitive pressures as well as more top line growth. Higher oil prices pose another threat, with prices being driven up in August by the mounting tension over developments in Syria, Lebanon and Egypt. The prospect of a US-led military strike against the Syrian regime following the deployment of chemical weapons against civilians has heightened tensions in the region, adding to the general downward pressure on the price of financial assets in August. These uncertainties may well persist into the autumn, with some important issues returning to the forefront of political debate. The US Government is approaching another breach of the so-called Federal 'debt ceiling', which is likely to produce more haggling between the White House and Congress before it is resolved. Nevertheless it is the future course of bond yields – and how they are likely to impact the US and global economy – which holds the key to short term developments.
UK
The UK economy continues to gain traction with the Office for National Statistics reporting that the economy, on revised figures, grew by 0.7% in the second quarter. The market focus has been on the new Bank of England governor Mark Carney, who formally unveiled the monetary policy committee (MPC)'s forward guidance policy with the central bank's latest quarterly inflation report. Like the Federal Reserve in the US, Mr Carney has pledged to keep interest rates low until a threshold level of unemployment of 7% is reached. Although that looks like an apparent easing of monetary policy, the MPC has added a number of conditions, or 'knock-outs', which would override the interest rate commitment. These include evidence of rising inflationary pressures and signs of renewed financial instability. The initial reaction to Mr Carney's announcement suggests that forward guidance has so far created more questions than answers. Money market interest rates now imply that the markets expect a rate rise by mid June 2015, at least a year before the Bank of England has stated it would consider such a move. To the extent that this reflects the economy is recovering faster than expected, this could be good news. Yet at the same time higher long-term market interest rates, if they persist, may also bear down on the rate of recovery that in practice can be achieved. Mr Carney clearly faces a challenge in sustaining the credibility of the Bank of England's policy announcements.
With volatility increasing as the summer moved on, UK equity markets have remained relatively resilient in recent months, possibly a reflection of improving economic prospects. Small and mid cap stocks have notably outperformed the larger FTSE 100 index over the month, with some of the more unloved sectors such as mining and industrial metals performing well. Focus for UK markets is likely to remain on the further communication from the MPC, especially in light of the recent negative market response. Sterling's recent strength may also come on the committee's radar but further reassurance on rates by Mr Carney may continue to fall on deaf ears unless supported by genuine policy action.
Europe
Amid increasing signs that some kind of economic recovery may finally be in sight, the eurozone is attracting increasing professional investor attention. Past politics will again come to the fore in September when German voters go to the polls on 22 September. The German Chancellor Angela Merkel is seeking another four-year term. While her party the Christian Democrats is a clear favourite to win the largest vote, Germany's parliamentary system makes it likely that the result will not produce an outright victory. A question mark hangs over which of the other parties will perform well enough to become Mrs Merkel's coalition partner. With the Free Democrats, the current coalition partners, fading in the polls the spotlight remains on how well the opposition Social Democratic Party fares. Its leader Peer Steinbruck has emphasised he will not join a 'grand coalition' of the two largest parties. The most likely outcome is that Mrs Merkel will continue to lead a government which continues to tread cautiously as the challenge of redefining the pace and scale of future European integration resumes. While the stronger nations to the north continue to produce consistent, if unspectacular, economic growth, there are genuine signs that the periphery may now be through the worst and on the road to recovery. Although still at concerning levels, unemployment is falling and leading indicators in Spain and Italy are pointing to a renewal of growth in the third quarter. Consumer spending in the periphery also appears to be picking up, raising hopes that they may soon be resilient enough to withstand future pressure on the single currency. If this turns out to be the case, Europe's equity markets, which have rarely been so lowly valued as today when compared to the US, will look increasingly attractive. Estimates for earnings growth next year in Europe are gradually being raised, creating grounds for cautious optimism.
Asia
While both Japanese equities and the yen have continued their rollercoaster ride in recent months, the economy appears to be moving slowly in the right direction. The ambitious policies of the new Prime Minister Shinzo Abe appear to be having some effect and a measure of stability has also returned to the Japanese bond markets in the face of the Bank of Japan's highly expansionary monetary policy. The acid test for Mr Abe remains the success or otherwise of his planned structural reforms. The government is being urged to press ahead with a controversial increase in Japan's consumption tax to raise revenues in a famously lowly-taxed economy. The sales tax is politically sensitive issue for two key reasons. One is that the consumption tax was hugely unpopular when it was first introduced in the 1980s. More important is that any increase in consumption tax is likely to be deflationary, slowing the rate of economic recovery. Nevertheless, with a public debt of around 250% of GDP, something has to give if Japan is ever to square the yawning gap between its public spending and tax receipts. What will encourage Mr Abe and the Bank of Japan is that the country appears to be close to breaking out of the cycle of deflation which has stalled its progress for the best part of twenty years. Sectors such as banks, retailers and real estate are likely to benefit if the progress towards renewed inflation persists.
The main short term threat to Japan's plans may be the travails of the emerging markets, which following the change in thrust of Federal Reserve policy, has helped to drive investors back into 'safe haven' such as the yen, an unhelpful move in a currency which must depreciate if Japan is to have any chance of succeeding in its ambitious revival programme. Against the dollar, the yen has still to break decisively through the critical 100 level. In contrast, while the Fed's taper talk has sent shock waves through many of Asia's emerging economies, Chinese equities have noticeably begun to outperform since early July. The potential reduction in global liquidity flows and rise in interest rates has highlighted the vulnerability of emerging economies that have run up large current account deficits with the help of cheap global financing. India and Indonesia have borne the brunt of the recent emerging market sell off. Both countries are facing an uphill struggle to protect their depreciating currencies. The dilemma is that interest rate rises to halt the depreciation could dent their economic growth prospects. China, on the other hand, with a current account surplus of around $500m and billions in foreign currency reserves, remains in a much stronger position. After a disappointing first six months, investor sentiment towards China appears to be warming. Recent economic data, including strong retail sales and industrial production figures, point to pick up in headline economic growth. Technology and consumer services stocks have been the standout performers in recent months and valuations still remain attractive. The growing influence of the Chinese consumer on the global economy is likely to remain a key theme for markets going forward.
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