Global pressures cast shadow over economic recovery in the UK and Europe.
The prospect of the Federal Reserve (Fed) slowing its asset purchases, combined with the threat of military action in Syria, hung heavily over financial markets in August. Oil prices shot up, while bond and equity prices came down, most notably in emerging markets, and overshadowing the encouraging signs of economic recovery in the UK and Europe.
US highs increase possibility of Fed tapering
Having reached new highs in July, US equity markets have pulled back as the prospect of Fed 'tapering' edges towards becoming a 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. This has helped to send the dollar higher and the currencies of weaker economies in the opposite direction.
A key question 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. The Fed's Open Market Committee chose against tapering its asset purchases at September's meeting, a move that has been somewhat overshadowed by mounting concerns over a breach of the debt ceiling and a possible shutdown of the US government. Although both parties remain in political stalemate, a short-term deal to fund the government is likely. However, whether a longer-term resolution to the debt ceiling issue can be reached remains to be seen and the political brinkmanship is likely to fuel further market volatility.
The revision to second quarter GDP was greater than expected and underlines the economy's resilience despite this year's fiscal headwinds. Pre-tax earnings for US corporations rose by 3.9% in the second quarter and there are some early signs of a pick up in capital expenditure.
With corporate profits as a percentage of GDP at a 60-year high, it is open to question how far earnings can remain on their upward trajectory as the economy recovers. The prospect of a US-led military strike against the Syrian regime has added to the general downward pressure on the price of financial assets in August and to rising oil prices. These uncertainties may well persist into the autumn, but it is the future course of bond yields – and how they are likely to impact on the US and global economy – which holds the key to shortterm developments.
Looking promising for the 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. Mr Carney has pledged to keep interest rates low until unemployment reaches 7%. Although that looks like an apparent easing of monetary policy, the Monetary Policy Committee (MPC) has added a number of conditions that would override the interest rate commitment. These include evidence of rising inflationary pressures and signs of renewed financial instability.
Money market interest rates imply that the markets expect a rate rise by mid-June 2015, at least a year before the Bank of England stated that it would consider such a move – implying that the economy is recovering faster than expected. Yet, at the same time, should higher long-term market interest rates persist, they may also bear down on the rate of recovery.
UK equity markets have remained fairly 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. A focus on UK markets is likely to remain and the sterling's recent strength may also feature on the MPC's radar. But further reassurance on rates by Mr Carney may continue to fall on deaf ears unless supported by genuine policy action.
Heightened interest in the eurozone
Amid increasing signs that some kind of economic recovery may finally be in sight, the eurozone is attracting increasing professional investor attention. Politics once again became the focus as German voters went to the polls on 22 September. German Chancellor Angela Merkel swept to a comprehensive victory, her conservative bloc taking over 41% of the vote but falling just short of an absolute majority. While a few new political alliances are possible, the most likely outcome is that Mrs Merkel will continue to lead a coalition government (although which of the other parties will perform well enough to become her coalition partner is yet to be seen) that remains cautious as the challenge of redefining the pace and scale of future European integration resumes. What is clear, however, is that this was a resounding result for Merkel and her supporters.
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. Although still at concerning levels, unemployment is falling and indicators in Spain and Italy are pointing to a renewal of growth in the third quarter. Consumer spending also appears to be picking up, raising hopes that the periphery 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 in Europe next year are gradually being raised, creating grounds for cautious optimism.
Investors turn their attention to Asia
The ambitious policies of 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 Government is being urged to press ahead with a controversial increase in Japan's consumption tax to raise revenues in a famously low-taxed economy. The sales tax is a politically sensitive issue, hugely unpopular when it was first introduced in the 1980s, with any increase likely to be deflationary, slowing the rate of economic recovery. Nevertheless, with a public debt of around 250% of GDP, something has to give. The country does appear to be close to breaking out of the cycle of deflation, which has stalled its progress for the best part of 20 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 renewed interest from investors in the yen, which must depreciate if Japan is to have any chance of a successful revival programme.
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. 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, points to a pick up in economic growth.
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