Strategy & economics
April market review
When compared to the relatively ebullient mood that prevailed for much of 2013, the first quarter of 2014 has seen the temperament in financial markets become more contemplative. A year ago, against an improving economic backdrop and ultra-loose monetary policy globally, markets were in sanguine mood, as they welcomed the resolution of political deadlock in the US, diminishing tail risks in the Eurozone, the evolution of Abenomics in Japan and a smooth leadership transition in China. This optimism was reflected in double-digit returns from developed-market equities during the year and also in significant expansion price-earnings multiples.
Moving the clock on to the start of 2014, markets have faced a reality check. In the US, the Federal Reserve (Fed) has begun the gradual reduction of additional liquidity injections (‘tapering’ of QE). At the same time, investors have had to deliberate on the implications of deflation risk in the Eurozone, headwinds from the consumption tax hike in Japan, concern over growth and a possible credit crunch in China, heightened geopolitical tension centred on Ukraine and a capital outflow from emerging markets. Even so, while markets struggled generally to establish any significant momentum in the first quarter, the US S&P 500 Composite Index did reach a new all-time high.
In reality, conditions this year are not so different to those in 2013; indeed, we expect most Western economies to grow slightly faster this year than during the preceding twelve months. For financial markets, however, 2014 is a year during which hopes that have become expressed in higher valuations need to be validated by further recovery. For equity markets, in particular, it is crucial that stronger growth in Western economies now begins to feed more obviously into corporate earnings.
As ever, it is monetary policy in the US that has been centre stage. The Fed has made it clear that unless economic conditions deteriorate, QE tapering is likely to continue at its existing pace until its conclusion in September 2014. As markets adapt to the gradual removal of stimulus, attention is shifting to the timing of the first rate hike in interest rates. The best clue has come from Janet Yellen’s first post-FOMC (Federal Open Market Committee) press conference. This was more hawkish than expected and clearly aimed at preparing markets for the start of the tightening phase of the policy cycle – possibly by mid-2015. Markets are likely to be less concerned by a monetary tightening if the general strength of the economy is judged to be sufficient not to require continued policy help. On this front, it has been reassuring to see a recent rebound in output, employment and confidence following the weather-related dip in activity around the turn of the year. If the US maintains this positive momentum, helped by a lesser fiscal headwind than in 2013, it is likely to register its strongest growth since 2005.
Similarly, developments in the UK so far this year have continued positive trends established during 2013. Last year, the economy outpaced most economists’ (albeit quite modest) expectations, and it seems likely that there will be a further pickup in momentum in 2014. From the latest national accounts data, the components of UK growth have begun to suggest that the economy is entering a new phase of the recovery, characterised by higher investment spending and improved productivity growth. In conjunction with a further tightening in the labour market, this suggests that average employee earnings will begin to post real gains during the current year. On a single-month basis, regular weekly earnings in February were up +1.8% YoY, the fastest pace in nearly one-and-a-half years.
This compares favourably with slowing CPI inflation, which fell +1.7% in February. As the wider economic outlook improves, it has become evident that households have become more confident in the outlook for their own finances, as confirmed by the GfK Consumer Confidence survey. These are encouraging signs; if they persist economic growth should become more self-sustaining and less reliant on the Bank of England (BoE). Indeed, The BoE’s policy stance is similar to that of the Fed, and it, too, has tilted toward tightening. Nonetheless, with improving growth dynamics it will not be long before we begin to worry about central banks being behind the policy curve.
While the recovery process in the Eurozone continues, as highlighted by wide-ranging surveys of economic activity, growth is still relatively dull when compared to that in the US and the UK. The debilitating effect of exceptionally high levels of debt in the southern Eurozone countries, sluggish domestic demand, and a stronger euro have constrained growth and exacerbated disinflation in the area. Indeed, inflation measured by the Eurozone Consumer Price Index (CPI) unexpectedly slowed from +0.7% to +0.5% in February, the lowest rate since October 2009. While we believe the risk of deflation to have been exaggerated by many commentators, the bias in the European Central Bank’s (ECB) monetary stance remains skewed towards easing. While the ECB has refrained from cutting interest rates further, Mr Draghi has strengthened ‘verbal’ easing and acknowledged QE as a potential policy tool. As markets continue to maintain their faith in the ECB as the ultimate monetary ‘fixer’, they are likely to adopt a benign view in relation to low rates of CPI inflation.
Although Western economies are exhibiting stronger growth trends, they are continuing to rebalance – an important feature of which is a reduction in trade deficits. As a result, Emerging Markets (EM) are enjoying a significantly lesser boost to their exports than during previous growth cycles. Within EM, China is often cited as the biggest worry, and recent data releases have persistently disappointed across a broad range of indicators. One closely watched gauge, the HSBC PMI Manufacturing Index, which is widely regarded as a bellwether of Chinese activity, has deteriorated for five consecutive months to an eight-month low.
It is evident that the macro environment in China will remain highly challenging in the near-term. Alongside the drive to reduce overcapacity, anti-pollution and anti-corruption initiatives and the necessary implementation of other reforms, the authorities’ efforts to curtail the opaque shadow banking sector and potentially tighter conditions in social financing are likely to add further downside pressure on growth. This has increased the likelihood that Chinese growth will fall below 7% in 2014, which will be a disappointing outturn when compared to the official target of 7.5%. However, it is already widely acknowledged that the Chinese investment-led growth model is not sustainable and that it is inevitable that growth will slow as the economy rebalances toward consumption. The good news in the bad news is that the government is reactive enough to provide the necessary stimulus if the economy decelerates too quickly (this has become evident recently with the announcement of a package of measures including tax cuts and infrastructure projects). Moreover, while there are appreciable stresses in the financial environment and there may well be further defaults of debt products, accumulated current account surpluses and domestic savings, as well as control on external capital flows, make more widespread systemic problems unlikely. Furthermore, as all the major banks are state-owned, central government has enough control to avoid the collapse of any major financial institutions. On the positive side, as China transitions to a market-driven economy and begins to reorient towards domestic demand, a higher level of credit defaults can be regarded as a coming of age and should result in longer-term risk being more appropriately priced.
So, what is our bottom line for the next year or so? We believe that the stresses in the world economy are gradually diminishing, but that individual countries still have structural problems that have to be addressed. While growth in 2014 is likely to be modestly stronger than that recorded in 2013, it is important that central banks and finance ministries do not step too hard on the accelerator. The slower the progress towards rebalancing, the more assured it will be. At the moment, world equity markets are up with events. On this basis, it is better to start with realistic expectations, leaving some scope for upside surprises. Bond markets are still revealing some scepticism with regard to future growth. As a result, they remain, in our view, somewhat overvalued.
This article is issued by Cazenove Capital which is part of the Schroders 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.
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. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested.
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 unless otherwise stated.