Market review and outlook
As sport enthusiasts enjoyed a sensational month of events including the World Cup, Wimbledon and Le Tour de France, investors were faced by unexciting and trendless financial markets. To illustrate, the St. Louis Fed Financial Stress Index (which measures the degree of financial stress in markets and is constructed from a combination of interest rate series, yield spreads and other indicators) has been on a sustained downtrend since the start of 2014 and fell to a record low at the end of June.
Major macro themes such as global recovery, Abenomics, reduction in tail risks and further easing by the European Central Bank, led to big price movements in 2013. But the first phase of the recovery story has now been fully discounted. Unless there is substantial evidence of stronger corporate earnings growth, returns are likely to remain relatively modest in 2014. The lack of volatility against the backdrop of improving economic data and accommodative monetary policy is, as we have argued, a temperate environment for financial assets. Accordingly, a broad-range of assets have delivered positive but dull year-to-date returns, with peripheral European equities and bonds topping the performance table. Near term, we do not expect Western markets to make substantial progress, although downside risks also look limited. Further ahead, if the emerging recovery in capital spending feeds through to productivity and corporate profitability, markets may enjoy a period of renewed strength.
Notwithstanding less exciting financial markets, there have been interesting developments on the economic front. In the US, the 288,000 rise in non-farm payrolls (employment) in June, which was the fifth consecutive month of material increase, suggested that the recovery in the labour market is more than just a rebound. The household survey showed employment rose by 407,000 in June, while the unemployment rate fell from 6.3% to 6.1%, the lowest since July 2008. The unexpectedly sharp fall in the unemployment rate gained some attention, as it dipped to the upper boundary of the Federal Open Market Committee’s (FOMC) central tendency for 2014 of 6.1% to 6.3%. The robust report came at a time when CPI inflation unexpectedly rose from 2.0% to 2.1% in May, the highest since late 2012. However, the latest FOMC minutes reveal a lack of concern over the potential for inflation to exceed expectations as wage growth remains subdued. More to the point, there is no indication that the Fed is about to follow the Bank of England’s (BOE) change in guidance, seemingly designed to prepare markets for an earlier tightening in monetary policy than is currently priced in. Accordingly, the three-month Eurodollar yield curve has shifted downwards since the start of 2014. Another influence on expectations with regard to the timing of the first rate hike has been a sharp fall in the consensus forecast for US GDP growth in 2014, from a high of 2.9% back in February to just 1.7% in July. We think these forecasts are an overreaction to the weather-related weakness in the first quarter and in underlying terms, we believe that growth in the US economy is probably running at around 2.75% per annum.
Meanwhile, analysis of prevailing activity trends in the UK produced very different conclusions. Not only have forecasts for 2014 generally been revised higher, but also the Office for National Statistics (ONS) has released early details of revisions to GDP data due to be published later in 2014, which show upward adjustments to growth in eight out of twelve years for the period from 1998 to 2009. Alongside rising momentum in the wider economy, conditions in the labour market are continuing to tighten, with recent data pointing to strong gains in employment and rising vacancy levels. While official data indicate that increased demand for labour has yet to feed through to wages and earnings, industry surveys suggest that pressures on wages is beginning to increase. The British Chamber of Commerce (BCC) quarterly survey showed continued strength in hiring intentions in both the manufacturing and services sectors, while the Recruitment & Employment Confederation (REC) employment report indicated the lowest labour availability and the strongest pay growth for new hires of permanent staff since records began. We believe that if growth in the economy remains at its current pace, it will be hard for the Monetary Policy Committee (MPC) to justify not raising rates later this year. Nevertheless, increases will initially be limited and gradual. We anticipate that the first rate hike will be in Q4 2014, by 25 basis points, followed by more increases in 2015.
In the Eurozone, activity indicators have provided mixed signals in recent months. Readings for the French economy have deteriorated, highlighting the cyclical and structural issues that face a government that is, itself, not without problems. On the other hand conditions in countries such as Spain and Ireland have clearly improved. In Spain, it is becoming evident that a sharp fall in unit labour cost has boosted competitiveness and lowered unemployment, leading to a significant pickup in exports as well as recovery in domestic consumption. For Germany, recent data has been mixed, partly because numbers for manufacturing in the second quarter have normalised following a strong, weather-related first quarter. The services side of the economy fared better, and it is noteworthy that consumer confidence has risen to the highest level since December 2006. This suggests that a strong labour market is supporting household spending and that Germany is gradually becoming less reliant on exports for growth.
Despite some more positive signals, Eurozone investors’ expectations, as measured by the ZEW survey, continued to fall despite the aggressive easing measures announced by the European Central Bank (ECB) in June. This is likely due to concerns raised by a weaker second quarter in Germany, the resilience of the euro and a retreat in Continental European equities in June.
Looking ahead, there is an increasing likelihood of policy decoupling between the Eurozone and the UK and the US. While the ECB may yet embark on further monetary easing, the debate in the US and UK is focused on when interest rates will start to rise. On the basis of recent trends, it seems likely that it will be the UK that enjoys the first rate rise, possibly in the fourth quarter of this year, albeit forward guidance from Mark Carney has been highly equivocal. Undoubtedly, wherever it occurs, the first increase in interest rates will cause investors to reassess strategies. Significantly, they are likely to come to the conclusion that rising rates have the potential to prove more of a hurdle to bonds than to equities.
This article is issued by Cazenove Capital Management which is a trading name of Schroder & Co. Limited, 12 Moorgate, London, EC2R 6DA. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority (FCA registered number 144206).
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