Investment View September/October 2014
In the run up to the Federal Reserve (Fed) meeting and the referendum on Scottish independence, markets were poised for a period of material turbulence, which stood in contrast to the low-volatility environment that has prevailed for much of this year. Scotland, however, opted to remain part of the United Kingdom, and the Fed’s meeting indicated no great change in US policy. In response, equity markets moved higher, with bond yields drifting up slightly, along with the dollar. However, any relief among investors at the 'no' vote in the Scottish independence referendum has proved short-lived.
Although some fund managers and analysts believed markets had hit a sweet spot as uncertainty over the future of the UK receded, the opportunity to focus on the 'fundamentals' has not provided much cheer. Since touching 6,900 after the Scottish vote, the FTSE 100 has steadily declined, with the 6,600 mark now not looking far away. The prospect of a hike in interest rates, which Bank of England governor Mark Carney this week warned was 'getting closer', has spooked investors, alongside the calamities at the UK's biggest retailer which found an "unexpected item" in the accounting area.
The UK economy has been remarkably strong in recent months with real GDP now above where it was at the 2008 peak. Encouragingly, also, demand for workers has remained high – as shown by remarkably low unemployment levels in the UK. Strong GDP data and strong domestic labour demand are things to be grateful for. In short, they are ‘good’ reasons for a rise in interest rates. Acting early on interest rates to reduce the risk of inflationary pressures building from demand pressures should be a reason for optimism. In past decades interest rates have risen due to supply shortages – for example, a shortage of oil due to the oil crises of the 1970s. Rising interest rates in this scenario, whilst potentially sensible, are usually a reason for pessimism and caution. Whilst geopolitical risks are rising around the world, the world currently appears to be better insulated than before against the risk of sharp rises in the oil price, which is largely due to the shale gas revolution in the US.
The recent slowdown of China’s economic growth has also muted the risk of supply-related shortages. A notable supply-related shortage the UK currently faces is in housing. However, the rectification of this shortage should act as a stimulus to the UK economy by employing large numbers of construction workers who will likely spend (rather than save) their earnings. Encouragingly then, the reason for any interest rate rises is mostly demand related.
‘Baby steps’ has been the expression used by Mark Carney for the speed of interest rate rises. This is largely due to the high levels of household debt in the UK and the nature of those debts. The average household in the UK has liabilities significantly greater than the US, for example, as a percentage of disposable income. In addition, the UK has a much greater proportion of variable rate mortgages than the US: roughly 14% of mortgages in the US are variable compared to roughly 67% in the UK. Even where UK households do have fixed rate mortgages, they are typically 5 year fixes compared to 30 year fixes in the US. All of this means that the Bank of England will be keen to raise interest rates very slowly. Provided the Bank is able to keep to ‘baby steps’, a shallow path of interest rate rises should be positive for the equity market generally.
At an asset class level, bonds would underperform in the event of a sustained rising interest rate cycle but must remain a critical element of portfolios as it is not a perfect world. We would expect equities generally to perform well, although sectors that behave similarly to bonds – typically utilities – are likely to underperform in relative terms. The FTSE 250 Mid
Cap Index, which historically has fallen more than the FTSE 100 in bear markets but risen more in bull markets, should again perform well in a rising equity environment.
UK equity analysts at Barclays said a much more significant effect of the vote was that it would allow investors to focus on stock fundamentals again, free from the distraction of a potential UK break-up. Barclays is bullish on the performance of the FTSE 100, predicting the UK blue-chip index will hit 7,250 by the end of the year.
‘We now believe it’s time for investors to move on and to switch their focus to fundamentals, where things are changing,’ said Barclays. ‘Away from the Scottish vote, the "big picture" is the mounting evidence of an upturn in earnings estimates.’ And it is not the only one: Credit Suisse this week raised its forecast for the FTSE to 7,000 from 6,900. I share the sentiment but think these views may be quite optimistic for 2014.
In recent weeks the bear case for European equities has become more pronounced on the back of weaker-than-expected GDP data and deflation concerns. This softening in economic momentum has led some investors to question whether the ECB is behind the curve and indeed whether it has the requisite firepower in its armoury. I share the view that these concerns have been overplayed by the market: European leading economic indicators are still largely stable and positive, whilst we also believe that there are a number of imminent catalysts which have the potential to be supportive for European equities.
Despite shrinking growth in Germany and a flat-line in France, there is little evidence of a prolonged slowdown in Eurozone growth, albeit we have seen some moderation. There is a disconnect between GDP and Purchasing Manager Indices (PMIs), that should give reason for hope. Although Q2 GDP growth has been weak, the PMIs of Italy, Germany and Spain have all been in expansionary territory.
Fears concerning deflation have also gripped the market, with Eurozone Consumer Price Index (CPI) having been on a significant downtrend since late 2012. We believe that CPI should trough in early autumn, due to purely mechanical reasons. This is to do with year-on-year input comparisons, such as the relative value of the euro and food prices beginning to put upward pressure on the CPI figure. In addition, there is limited evidence of a deflationary mindset amongst European consumers, with consumer confidence surveys painting a positive picture.
Property continues to perform strongly and the widely held view remains extremely positive for this asset class. Bonds and fixed income remain a challenge but have performed much better than many commentators predicted at the start of the year. Our preference remains to support strategic bonds and particular high yield funds.
The next few weeks will be an important time for markets and may provide a strong indicator of where we are heading. As we have discussed previously there remain strong views that something of a market correction is imminent. The view cannot be ignored and we watch carefully but this view has been around for well over a year now.