Strategy & economics
High roads and low roads
The summer has brought mixed fortunes for the world economy. While some economies, including the US and the UK have made steady progress, others have lost momentum. In the latter category, countries in the eurozone have faced toughening conditions, with sentiment depressed by geopolitical developments related to the situation in the Ukraine (and elsewhere) and some key economies still struggling to identify a clear path back to normality. The reflection of contrasting economic developments has been seen in growing divergence in monetary policy. While the ECB has reacted to the deteriorating situation in the eurozone by reducing interest rates and announcing further action designed to boost lending, the debate in London and New York has moved on to when it might be appropriate to initiate a tightening in policy. (It is a slightly bizarre thought that not many people under the age of 30 employed in financial markets and elsewhere will have experienced an increase in interest rates during their working lives.)
Returning to normal in the UK and the US does not mean returning to the sorts of growth rates that were seen during the decade prior to the recession. This was an era during which growth was fuelled by huge expansion in credit, with economies eventually imploding as a result. The new normal is likely to be characterised by more sedate but also ultimately more sustainable economic expansion. But lower average growth means that the normal fluctuations in activity, particularly on the downside, will have greater potential to arouse anxiety. For the current year, and most likely in 2015 also, we expect to see average growth of about 2.75% for both the US and the UK. For the latter, this is appreciably above our estimate of the longer-term sustainable rate, but it should be supported initially by a falling unemployment rate and then by improving productivity.
One area in which the UK has been spectacularly successful over the past few years has been private sector job creation. This continues at a pace much faster than might be expected, even after allowing for faster GDP growth. The reason would appear to be that companies are preferring to take on workers at the lower end of the pay curve, than to invest in capital. This has been reflected in both poor productivity growth and very slow growth in average earnings. However, a pick up in capital investment in recent quarters suggests that this phase of the recovery may be coming to an end. If so, we can expect productivity growth to improve and corporate profit margins to expand.
The Bank of England (BoE) has provided mixed signals with regard to future changes in interest rates. Nonetheless, while so-called ‘forward guidance’ has seemed somewhat confused at times, there is general agreement amongst economists that interest rates are likely to start rising during the first half of 2015, and then will head slowly towards 2.5% (by early 2017, according to BoE Governor, Mark Carney). The first steps towards a policy tightening in the US may take slightly longer to come through. While two members of the Monetary Policy Committee have already started to vote in favour of rate rises in the UK, the tone of the conversation on the US Federal Open Market Committee remains a little more conciliatory – for the moment.
In one sense, rising interest rates should be seen as good news, since they will indicate that the authorities have determined that the recoveries in the US and UK are sufficiently robust not to be undermined by a policy tightening. Having said that, markets are likely to be volatile as the first rate rises are announced. Normally, it takes about a year for a change in interest rates to feed through to economic activity. On this occasion, however, there may be a more immediate, although largely temporary, reaction to the first hike.
The outlook for the eurozone looks increasingly problematic. The good news is that growth should be positive this year, following a contraction in GDP in 2013. However, it is evident that the recovery in France stalled during the first half of 2014 and that Italy has slipped back into recession. Even Germany has struggled, undermined not only by the situation in the Ukraine, but also by weakness in some of its key export markets.
We are becoming increasingly concerned that without significant structural reform, particularly in labour markets, the euro will act as a tightening noose around activity in the eurozone over coming years.
Asia and emerging economies are also facing headwinds. Unsurprisingly, the increase in consumer taxation has taken a heavy toll on the Japanese economy. We had expected a pause this year, but it is becoming apparent that the slowdown may persist into 2015. For all the headlines that were generated, Abenomics has not proven to be a quick fix. Indeed, Japan is another economy that desperately requires major structural reform.
While, at a glance, growth in the Chinese economy might seem impressive, it too has decelerated. The official growth target is 7.5%, but it is becoming increasingly likely that this will not be achieved. The central bank has eased policy in order to boost activity (and shore up the property market), but achieving the switch of focus from a reliance on exports to a greater contribution from domestic demand is proving harder to effect than the authorities might have supposed. What is more, it is not long before the Chinese economy will have to face up to the problems caused by an ageing population.
Other emerging economies have also found the going more difficult. Gone is the era that they could feed off rising excess demand in the West, and this has hit both manufacturing-based countries and commodity producers. One potential outlier in this story is India. As a more closed economy, it is more reliant on its own internal dynamics. As such, it will be interesting to see whether the package of reforms promised by the new government has an invigorating impact on growth.
Equity markets were ultimately flat over the summer period, defying the ‘Sell in May and go away’ adage, despite the ongoing tension in Ukraine, the ratcheting up of rhetoric and action against ‘ISIS’ and a geographically mixed Q2 earnings season.
Markets are increasingly focusing on global deflationary forces and divergence between economies in the aftermath of the financial crisis.
The spectre of lower trend growth in developed countries and the ongoing China slowdown continues to impact commodity prices. This quarter saw significant widespread price declines across the commodity complex from energy (despite the geopolitical focus) to precious metals to agriculture. Industrial metals performed better but then they had already taken a markdown previously.
This ongoing weakness in commodity prices has no doubt contributed to the general lowering of future inflationary expectations that we are seeing in fixed income markets and that is contributing to central bank discussions, especially in Europe.
Economic divergence and decoupling is an increasing theme within developed markets resulting in monetary policy and balance sheet expansion starting to move in different directions for the US/UK versus Europe/Japan.
This monetary policy divergence has impacted currency and bond markets more than the equity markets so far. Of the major currencies the USD has been the strongest as the market readies itself for the end of QE and the subsequent, delayed but inevitable, rate rises. Commentary from the ECB, about their concerns around the lowering of forward inflationary expectations, led to persistent talk of looser policy and significant expansion of the ECB balance sheet with echoes of Draghi’s previous ‘we will do whatever it takes’ speech. The combination of these two has led to the euro weakening by about 7% against the USD this quarter.
After trading in a narrow range all year, the yen also weakened about 7%, against USD, based on strengthening USD as well as weak local economic data giving rise to expectations of further policy action designed to weaken the yen.
Early year strength in sterling reversed as uncertainty over the Scottish referendum increased towards the day of the vote. The post-event realisation that the political and corporate investment landscape is still clouded, and is likely to remain so through next year’s election, limited the recovery in sterling.
UK equity markets continued to lag other major markets over the quarter, and year to date, being effectively flat for 2014. While sterling strength, in the second half of 2013 through into the first half of this year will have held back the FTSE (with the majority of earnings being earned overseas) the composition of the index will also have contributed towards the lagged performance. As examples, the energy sector makes up 17% of the FTSE 100 Index and just under 10% of the S&P 500 Index while information technology makes up 1% of the FTSE 100 Index but is the largest sector of the S&P 500 Index at just under 20%.
We expect that the decoupling theme will continue with growing economic differences between countries and regions, increasing the divergence in monetary policy as well as earnings.
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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