Market Update - May
Economic recovery on track with growth feeding through to corporate earnings..
We are continuing to see improved economic growth in the UK and the US and a more pronounced recovery in the Eurozone. Importantly for equity markets, there is evidence that this pick up in economic activity is feeding through to corporate earnings. In the US, analysts are factoring in earnings growth of 9% this year, and in the first quarter of 2014 earnings have exceeded expectations. In Europe, there is more dispersion, with some companies benefitting more from the recovery than others, allowing active investment managers the opportunity to outperform. We maintain our positive view on equities as we believe that the gradual economic recovery will continue to drive earnings growth even though valuations are no longer looking as attractive as they were.
Interest rates to increase?...
We remain underweight to bond markets, where yields are unattractive. However, despite the improved macro backdrop and diminished systemic risks, bond yields face little upside pressure as inflation remains subdued across the board. With credit spreads now back to pre-crisis levels, bonds are becoming increasingly vulnerable to an eventual tightening in monetary policy. The UK is likely to face the most immediate pressure for an interest rate increase as economic activity is robust, broad-based and gathering pace. This has driven down the unemployment rate to 6.9%, the lowest for 5 years and below the 7% threshold that the Bank of England previously suggested would lead to the Monetary Policy Committee to consider raising interest rates – forward guidance that was quickly scrapped. Adding to the pressure to raise interest rates, house prices are now rising rapidly. While there is an understandable desire not to react too early, and thereby risk choking off the improved momentum in the economy, we believe the greater danger is that interest rate increases are postponed for too long. History tells us that policy procrastination leads only to rates having to rise faster, once the tightening process does start.
Corporate activity picks up…
It is worth noting that on both sides of the Atlantic there has been a marked rise in corporate activity since the start of the year, especially in the technology and healthcare sectors. According to Bloomberg data, April was the busiest month for mergers and acquisitions since at least mid-2007. This is evidence of growth in confidence in the corporate sector, with management teams also wanting to take advantage of continuing easy monetary conditions, while they last, and higher equity valuations. At the same time, there is evidence that companies in both the US and Europe are beginning to step up capital investment programmes, which should be reflected in both improved productivity and better profit margins.
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