Market News

Economic Update - August 2014

18/08/2014

Janet Mui

Janet Mui

Global Economist, Cazenove Capital

Schroders

Renewed volatility materialised during August, probably the least welcome time of the year to test our investment nerves, considering quite a number of readers are probably sipping cocktails by a beach somewhere. The escalation of geopolitical risks has been the biggest contributory factor to the recent pull back in risk assets, especially in continental Europe, where economic sanctions on Russia and the associated retaliation threatened to undermine an already stuttering recovery. Although the trade links between Russia and the rest of continental Europe are not significant, one cannot rule out the possibility of further escalation, particularly on the energy side, which could put further strain on fragile economies.

2014 started with more optimistic consensus growth expectations. However, there is growing uncertainty about whether momentum can be sustained during the second half. While economic surprises remained negative in the US, UK and much of the Eurozone in the second quarter, Italy slipped back to recession and Germany risks seeing its first GDP contraction in six quarters. For Japan, data releases after the consumption tax hike in April have been mixed but mostly skewed to the downside, and there are lingering doubts over the efficacy of President Abe’s ‘third arrow’ which focuses on structural reform. In China, while there has been a reasonable pickup in economic data, which has helped boost market sentiment, it is uncertain whether the rebound in activity is sustainable. China faces structural challenges that demand more than the quick fix of a mini-stimulus package, and the benefits from the announced reforms are likely to be visible only in the longer term. 

Growing uncertainty in key economic regions, escalated geopolitical risks and tighter market liquidity during the summer have combined to trigger a mild set-back across risks assets, most notably equities and high-yield credit.

In the US, recent economic developments offer some reassurance that things are heading in the right direction. GDP growth rebounded more than expected in the second quarter, expanding at an annualised rate of +4.0%, following a contraction of -2.1% (upwardly revised from -2.9%) in the first quarter. Household consumption and investment recovered strongly, indicative of robust, domestically driven, private sector growth. We think that the US GDP figures are encouraging and that consensus growth forecasts will likely be revised up from the current +1.7%. Significantly, economic data (aside from those relating to the housing sector) sustained solid momentum at the start of the third quarter. To cite a few notable releases, business surveys conducted by the Institute of Supply Management (ISM) have strengthened to multi-year highs, with strong order pipelines. Non-farm employment gains have been maintained above 200,000 for the sixth consecutive month, a development that would have historically triggered rate increases.

Accordingly, we think that after the negative impact of weather disruption during the first half, growth momentum in the US and the UK economies is now quite similar. At a micro level, corporate mergers and acquisitions activity in the US has increased, reflecting rising business confidence as well as perceived value in the current level of the equity market. A positive second quarter reporting season has led to modest upward revisions to S&P 500 earnings forecasts, which has helped explain the relative resilience of the US equity market.

The Eurozone stumbled through a problematic second quarter, causing the European Central Bank (ECB) to adopt a more cautious view at its latest policy meeting. Disappointingly, Italy slipped into a recession in the second quarter and real GDP remains 9.1% below its pre-crisis peak. As ECB President, Mario Draghi, pointed out, the lack of structural reform is holding back growth in certain economies, a pointed reference to Italy. Germany also found itself under a negative spotlight, as industrial data disappointed throughout the second quarter, putting downside risks to growth during the period. We remain cautiously optimistic on Eurozone growth and we believe the jitters in the second quarter were fluctuations around a gently improving trend.

On the positive side, the potential prolonged policy decoupling between the US/UK and the Eurozone is likely to weaken the euro, thereby boosting exports, inflation and, potentially, asset prices. Furthermore, the ECB’s Bank Lending Survey for the second quarter showed that credit standards eased for corporate lending, mortgages and consumer credit, while net loan demand was positive for all loan categories. Notably, these trends seem strongest in the peripheral countries, where progress is most needed. The survey also suggested that banks expect to continue to modestly ease lending standards over the next quarter. Hence there is evidence that credit conditions are genuinely improving, possibly helped by the introduction of Targeted Longer Term Refinancing Operations (TLTROs).

In stark contrast to the lacklustre growth on the other side of the Channel, the UK achieved a milestone in the second quarter as GDP finally surpassed its pre-recession peak. The services sector expanded at the strongest pace in seven quarters. At the same time, the trend in employment remained strong and conditions in the housing market continued to improve. In its July World Economic Outlook (WEO), the International Monetary Fund (IMF) revised up its UK growth forecast for 2014 for the fifth successive time, most recently from 2.8% to 3.2%, which is the highest predicted growth amongst G7 countries. While topping the growth league is something UK politicians are keen to highlight, especially ahead of the general election next year, it comes at the cost of excess demand, as evidenced by a recent deterioration in trade accounts.

The widening growth differential between the UK and the Eurozone (UK’s largest trading partner) means imports are outpacing exports, causing a structural deterioration in trade deficit. While UK activity is undeniably expanding at a solid pace, we believe that there will be a small loss of momentum during the second half of the year. Rather than something to worry about, this would represent a return to a more sustainable rate of expansion. On monetary policy, we continue to think it is likely that interest rates will go up either later this year or early in 2015. This is likely to be preceded by one or two Monetary Policy Committee (MPC) members starting to vote in favour of rate hike, which will kick off a more intense policy debate and prepare financial markets for the inevitable. How much of a threat financial markets perceive this to be will be determined by how an initial policy tightening is presented by the MPC. The risk is that the economy continues to grow at 3%+, and that investors judge the initial tightening as being only the first step in a longer sequence. It is evident at the moment, however, that the Governor of the Bank of England is keen to reassure markets that any tightening will not be overly aggressive.

 

Important information

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). 
Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance.

This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements.

All data contained within this document is sourced from Cazenove Capital Management unless otherwise stated. Where FTSE International Limited (“FTSE”) data is used, “FTSE” is a trade mark of the London Stock Exchange Group of companies and is used by FTSE International Limited under licence. All rights in the FTSE indices vest in FTSE and/or its licensors. Neither FTSE nor its licensors accept any liability for any errors or omissions in the FTSE indices or underlying data.  No further distribution of FTSE data is permitted without FTSE’s express written consent.

Read the full report

Market commentary - Aug 2014 2 pages | 267 kb

DOWNLOAD

The opinions contained herein are those of the author and do not necessarily represent the house view. This document is intended to be for information purposes only. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Cazenove Capital does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Cazenove Capital has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Cazenove Capital is part of the Schroder Group and 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. For your security, communications may be taped and monitored. 

Contact Cazenove Charities

Achieving your charity's investment objectives takes time and thought. To find out how we can help you please contact:

Giles Neville

Giles Neville

Head of Charities giles.neville@cazenovecapital.com
John Clifton

John Clifton

Business Development Manager john.clifton@cazenovecapital.com