Market review and outlook
As we welcome the first hint of summer, the economic and market climate is feeling more temperate as well, thanks to a collection of positive developments in both developed and emerging markets. From a market perspective, the most significant event over the past few months has been the package of measures delivered by the European Central Bank (ECB) at its June policy meeting, which arguably constituted a more aggressive easing than had been expected. Catching the headlines, the ECB has introduced a negative deposit rate of -0.1% and has cut the refinancing rate by 0.1% to 0.15%. In addition, it has announced further provision of liquidity via four-year targeted longer-term refinancing operations (TLTROs), aimed at improving bank lending to the real economy. Simultaneously, it will stop sterilising its securities market program (SMP), which amounts to an immediate injection of liquidity. Last but not least, the ECB signalled that further monetary easing will be introduced, if deemed necessary, underlining this possibility through preparatory work related to outright purchases of asset-backed securities (ABS).
Analysing the likely impact of these measures, we are doubtful whether the apparent easing will have the positive impact on the areas of the Eurozone where a boost to economic activity is most required. The challenge lies in getting the weaker banks to take up more liquidity while, as a result of the stress tests and Asset Quality Review (AQR) later in the year, they remain under continuing pressure to deleverage. Despite these concerns, there is no arguing with the fact that the presumption and then reality of an easing by the ECB (along with the potential for full-blown asset purchases in the future) has had a significant impact on interest rates and yields in the Eurozone. Most obviously, government bond yields in peripheral European economies have fallen sharply. As a result, the spread between Spanish and UK 10 year government bond yields is now negative, compared to over 6% at the height of the Eurozone debt crisis. Meanwhile, at the time of writing, equity markets in Spain and Italy have gained +11.8% and +16.7%, respectively, over the year to date. Whether these moves prove justified remains to be seen, although it should be noted that some more positive signals are beginning to emerge from the Eurozone economy.
In the UK, it is evident that the economy is continuing to gain momentum, with growth in 2014 likely to top the G7 league table. Since Mr Carney took office almost a year ago, the Monetary Policy Committee has tried to play down the strength of recovery by referring to the amount of slack in the economy. From the Bank of England’s May Inflation Report, the MPC believes that spare capacity is equivalent to 1.0-1.5% of GDP (unchanged from the estimate in the February report), and it believes the output gap will not close until the end of the forecast horizon.
However, less than a month after his overtly dovish comments at the May Inflation Report press conference, there was a change of tone in Mr Carney’s Mansion House speech. His observation that the first rate hike could ‘happen sooner than markets currently expect’ suggests that the authorities are beginning to prepare markets for a policy tightening. His justification for a change in view is that growth has been much stronger and unemployment has fallen much faster than the MPC had expected. We have long held the view that the actual spare capacity in the economy is less than the MPC’s estimates. It has become evident that a number of key labour market indicators, such as participation rate, vacancies and average hours worked per person, have already reached levels close to or above their long-term averages prior to the recession. Although wage growth remains subdued, this probably reflects the lagged effect of duller growth a year or so ago. With the sharpest drop over the past three months in the number of unemployed since 1997, it will probably not be long until we see the emergence of upside pressure on wages. We have argued for quite a while that it would be prudent for rates to be raised sooner rather than later, and we welcome the apparent change in tone from the Bank. It is hard to justify maintaining interest rates at the level set during the crisis, a stance that could necessitate a more aggressive tightening in the future. We think any tightening will be initially very modest and gradual, which is probably the best scenario for the economy as well as financial markets.
In the US, markets shrugged off the downwardly revised first quarter GDP estimate (from +0.1% to -1.0%) as post-winter activity points to a strong rebound in the second quarter. Perhaps the best manifestation of robust activity is that the gain in non-farm payrolls in May was above 200,000 for the fourth consecutive month and the three-month average was the highest for more than two years. Better-than-expected readings from the ISM manufacturing survey, retail sales, factory orders and NFIB Small Business Optimism also pointed to growing economic momentum. As a result of positive developments domestically, as well as elsewhere, the S&P 500 continued to record new all-time highs, while, somewhat counter-intuitively, the 10-year treasury yields dipped to a one-year low in May.
In emerging markets, a modest policy stimulus from China and election results in India have helped boost sentiment. In an effort to defend its growth target and enhance the environment for structural reform, the Chinese government has rolled out a number of fine-tuning measures, most notably a cut in the targeted reserve requirement ratio (RRR) covering a selection of financial institutions. Following some disappointing activity data, the announcement of the mini-stimulus package, which included extending tax breaks for smaller businesses and expanding export rebates, helped reassure investors, as did a modest rebound in both the official and HSBC PMI manufacturing indices in May. Notwithstanding this, it is evident that the macro environment in China will remain highly challenging in the near-term, as the authorities continue their efforts to refocus the economy towards domestic demand. Further ahead, the structural issues associated with an ageing population will also have to be addressed.
In India, the victory of the BJP, led by Narendra Modi, has (re-)fuelled an equity market rally that sees the Sensex 30 Index up +20.8%, year to date, at the time of writing. There are high hopes that Modi will bring about game-changing reforms to end policy stagnation, address corruption, expedite project approvals and revitalise private sector investment. Private investment has been weak, but given Modi’s pro-business stance, it is hoped that corporate confidence and capital spending will improve, which will be beneficial for growth sustainability. Another supportive factor is that the BJP has formed a majority government which should facilitate implementing reforms, though state governments can still prove obstructive. Given the substantial slowdown in growth over the past two years, Modi will face an immediate and significant challenge to meet expectations. Reform is always easier said than done ‒ it will take a long time for Modi’s government to address deep-rooted structural issues, especially when fiscal and monetary policy are constrained by the budget deficit and high inflation. More clarity on the reform agenda, a commitment to contain inflation and an emergence from the stagflation-type environment will be key to sustaining a longer-term bull market.
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