Investment View June/July 2014
The U.K. economy may be finally leaving behind the mire of the financial crisis. House prices hit a new record in May, eclipsing the pre-crisis peak in October 2007. Unemployment has fallen to 6.8%, consumer confidence is at a record high and the economy is now forecast to record strong growth in this year and next.
As I commented in the previous issue of Investment View the chief economist of a major fund house suggested in May that we might see interest rates increase sooner than most would expect. During the month this topic has significantly heated up. It does appear that the BoE is preparing markets for that first increase to take place before the general election next spring and expect 25 basis points of rises per quarter, taking the end of 2015 forecast to 1.50% - later and lower than priced in by markets.
Bank of England Governor Mark Carney surprised investors with the content of his Mansion House Speech earlier in the month with a significant change in tone on interest rates. Carney warned that the first rise in interest rates “…could happen sooner than markets currently expect”. Before the speech, markets were pricing in the first rate rise in the second quarter of 2015. The latest pricing now expects the rise to come in November/December 2014, which has helped boost sterling against most currencies, but hit the FTSE100. The push to breach 7,000 thwarted once again. Overall, Carney’s speech does suggest that the Monetary Policy Committee (MPC) is considering starting the rate hiking cycle sooner in order to ensure that the pace of hikes is very gradual. However, in contrast to the hawkish comments, Carney seemed to make a strong case for maintaining very loose monetary policy given the challenges the economy faces. He certainly has a reputation of backtracking on forward guidance both from his time as the governor of the Bank of Canada, and more recently with the disastrous use of the unemployment rate as a threshold. It is worth noting none of the MPC members voted for a rise at the last meeting.
The decision to increase rates is not straightforward as the external environment remains difficult, with the Eurozone struggling to boost growth and inflation, while the UK domestic economy is still not showing signs that spare capacity is being absorbed – highlighted by the falls in wages when inflation is taken into account. Inflation is below target at present and is likely to remain so over the rest of 2014. However, we do not believe that this will stop the BoE from initiating gradual interest rate rises from the end of this year. Domestic inflation should begin to accelerate as the economy continues its strong recovery and slack is eroded. While wage growth remains stubbornly low, it should start to pick-up later in 2014. The impact on UK equities is that the improvement in the domestic economy is feeding through into stronger earnings growth, although the strength of sterling, driven by the imminent rise in interest rates, is acting as a drag for many internationally focussed companies
In the US, as expected the Federal Open Market Committee (FOMC) decided to taper its asset purchases by another $10 billion per month, which will reduce the monthly flow to $35bn per month. At this rate, the asset purchase programme will end in either October or December. Equities and bonds both rallied following the dovish press conference. Indeed, despite another upward revision to the FOMC’s projected path of tightening, markets are still pricing in a more gradual path. Something has to give. Either the bond market will be proved right and the Fed will have to change its projections, or markets will need to re-price.That said, the re-pricing may not be imminent – at least while Janet Yellen is content to send out dovish messages during her press conferences and market participants are happy to take her word for it.For US equities the underlying fundamentals in terms of consumer spending, housing and business confidence are improving but offset by headwinds such as fiscal tightening and increasing borrowing costs.
There is more of a mixed background in Europe. On the one hand the ECB seems likely to remain ultra dovish, potentially for many years. Japan provides the classic example of a country that was unable to prevent a slide into deflation. From a Euro-zone perspective it is important to note the trajectory of inflation, since Japanese price growth slowed over the early ‘90s before turning consistently negative in the latter part of the decade. There has subsequently been criticism of Japanese policymakers for making mistakes on both the monetary and fiscal side over the period. It should be noted that the ECB has taken some tentative steps into non-conventional policymaking, and the central bank’s Asset Quality Review has the potential to address banking sector issues. However, if these actions prove insufficient to start to bring inflation back up in 2015 then the central bank should be prepared to act more forcefully.For European equities valuations are supportive and corporate competitiveness improving, but fiscal programmes and structural reforms remain constraints while as yet the ECB has not managed to improve credit availability in many sectors.
In emerging markets performance is increasingly divergent; while some countries benefit from strong domestic fundamentals, others are under pressure from politics, current account deficits and tighter monetary policy required to stabilise depreciating exchange rates. This asset class remains challenging but full of potential.
As we have noted before, valuations in a range of growth assets can no longer be regarded as cheap, but in general we are a long way from a clearly irrationally exuberant valuation environment. The recent pick up in corporate mergers and acquisitions activity, material high yield issuance and the fall in spreads in some parts of the fixed income universe are hinting at some increased investor willingness to take risk. The summer months tend to see markets trade on thin volumes and it can often lead to irrational volatility. Once autumn arrives we may have a clearer view on interest rates and whether the magic 7,000 can be achieved in 2014.