Strategy & economics
May market review
April delivered improved growth in the UK, a rebound in activity in the US and a more pronounced recovery in the Eurozone. Equities in developed markets broadly ended in positive territory, supported by better macro data and with an additional boost coming from corporate activity and IPOs. Despite the improved macro backdrop and diminished systemic risks, bond yields faced little upside pressure as inflation remained subdued across the board. As a result, fixed income markets enjoyed a positive month, with notable outperformance in lower-quality credit and peripheral sovereign bonds as investors continued to reach for yield. With spreads now back to pre-crisis levels, fixed income is likely to become increasingly vulnerable to an eventual tightening in monetary policy.
The UK is likely to face the most immediate pressure for monetary tightening. Economic activity is robust, broad-based and gathering pace. Trends in the labour market are showing a significant tightening in supply/demand conditions, and there are now signs that this is beginning to feed through to wage growth – something that has been absent from the recovery so far. Private sector regular earnings rose by +1.8% YoY in February, finally exceeding CPI inflation of +1.6%. Appreciably stronger wage growth in areas such as construction (+2.9% YoY), manufacturing (+2.8% YoY) and retail (+3.8% YoY) are clearly linked to improving levels of activity. The emergence of real wage growth is clearly welcome news for households and favourable for consumption; however, it presents a potential threat to companies’ costs and cannot be allowed to continue unchecked.
The strength of demand for labour can be seen in the rise in job vacancies, which now stand at their highest level since mid-2008. This has driven down the unemployment rate to 6.9%, the lowest for 5 years. This is below the threshold of 7% that the Bank of England previously suggested would lead to the Monetary Policy Committee (MPC) to consider raising interest rates – forward guidance that was quickly scrapped. While CPI inflation remains subdued for now, diminishing slack in the labour market and ample liquidity in the financial system are likely to prove inflationary in the longer term. So, it seems almost inevitable that there will be pressure on the MPC to tighten sooner than it currently intends. Adding to the pressure to raise interest rates, house prices are now rising rapidly. Initially, this was a London-based phenomenon, but it is quickly spreading to other areas, supported by government lending initiatives. 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. Previously history tells us that policy procrastination leads only to rates having to rise faster, once the tightening process does start.
In the US, the Fed has continued to taper quantitative easing. This process, which began in January and which has seen a reduction of $10 billion after each six-weekly Federal Open Market Committee (FOMC) meeting, continued in April, despite seemingly disappointing first-quarter growth. While below expectations, the +0.1% annualised GDP growth rate was more a reflection of severe winter weather than a genuine deceleration in activity. Reassuringly, key indicators such as the ISM Manufacturing Index, employment and retail sales have recovered since the winter hiatus, reflecting the strength in underlying activity. However, an area of weakness that has emerged is in the housing sector, with the rising bond yields seen in 2013 deteriorating affordability. Overall, we are cautiously optimistic on 2014 growth, although the pick up in growth may not be as substantial as some forecasters were suggesting at the start of the year.
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.
In the Eurozone, with markets sensitised to what has been judged as a growing risk of deflation, all eyes were on the April CPI data. The core CPI inflation rate rebounded to +1.0% (as expected), lowering the odds of any imminent action from the European Central Bank (ECB). While commentators have become increasingly anxious about the implications of low (and potentially falling) inflation, we suspect that the ECB is more sanguine about recent developments. Hence, while leaving open the possibility of a further policy easing, the ECB is probably less likely to make a move than generally believed.
Supporting this conclusion, data releases in April have pointed to a further improvement in economic activity in the Eurozone, with the composite PMI activity index showing the best reading for almost three years. The upturn continued to be led by Germany, supported by solid trends in both the consumer and industrial sectors. Turning to the so-called peripheral nations, GDP growth in Spain increased to +0.4%, QoQ, in the first three months of the year from +0.2% in Q4 2013. This was the fastest pace of expansion since Q1 2008 and the fifth consecutive quarter of improvement. In Italy, the unemployment rate remained at 12.7% for the third consecutive month in March, a sign that conditions in the labour market are beginning to stabilise. A similar trend has been seen in the overall Eurozone unemployment rate which has dropped and remained steady at 11.8% for the past four months. Of possibly even more significance, the latest ECB Bank Lending Survey provides further evidence that credit conditions facing both households and corporates are improving. Net loan demand has turned positive for all credit categories, with banks expecting a further net increase in the second quarter.
All the above are favourable and provide time for the ECB to stay in wait-and-see mode. With regard to market implications, the continuing possibility of an easing by the ECB is likely to be supportive to equities. The effect on government bond and credit is perhaps less clear as spreads have already narrowed considerably and there is little scope for further compression. On the flipside, if inflation surprises on the upside, equities are likely to benefit from improved corporate pricing power amid strengthening growth and accommodative monetary policy.
This article is issued by Cazenove Capital which is part of the Schroders Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority.
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All data contained within this document is sourced from Cazenove Capital unless otherwise stated.