Investment View August/September 2014
Preliminary data released earlier in the month showed that UK GDP grew by 0.8% in quarter two and finally exceeding pre-crisis levels. How come the UK economy is doing so well despite the austerity programme that the UK has embarked on? M&G’s Bond Vigilantes recently provided an interesting explanation, which is reproduced with some editing.
“On the right is UK Chancellor George Osborne, the austerity axe man. On the left was opposition leader Ed Miliband, the fiscal freedom fighter. But it now appears that Miliband and co are so alarmed that Cameron and Osborne are better trusted by the electorate to run the now booming UK economy that they are quietly embracing Tory austerity. The Liberal Democrats have accused the Tories of pursuing austerity for austerity’s sake, but are still targeting eliminating the budget deficit in the next three to four years.
The problem with all this austerity posturing is that it’s built on a completely phoney premise. As confirmed by data released recently, there hasn’t been any UK austerity, at least not for a couple of years. Indeed, that probably goes a long way to explaining why the IMF predicts that the UK will have the fastest growing economy in the developed world this year.
The chart puts the UK’s budget balance into international context. The US has seen immense fiscal consolidation, which was a major drag on growth in 2011-2013 but which will substantially fall hereafter. Eurozone fiscal consolidation was enforced by markets to an extent, although the Eurozone as a whole, like the US, is currently running a budget deficit akin to levels seen in 2004-05. And Germany, a country under zero pressure from markets, expects to balance its budget this year. The UK economy grew almost three times faster than Germany’s in the year to Q2, and yet its deficit remains huge by historical standards.
The primary reason for the UK’s less than frugal fiscal policy is an inability to cut back on government spending. It’s not just overspending, however. Tax revenues in the first four months of this tax year are 1.9% below where they were in July 2013, and that’s in nominal terms, let alone real terms. It’s likely that part of this is due to the front loading of receipts last year, thus making like for like comparisons tricky, and the OBR will probably forecast a pickup in receipts towards the end of this year.
An addiction to spending combined with weak tax revenue growth means that the Public Sector Net Borrowing figures are going nowhere fast. There’s no denying that the UK’s government finances make grim reading. While current fiscal policies aren’t sustainable in the long term, loose fiscal policy has recently been successful in generating strong economic growth, and more importantly it appears to have helped encourage the private sector to finally start investing.
Furthermore, you would traditionally expect countries that run sustained loose fiscal policy to have relatively steep yield curves (a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The slope of the yield curve is important: the greater the slope, the greater the gap between short- and long-term rates) , but the opposite is true in the UK at the moment, with some longer forward yields close to record lows. In other words, the markets don’t care – yet – and a good argument can be made for the government to fund some much-needed and ultimately productive UK infrastructure investment.”
Perhaps the UK Government and its successors will look to inflation to resolve the substantial borrowings or perhaps growth will also improve tax revenues. No doubt this will become a major topic for 2015. It should also be said that austerity has been endured by most households through nil or very limited wage increases and low interest rates. However, it seems that Government austerity is more words than action.
The month has seen geopolitical issues continue to bubble under the surface, with conflict in Iraq presenting a new variable for investors to ponder. While tensions between Russia and Ukraine, the cause of considerable volatility in the first quarter, have abated, scope clearly remains for short-term volatility.
The outlook for global equities remains broadly positive. Valuations have recovered from their lows and are in line with long-run averages, suggesting that we need to see accelerating earnings growth to move markets higher. The economic and monetary cycles are supportive of this view. This environment should also allow good stock pickers to deliver returns above and beyond those achieved by the market as a whole. Fund managers continue to look for bottom-up, company-level ideas where positive change is not fully priced in by the market. Opportunities can be found.
In emerging markets the macro picture has not changed significantly – growth continues to be slower (than developed markets) but positive and some countries are coping better than others in managing this transition. Given this outlook, we are favouring the Pacific region with Funds dominated by companies based in Asia rather than Funds investing in companies operating in countries that are still wrestling with meaningful macro imbalances.
Credit markets have continued to perform well and high yield and strategic bond funds that we support are performing very satisfactorily despite the doom and gloom often reported around fixed income. Now that there is more open talk of interest rates rising in the UK and US, the actual rise, when it comes, should have less impact.
In terms of property, we anticipate that the recent improvement in UK capital values will continue, while rents should grow more strongly as the domestic economy improves. As a result, investors can expect reasonably strong, positive total returns from commercial real estate over a three-year period. Prime/good quality secondary assets and selective poorer quality secondary assets in stronger locations are likely to provide the best opportunities in the improving economic environment we anticipate during the remainder of 2014.
For some months now there has been talk that a market correction must be on its way. Views are very mixed. The Fund managers we work with are very aware of this sentiment but many do not share the view but are quietly keeping a little more cash in reserve. Their proven antidote to a decline is to embrace it and be ready to buy shares of companies that are fundamentally sound and equipped to thrive after a market pullback. The key is to be prepared – not by selling but to be an opportunistic buyer as prices fall. We share that view.The bull market is over five years old now, but “It seems to be maturing rather than aging” according to a respected commentator.