March market review

Following a rebound in both developed and emerging market equities during the first half of February, the final week of the month saw a sharp rise in volatility. As the situation in Ukraine worsened, geopolitical worries once again topped the list on every investor’s agenda. The immediate concern has moved on from the impact of generalised political instability to the threat to Ukraine’s sovereignty over the Crimea region from Russia, which culminated with President Vladimir Putin’s decision on March 1st to deploy Russian troops in the Crimea. The inescapably negative market reaction was, perhaps, most obvious in abrupt declines in both the Russian stock market and the rouble. While the likelihood of full-blown military action from Russia seems to have diminished, as I write, there remains a high degree of uncertainty. Therefore, it is inappropriate at this stage to make significant adjustments to our investment strategy, although it is important to analyse the nascent risks.

The main concern is the potential disruption to energy supply to economies such as Germany, since Russian natural gas, on which continental Europe is heavily dependent, is exported via a Gazprom pipeline through Ukraine. Were there to be interruption to supply, as well as having an impact on industrial output, there could be a more widespread impact on energy prices. UK readers will be pleased to know that the UK has no dependence on Russian natural gas, although it could be impacted by any increase in energy prices. To date, the consequent rise in oil prices has been insignificant, and the impact on gas prices has been localised.

Ukraine, itself, is a large producer of grain. Wheat prices have already risen, albeit not dramatically, and there is a risk that this will have some inflationary consequences elsewhere in Europe.

There is also a potential impact on the western European financial system, via the exposure of banks to Ukraine and Russia. Around 88.7% and 73.4% of Ukrainian and Russian banks' foreign borrowing, respectively, are from European banks. However, total banking exposure to the two countries is insignificant relative to aggregate European balance sheets.

Another avenue through which the situation in Ukraine could have a wider impact is trade. Belarus is likely to suffer most, as exports to Russia and Ukraine account for 35% and 10%, respectively, of total exports. However, the negative spill-over from trade to the Baltic states is likely to be relatively localised, particularly as major Western economies’ export exposure to Russia and Ukraine are modest. The biggest economic victim of the situation in Ukraine is likely to be Russia itself. It has been suffering from a slowdown in growth attributable to lower energy prices, tight monetary policy (necessitated by high inflation), capital outflows and lack of structural reform. The slump in confidence, possible sanctions and an adverse international political environment are only going to exacerbate Russia’s woes.

Overall, this assessment suggests that the economic impact of events in Ukraine will be limited, unless the situation deteriorates.

Notwithstanding the escalation of political risk, a further pickup in eurozone economic momentum has provided a comforting breeze. The Eurozone Composite Purchasing Managers’ Index (PMIs are measures of economic activity) rose in February for the eighth consecutive month to a 32-month high, confirming that private sector recovery remains on track. Eurozone companies have been benefiting from strengthening market conditions, as evidenced by strong new business orders which also expanded at the fastest pace in 32 months. The improvement in sentiment in the eurozone has been apparent in a broad-based rise in investor, business and consumer confidence surveys. However, it is still an early-stage recovery with wide regional variances, most obviously between robust PMI surveys from Germany and a prolonged contraction in France.

A major concern in the eurozone has been the persistent downward trend in consumer price inflation. While the February reading remained steady at +0.8%, the measures for Germany, Italy and Spain all surprised to the downside. In particular, inflation in Spain fell to 0.0% from +0.2%. However, concerns relating to disinflation could soon begin to abate, as rising activity levels and low inventories should lead to improved pricing power. In addition, one of the biggest downward contributions to eurozone inflation has been from energy prices, and this is now beginning to diminish – and could be reversed, depending on developments in Russia and Ukraine.

The improved momentum in the UK economy has continued. Most significantly, we believe the economy may be entering a new phase of the recovery based on an upturn in the investment cycle. We have written previously that for the UK economy to develop more resilience, we must see productivity-based increases in real wages, and these can only come through once we have seen an upswing in capital spending. While household spending has supported gross domestic product (GDP) growth over the last two years, the latest national accounts suggested that investment played an important role in the second half of 2013. Gross fixed capital formation, which has been relatively weak since the start of the economic recovery, expanded in each quarter of 2013 and accounted for around half of all expenditure growth during the fourth quarter of the year. Business investment, an important indicator of corporate behaviour, also grew for a fourth consecutive quarter, and was 8.5% higher than the same quarter a year earlier. The sustained increase in investment spending should lead to improved labour productivity and better growth in corporate earnings (the latter, of course, should prove beneficial to the stock market).

In terms of growth expectations, the Bank of England (BoE) has revealed itself to be amongst the most bullish of forecasters. In its February Inflation Report, it predicted that GDP growth in 2014 would be 3.8% if interest rates remain unchanged (which it has led us to expect will be the case). This forecast compares to a consensus expectation of ‘only’ 2.7%. With regard to prices, the BoE expects Consumer Price Index (CPI) inflation to rise slightly by the year end to a rate of 2.2% in the fourth quarter of 2014 (again based on unchanged interest rates). If the economy is anything like as strong as the Monetary Policy Committee (MPC) expects, we believe the inflation risks will become skewed to the upside. Assessment of the economy’s position will be based upon a broad range of indicators, on which the BoE will start to publish forecasts. In relation to forward guidance on monetary policy, however, the BoE will focus on the economy’s ability to absorb spare capacity (itself, a somewhat nebulous concept), largely within the labour market, which is estimated to be between 1.0% and 1.5% of GDP. Mark Carney stressed the first hike of interest rates will be state-contingent and not time-contingent. It is very difficult to estimate the timing of rate hikes, given the wide range of indicators being assessed and the difficulty in accurately estimating productivity growth. However, the Bank reassured that rate increases will initially be limited and gradual. Even when the economy has returned to normal levels of capacity and inflation is close to target, the bank rate is likely to be materially below the 5% average level recorded prior to the financial crisis.

So, if conditions have improved in Europe, what is happening on the other side of the Atlantic? We have intentionally left this question to the end, since the impact of a very harsh winter in many areas has rendered the latest data signals highly unreliable and of questionable significance in the assessment of the underlying state of the economy. Undeniably, US data releases in January and February were in the main disappointing. Reflecting this, the Citi Economic Surprises Index for the US has fallen back to the lowest since July 2013. While it is virtually certain that the deterioration in data is largely weather-related and hence likely to be temporary and though we do expect the economy to expand faster in 2014 than in 2013, we are concerned that expectations are beginning to run ahead of themselves. Reassuringly, GDP data for the fourth quarter of 2013 showed broad-based positive contributions to growth, except from government expenditure. The drag from fiscal austerity will fade during 2014, and is an important reason why we believe US growth will begin to improve. Nonetheless, the gain in momentum may not be as appreciable as some forecasters are predicting.

In next month’s commentary, we will focus on Asia and emerging markets. In particular, we assess the probability that, as fears increase with regard to the deteriorating credit environment in its economy, China will undershoot the official 7.5% growth target.

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. 

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.