Strategy & economics
October market review
We have now reached the critical time of the year when investors review macro developments, reassess strategies and plan for the year ahead. It is probably the toughest occasion in recent years as valuations in some markets have become more testing and uncertainties relating to the world economy and political environment have increased. On the political front, the Scottish referendum dominated headlines in September and the “Occupy Central” movement in Hong Kong provided a challenge to China’s centralised power. On the geopolitical front, upheavals in the Middle East intensified and standoff between Ukraine/Russia lingered on. On the macro front, the emergence of disturbingly weak data from Germany, the economic powerhouse of the eurozone, caused investor sentiment to nose-dive. Not a usual suspect, but geohealth worries also appear on the list of uncertainties, as the first cases of Ebola were diagnosed outside of Africa, triggering concern of a global outbreak of the deadly virus. This combination of uncertainties was enough to tilt the markets into risk-off mode – with a vengeance.
We believe recent developments confirm our view with regard to economic and policy divergence amongst developed economies. Ever since Mr Draghi’s “whatever it takes” comments in mid-2012, markets have largely discounted the risk of a renewed eurozone debt crisis. Market volatility remained low, economic data from the area revealed tentative signs of recovery, Mr Draghi retained an ultra-accommodative tone and peripheral bond yields retreated to record low levels. While there has been some progress, albeit from a low base, in peripheral economies like Spain and Portugal, not much has changed on the structural front. This time around, renewed nervousness relating to the eurozone has been triggered by a string of poor data in Germany, something that was not seen even at the height of the debt crisis. The downturn in German industrial data and business sentiment increasingly appears to reflect not only heightened geopolitical tension, but something more fundamental in nature, the consequence of persistent weakness in some of its key export markets. Germany’s initially very successful post-recession recovery was helped in no small way by the relative weakness of the euro. But it is the gradually tightening currency and monetary noose represented by the euro that is now restricting Germany’s further expansion by undermining growth in key economies such as Italy and France. We are becoming increasingly concerned that in a fixed currency regime and without significant structural reform, particularly in the labour market, France and Italy are likely to see a persistent loss of competitiveness versus Germany. While Germany should be able to regain some momentum, helped by relatively resilient domestic demand, its consumption is unlikely to be strong enough to lift neighbouring economies. Hence, we see downside risks to overall eurozone growth. Whether this forces countries to embrace structural reform more rapidly remains to be seen.
Given its proximity to the eurozone, the UK is unlikely to be immune to the weakness of its biggest trading partner. The trade deficit has consistently been a weaker aspect of the UK economy and it is going to remain a drag on growth. While domestically-generated growth remains very respectable, there does appear to have been some loss in momentum since the middle of the year. Far from being worrisome, a slight moderation in activity should result in the economy establishing a more sustainable growth path. We have argued for a while that growth expectations for the UK have moved too far ahead. Reflecting this, the consensus for UK growth in 2014, as measured by Bloomberg, started at 2.4% in January, reached a high of 3.1% in September, but has subsequently started to fall. Meanwhile, the Citi UK Economic Surprises Index has been mostly in negative territory since the second quarter. Notwithstanding evidence that growth has slowed a little, conditions in the labour market have remained buoyant, with the unemployment rate dropping to 6.0% – the lowest level since September 2008. Significantly, the rate of decline in the unemployment rate has been much faster than the Monetary Policy Committee (MPC) has been forecasting. Despite consecutive downward revisions to unemployment rate forecasts in each of the Bank of England’s (BoE) Inflation Reports this year, the actual drop has been much faster. Even so, while the rapid absorption of slack in the labour market might seem to warrant a rate hike, the MPC has remained reluctant to begin normalising monetary policy, justifying its inactivity by highlighting the subdued trend in inflation as well as heightened risks in the external environment.
The US economy has been relatively unaffected by economic woes in the eurozone and the geopolitical tensions in Eastern Europe. As a result, trends in the US economy have improved after a difficult (weather-related) start to the year. Significant upward revisions to fixed investment in the second quarter point to a recovery in corporate capital spending, while generally improved confidence and business conditions have been reflected in the rising level of corporate mergers and acquisitions. To date, a majority of deals have been defensive, but we would expect the focus to move towards business expansion, reinforcing the signals coming from the upturn in the investment cycle.
Recent economic releases indicate that US industrial and services activity continues to expand at a robust pace, while the labour market remains in good shape. The latest data relating to the housing market and retail sales have been a bit duller, but further employment gains and lower energy prices should be helpful in raising consumers’ real spending power further down the road. Reflecting the progress being made in the economy, especially that in the labour market, median Fed fund rate expectations expressed by members of the Federal Open Market Committee (FOMC) have shifted upwards. Despite this, and somewhat to the surprise of financial markets, the most recent FOMC minutes were more dovish than expected, reflecting concern about the downside risks relating to the external environment, in particular the eurozone. In addition, concern was expressed over the potential impact of a stronger US dollar. As much as anything, the Fed minutes appears to reflect ongoing uncertainty amongst the FOMC members with regard to both the internal and external environment. At the same time, it seems likely that a majority of the committee are still looking for justification for delaying the start of the tightening process. In similar fashion to the MPC, the FOMC is rarely proactive, preferring to have evidence in published economic data before enacting a policy adjustment. The implication is that the US is likely to enjoy a prolonged period of monetary accommodation, despite solid growth. What might be expected to prompt a more aggressive stance would be evidence that wage inflation is picking up.
Balancing these various macro trends and influences, and analysing the implications for equity markets, the US is our preferred region, followed by the UK, while we have turned more cautious on the eurozone. We continue to believe that government bond markets and investment grade credit are significantly overvalued.
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