Strategy & economics
February market review
January is the time of year when a coven of policy makers, politicians and business leaders gather in the serene (and expensive) resort of Davos to devise New Year’s resolutions for the global economy. The World Economic Forum (WEF) concluded on a cautiously optimistic tone, which has quickly been put to test by renewed jitters in emerging markets and consequent shockwaves across global risk assets. The trigger to renewed volatility in financial markets was the initiation of ‘tapering’ of quantitative easing (QE) by the Federal Reserve (the Fed). Through the QE programme, the Fed has been injecting $85bn of liquidity into the monetary system on a monthly basis and that amount is now being reduced by approximately $10bn every month.
As the stream of additional liquidity diminishes, emerging markets are being judged as most vulnerable to a possible outflow of the cheap capital from which they have benefited over recent years. Stress within emerging markets generally has been exacerbated by unflattering growth numbers from China and rising concern over the mountain of debt in its opaque shadow banking sector. Elsewhere, macro conditions within other emerging markets have also deteriorated, added to which there have been localised political problems in Turkey, Ukraine and Thailand, not to mention a drain of foreign reserves from Argentina. Unsurprisingly, equity indices in key emerging markets saw noticeable falls, but the most negative impact was on their currencies. In an attempt to halt capital outflows and contain rising inflationary concerns, Turkey, Brazil, India and South Africa hiked their benchmark interest rates. Temporarily, at least, this helped ease selling pressure on their currencies. However, the abrupt monetary tightening creates a longer-term trade-off between growth and inflation (lowering the latter is at a cost to the former). This makes emerging markets even more unattractive at a time when, simultaneously, they are having to cope with the implications of reduced excess demand in developed economies. The contrarian buying opportunity in emerging markets is on a valuation basis, with the widest divergence between the MSCI Emerging Markets Index and the MSCI World Index since late 2006. But timing is the key.
Over the course of an eventful January, investors were unsettled by increased volatility, displayed through the spike in the VIX Index (a measure of volatility). We would argue that volatility has been held artificially low due to excessively accommodative central bank monetary policies and that it is likely to settle at higher levels as policies begin to normalise. The markets now need to remove their undivided attention from QE and refocus on real economic growth. This will not be an instant transition, and it is not being helped by the disparity between inflated expectations and recent unexciting data releases. As this process evolves, it will be all too easy to become caught up in short-term volatility and hence miss the big picture of potentially faster growth in 2014 on both sides of the Atlantic.
In the US, gross domestic product (GDP) growth of 3.2% (annualised) in the fourth quarter of 2013 validated the Fed’s decision to embark on QE tapering. In particular, a strong contribution from consumption suggested employment gains have translated into higher aggregate spending. A trend worth noting is the acceleration in final sales of domestic product in every quarter of 2013, which is a clear manifestation of the developing momentum in domestic demand. Another important trend is the narrowing in the trade deficit, driven by both rising exports and lower imports. On the supply side, the improvement has been attributable to the shale gas story which is creating a cost advantage for the manufacturing sector (and also resulting in lower energy imports); whereas, on the demand side, rising consumption of domestically produced goods and services are having a clear impact. Another eye-catching, but less attractive, component of the fourth quarter GDP release was the 9.8% slump in residential investment, following five consecutive quarters of double-digit expansion. The correction was driven by the sensitivity of housing demand to the upwards drift in mortgage rates. High frequency indicators such as pending home sales, existing home sales and housing starts have weakened most recently, pointing to more subdued trajectory in the sector.
There has been a continuation of positive developments in the UK, most notably evidenced by the sharp fall in the unemployment rate to 7.1%, the return of CPI to the 2% target, and much better momentum in broader economic activity. With the unemployment rate falling significantly faster than the Monetary Policy Committee (MPC)’s initial projections, the Bank of England (BoE) minutes played down the significance of the previously suggested 7% threshold for a tightening in policy. In an interview at the WEF, Mr Carney effectively signalled that the BoE will scrap the original forward guidance and suggested that interest rates are likely to remain ‘well below historical norms’ in the medium term, even as the UK economy recovers. For the moment, inflation is moving in the BoE’s favour, so it can afford to stay behind the policy curve for the time being. Although the medium-term outlook for inflation seems benign, the discussion of rate hikes will likely emerge with full force if we see inflationary expectations begin to pick up. Given that wage growth tends to catch up with economic growth with an approximate one-year lag, we may see the policy debate kick in towards the end of 2014. On that front, adding to index-linked fixed income positions may prove to be a good strategy if central banks become too complacent on inflation outlook and avoid making appropriate policy adjustments.
In the Eurozone, the Purchasing Managers’ Index (PMI) for manufacturing started 2014 at a 32-month high, with Germany posting a robust reading, while France moved much closer to the expansion threshold. Even Greece’s PMI manufacturing returned to expansion territory – for first time in 53 months – a milestone, given that in the not-so-distant past it was on the brink of sovereign default and loss of Eurozone membership. There is also evidence that the tentative recovery in southern Europe is gathering pace. Illustrating this, Spain’s economy in the fourth quarter of 2013 grew at the fastest pace in almost six years. This was accompanied by the encouraging news that the number of unemployed in Spain declined three months in a row and registered the sharpest monthly fall on record.
Reflecting rising economic optimism and attractive valuations, peripheral Eurozone equity markets, including Italy, Portugal and Ireland, saw the best performance amongst developed market equities in January. On the fixed income side, Spanish government bonds were the outperformers during the month following a further tightening in sovereign spreads. Indeed, having been on the verge of triggering the Outright Monetary Transactions (OMTs) not so long ago, Spain sold €3.5 billion of five-year government bonds at a yield of just 2.4%, the lowest on record. Nonetheless, given there are still severe structural problems in the economy, there is an obvious risk of complacency and overblown optimism in the sovereign bond market.
To conclude, against the current macro backdrop, we continue to favour developed market equities, with a slight bias towards Europe from a valuation perspective. On a cautiously optimistic note, the very strong performance of equities in 2013 probably reflected investors’ increasing confidence in the outlook for western economies as evidenced by the price/earnings expansion. While this needs to be validated by a pickup in growth momentum throughout 2014, it also suggests that returns from equities in the current year are likely to be lower.
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. Issued in the Channel Islands by Cazenove Capital Management which is a trading name of Schroders (C.I.) Limited, licensed and regulated by the Guernsey Financial Services Commission for banking and investment business; and regulated by the Jersey Financial Services Commission.
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All data contained within this document is sourced from Cazenove Capital Management unless otherwise stated