In The Midst of Things | AAG Wealth Management

In The Midst of Things

Posted: June 30, 2014

Investors approached 2014 with cautious optimism for the global economy and markets, with more than five years between the start of the year and the collapse of Lehman Brothers and the onset of the world financial crisis. Halfway through 2014 and this mix of optimism and caution still stands – although the balance has shifted in the intervening months. In Britain, improved conditions have boosted confidence not seen since before 2007; in the US, China and the larger emerging markets, a slowdown in economic growth has fed caution. Hopes for more momentum for the global economy have not yet materialised. The International Monetary Fund’s (IMF) global growth estimate for the year of 3.6% is unchanged; while its forecast for the US economy, after an unusually severe winter, has been slashed from 2.8% to 2.0%. (However, an even more circumspect Bank for International Settlements has warned of too much optimism and not enough caution.)

Somewhere along the path, however, investors might have reason to shed some of the caution. The IMF expects US growth to rise to 3.9% next year; while there are hopes that some of the obstacles to stronger growth at the start of the year – particularly, ice storms and lost work hours across America – will be left behind, as the US economy gathers momentum. For the rest of the year, accommodative conditions, low inflation and improved corporate confidence should stimulate stronger global activity. And midway through the year, investors have been able to profit from developed and emerging world equities – the MSCI indices for each are up 5.2% and 4.1% respectively – as well as bonds and commodities. Only Japanese equities have lagged in the developed markets and this, for many, is an opportunity in a world of high valuations.

Certainly, there are threats lurking to the global economy and markets. A failure of the US economy to accelerate beyond 2% growth, or the Eurozone recovery to gather pace, poses risks; as does a hard landing for the Chinese economy. Geopolitical tensions that could cause problems for global markets include chaos in the Middle East and Ukraine, as well as China’s increasingly assertive stance over the fossil fuel-rich South China Sea. Fund manager AXA Framlington also highlights the threat posed by an exit of Scotland from the UK or the UK from the European Union. The risk of deflation in the Eurozone remains a cause for concern, too. However, global inflation remains benign and, despite hints from the Bank of England of an earlier-than-expected rate rise, the US Federal Reserve is expected to hold a near-zero base rate until 2015. Overall, global financial conditions and monetary policy look supportive, as the world economy continues its slow recovery.

‘Animal Spirits’
Wall Street is brimming with confidence as the Fed holds its base rate, exits its bond-purchasing scheme and preserves the benign conditions for asset values. The S&P 500 index at 1,961 is only seven points off its record high set earlier in the week – and has gained 6.2% since the start of the year. Although the economy shrank by 2.9% on an annualised basis over the first quarter, investors have remained sanguine that the dent was a consequence of the harsh winter and not underlying economic problems. Investors are confident that US corporate earnings will improve over the rest of the year, alongside an expected bounce in the economy. Cash-rich US corporates have stepped up investment alongside buybacks and dividends. And, in a sign that ‘animal spirits’ are returning, takeovers so far this year have totalled $748.5 billion out of £1.7 trillion worldwide.

In Asia, the Nikkei 225 Stock Average lost 2.1% over the week to 15,095 points, which ended five weeks of gains for the Japanese index. After its 56.7% gain in 2013, the Tokyo index is 7.3% down this year. Last week’s slump came amid concerns that Prime Minister Shinzo Abe’s efforts to boost inflation have started to falter. Worryingly, the core annual inflation rate fell to 1.4% in May from 1.5% in April, suggesting the Bank of Japan’s efforts to stimulate the economy have waned. Abe last week, in spite of the reverse, claimed that the new government polices had defeated the deflation that stunted Japan’s economy over the past 15 years.

Deflation remains a key concern in Europe, alongside the growing political tensions surrounding the UK’s future in the European Union (EU) that were thrown into relief by Prime Minister David Cameron’s stand against the selection of federalist Jean-Claude Juncker to head the European Commission. Meanwhile, Brussels’ economic pact signed last week with Ukraine, Moldova and Georgia antagonised Russia to threaten “serious consequences”. There was good news from the bloc’s largest economy, Germany, as its Consumer Price Index last month made a stronger-than-expected advance to an annualised rate of 1.0%, compared to forecasts of 0.7%, and up from a four-year low of 0.6% in May. The STOXX Europe 600 index, which includes companies drawn from 18 countries, has gained 6.0% this year, following its 17.4% advance in 2013.

In the UK, shares in Barclays lost 8% in value over the week as investors reacted to a US lawsuit over the bank’s operation of anonymous ‘dark pool’ trading facilities. The City was also assessing another transatlantic clash after drug group Shire rejected a £27 billion bid by stateside rival AbbVie. The move, which follows Pfizer’s unsuccessful swoop on AstraZeneca, is the latest instance of a cash-rich US corporate targeting business in the UK with a view to a lower tax regime. Bank of America Merrill Lynch reports that US companies have $1.3 trillion in cash to woo Europe’s corporates, with more than 60 targets that range from Britain’s ARM Holdings and BAE Systems to continentals BMW and Nestlé. Large-cap UK companies have gained 1.0% this year, compared with 14.4% in 2013; while large and mid-caps are up 0.4% after last year’s 28.8% advance.

Rate Debate
An answer to the question of when the UK base rate will rise does not appear to be nearer. Markets have looked to construe an exact timing from the Bank of England governor Mark Carney’s Mansion House statement that the rate rise could be “sooner than markets presently expect”. Carney had markets guessing again last week when he suggested that the economy was not ready for a rise. He added that 2.5% would be the “new normal” for the base rate over the next three years. Sir Charlie Bean, the governor’s outgoing deputy, stated that it might be reasonable to expect a return to a pre-recession level of 5% but it’s probably “a long way down the road”. However, Carney was accused of back-pedalling and behaving like an “unreliable boyfriend”.

As fund manager Neil Woodford observes, the markets have overlooked the nuances of the Mansion House speech. Carney made it clear that he has an eye on the labour market, productivity and inflation, and Woodford points out that wages are not rising, there is capacity for improved output and prices are falling. “As far as I’m concerned, these are all reasons why interest rates may not rise in the near term,” says the Woodford Investment Management founder. “But the fact is, I do not know when interest rates will rise and neither does the Monetary Policy Committee – Carney has said as much.” The market is wrong to expect an imminent tightening of monetary policy, he contends, and it would be a mistake with consumers still heavily indebted.

Woodford argues that an increased base rate would reduce household income and jeopardise the UK’s recovery. (He cites research that each 0.25% increase in the average mortgage rate would amount to a 1.25% decrease in a household’s disposable income.) Certainly, borrowers have enjoyed the historically low 0.5% base rate for the last five years at the cost of paltry returns for savers, who may struggle to sympathise with these policies. However, investors and savers this week have the welcome boon of an increase of the ISA allowance to £15,000 and an end to the restrictions on stocks and shares and cash combinations. The changes make the Stocks & Shares ISA an even more flexible instrument to adjust investments to suit individual needs.


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