In this week’s bulletin:

  • Economic data showed a two speed recovery in the eurozone with the German economy racing ahead of its rivals at the fastest rate for two decades – demand for its cars boosted exports.
  • US Federal Reserve Chairman, Ben Bernanke, was forced to announce a change in policy following recent poor US economic data: the Fed will give a monetary boost by re-investing its maturing mortgage-backed securities into government bonds, thus keeping interest rates low.
  • In the UK the BoE reduced its growth forecast for the next two years but still sees the economy growing around 2.7% pa – much in line with longer-term trends.
  • Stock markets suffered a two way pull but finally succumbed as investors decided to head for less-riskier investment such as the dollar, government bonds and yen.
  • Standard Life’s investment chief Keith Skeoch believes now is the time to buy UK equities seeing the FTSE100 index hitting 6,000 by year end.
  • Despite their excellent run there is still value and merit for investors in owning corporate bonds within their portfolios according to fund manager Paul Read of Invesco Perpetual.

 Vorsprung durch Technik
It was a week of mixed fortunes for the global economy and financial markets last week. Topping the bill though was Germany, following the release of economic data which showed that the country’s economy had grown by 2.2% during the second quarter – the fastest pace for two decades – boosted by exports. As The Financial Times pointed out, German manufacturing success has enabled the country to return to pre-crisis levels for exports of goods, with renewed demand for German cars and machine tools, particularly in Asia, leading to a surge in output. For the euro-bloc as a whole, growth was a respectable 1% during the quarter, equivalent to 4% annualised and nearly three times the rate recorded since the euro was created in 1999.
Yet beneath the headline rate, the familiar theme of a two-speed Europe is apparent: Germany represents the healthy ‘core’ whilst much of the troubled southern periphery continues to stumble along. Greece, for example, sank deeper into recession – the economy contracted 1.5% in the second quarter with a fall in investment and a significant reduction in public consumption contributing to the decline in GDP. Unemployment has also shot up to 12.5%, reflecting worsening conditions for the real economy, which, although awful, is still not as bad as in Spain where the rate is 20%. “It’s the same old story: Germany in a league of its own, carrying a few of its neighbours along and beneath that, the laggards that are teetering on the brink of recession,” said Carsten Brzeski of ING.
The mixed economic data did little to assuage concerns in the money markets, which saw German benchmark market interest rates fall to record lows as investors opted for quality – fleeing from bonds issued by the peripheral states. The net result was that the spreads between German bunds and Greek, Portuguese, Irish, Italian and Spanish debt all rose sharply which, analysts say, illustrates the on-going problems. Ireland came into focus with fresh concerns about its banking sector and market rumours of the ECB intervening to buy Irish bonds – The Financial Times noted that there has been a near doubling in interest rates paid by Ireland compared with three weeks ago.
Fed Gives Economy another Fix
Worries about a possible ‘double dip’ for the US economy – although considered highly unlikely – led the US Federal Reserve to give its frail patient another monetary shot in the arm. Fed Chairman Ben Bernanke said last week that economic growth was likely to be “more modest in the near term than had been anticipated”, as evidence showed that the US recovery had slowed, household spending was constrained and bank lending was contracting. As a result, the Fed decided to make a shift in its economic stimulus programme, saying it would re-invest money from its portfolio of maturing mortgage bonds (bought as part of its policy to prop up the housing market) into longer-term government debt. The effect of this change will mean that, instead of a small amount of monetary tightening, the reinvestment of its MBS bonds will keep interest rates low and cause a small but meaningful shift towards monetary easing.
It was only last month that Mr. Bernanke told Congress that he was not planning specific new measures to support the economy, but the recent raft of poor economic data appears to have forced the Fed’s hand. As The Times said, almost two years of near-zero interest rates, a $1.2 trillion expansion of the Fed’s balance sheet and a near $800 billion government stimulus package have yet to generate a sustainable recovery in economic growth. Not that it’s all bad news though: American economist Irwin Stelzer opined that most economists do not believe the US will drop into double-dip territory. Corporate earnings are at the record highs reached before the downturn and they have $2 trillion of cash that they will soon have to spend. Business spending on equipment and software is increasing at an inflation-adjusted rate of more than 20% – the most rapid since the late 1990s. And if necessary, the Fed can resume money creation, known as ‘quantitative easing’. Stelzer finished by saying that a “longer-than-one-week look” shows that jobs are being created in the private sector, share prices are up, profits are ample and businesses have started to reinvest.
King Cuts Forecast
Last week the Bank of England cut its forecast for UK output over the next two years, warning that constrained bank lending and questions about recovery in the economies of Britain’s main trading partners posed risks to growth. At the same time, the BoE raised its forecast for inflation over the same period, saying prices are likely to rise faster than its 2% target. However, bank governor Mervyn King also said that it was unlikely to toughen monetary policy – a euphemism for raising interest rates – in response because it believes temporary factors are behind the current inflation blip. The BoE now expects the UK economy to grow at an average of 2.7% – much in line with longer-term trends – rather than the 3.4% it originally thought, and more in line with recent data showing the UK economy has grown around 1.7% so far this year.
Much like in the US, recent economic data for the UK has been mixed to good, but with some signs that the rate of growth is slowing. Last month, growth in retail sales slowed to 2.6%, down from 3.4%, as consumers became more cautious ahead of likely job cuts. “The overriding factor is consumer confidence – it’s fallen recently, though people are still more confident than this time last year,” said the British Retail Consortium’s director general. The Financial Times took a slide rule over some of the latest data and came to the conclusion that there are still some silver linings to be found – even if the news is a little gloomier than a few months ago. The number of people at work surged in the three months to the end of June, although this is likely to slow as the public sector begins to cut jobs. In the car market there is still growth in the high-end of the market, although fleet sales have fallen recently. The paper concluded that recovery is likely to be long and slow.
Investors Vacillate
Global investors started the week in good mood, but were quickly forced onto the back foot after being hit with a triple whammy: Ben Bernanke’s less optimistic prognosis on the US economy, the largest US trade deficit in 21 months and disappointing import figures from China. The trade deficit jumped $7bn to $49.9bn in June as a result of falling exports, whilst in China, data from Beijing showed that industrial production growth slowed marginally to 13.4% (from 13.7%) last month. In response to the news investors took shelter in the perceived safety of government bonds, the US dollar and the yen. Japan’s stubbornly strong currency rose to a 15-month high against the US$ – pummelling shares of the country’s largest exporters and approaching a level where some analysts believe the government will be forced to intervene.
The relentless rise of the yen has sparked new fears for the country’s economy, but many think that the Bank of Japan is unlikely to take any meaningful action – partly because of disastrous forays in the past and also so as to remain on good terms with the US, according to The Times. Washington has made no secret of its irritation with China’s manipulation of its currency and the perceived unfair advantage it gives the country’s manufacturers and the threat to US jobs. So, as the global economic tides eddied, investors decided to adopt a ‘risk-off’ mode in the short term, preferring to wait and watch developments. By the end of the week most equity markets had given ground, with Wall Street leading the way; although in London falls were more modest with the FTSE 100 slipping around 1% by close of business on Friday.
Buy, Bye
For the most part, shares have remained pretty flat over recent months, reflecting investor uncertainty about whether it’s a good time to buy equities or, for some, time to sell. So, many stock markets have been subject to a two-way pull: buoyed by good corporate news to only then be disappointed by worse-than-expected economic news. So where does this leave private investors? Well, for the chief executive of Standard Life, Keith Skeoch, now is definitely the time to buy, believing that the FTSE 100 will defy volatility in the global financial markets by “reaching the 6,000 point barrier” by the end of the year. The index closed at 5275 on Friday. “If you look at [government] bond prices across the world, then we think the markets have already priced-in slow growth – verging on a double-dip recession – but not deflation,” commented Mr. Skeoch.
The Sunday Times agreed, saying British shares are at their cheapest for 50 years relative to government bonds. Barclays Capital, the investment bank, analysed over 100 years of data and found that currently dividend yields are trading at a premium to gilt yields – a very rare event and, using monthly data (as opposed to annual data), the first time since 1958. Shares have historically yielded less than gilts on the basis that they offer greater capital growth prospects. And it’s not just British shares that are cheap. Dennis Jose of Barclays Capital said, “European equities are trading at multi-decade valuation lows relative to cash, government bonds, investment grade and high yield [corporate] bonds and US equities. Taking the price-earnings ratio, for example, European equities are currently trading at a 36% discount relative to the 27-year average.”
But equities are just one option for investors and diversification is fundamental to any investment strategy, so what other choices are there for investors? Corporate bonds – IOUs issued by companies – have been very popular with investors seeking higher levels of income and in recent times they have also delivered capital growth. But having enjoyed a good run, what now, asked The Times. Paul Read, a respected bond manager at Invesco Perpetual, believes corporate bonds still have a role to play in many investors’ portfolios. “Corporate bonds are there to provide a good long-term source of income in a period when significant parts of the income people had depended on has gone. We have lost the BP dividend, we have lost many bank dividends, gilt yields are low and the interest rate on your bank account is low. There are not many good sources of relatively safe income available, so I think that corporate bonds should be a very important part of people’s portfolios.”

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