David Kern, Chief Economist, British Chambers of Commerce
In this week’s bulletin:
- Better-than-expected jobs data sends Wall Street to its highest level since January 2008 as Bernanke defends QE3 programme.
- Data from Europe and China points to slowing global economy, raising the likelihood of further action to boost growth following next month’s transfer of political power in the world’s second-largest economy.
- Equities continue their silent rally despite global headwinds.
- Global equity markets rally on better-than-expected US jobs data
- US Federal Reserve chairman defends QE3 and dismisses talk of higher interest rates
Global equity markets enjoyed a powerful rally last week as investors cast aside concerns about the eurozone and focused instead on better-than-expected US jobs data. Faced with ever-increasing signs of a slowing global economy, last week’s official non-farm payrolls report was regarded as a key test of policymakers’ messages that the world’s largest economy could be gathering momentum in the face of weakness elsewhere. The August numbers showed that an extra 114,000 jobs were added and, more significantly, previous monthly gains were revised 86,000 higher. However, the greatest surprise to analysts was the overall drop in the percentage of people unemployed, from 8.1% to 7.8% – close to a four-year low and, crucially for President Obama, just below the rate when he came to office. The reaction to the data was predictable enough: investors sold US Treasuries and bought shares. Gold fell as did the US dollar, with analysts believing that it would need a string of steadily improving numbers to change the US Federal Reserve’s recent QE3 programme of pumping an extra $40 billion each month into the economy.
The Fed’s decision last month to pump as much liquidity as deemed necessary into the American financial system has not been without its critics – particularly the Republicans’ presidential candidate, Mitt Romney – who argue that low interest rates make it harder to cut the budget deficit. Mr Romney has also argued that low interest rates hurt the income of savers and increase the risk of long-term inflation. He said that when the government borrowed, the Fed “takes it and puts it in their pocket, basically printing more money”. However, Fed chairman Ben Bernanke stepped into the fray, rejecting the idea that he should raise interest rates to force Congress to tackle the deficit. “Using monetary policy to try to influence the political debate on the budget would be highly inappropriate,” he said. So, by the end of the week, stock markets were in fine fettle and enabled Wall Street to challenge multi-year highs by closing at the highest point since January 2008. The only exception was Japan, despite its currency falling on the US news, where share prices slipped backwards.
A dearth of growth
- Investors fret over future economic growth prospects
- Poor data from Europe and China point to slowing global economy
“We are bumping along the bottom”
David Kern, Chief Economist, British Chambers of Commerce
Notwithstanding the better employment numbers, worries over future global growth have weighed heavily on investors, which is unsurprising given the steady flow of worse-than-expected news from the world’s other engines of growth: Europe and China. The fourth quarter got off to a poor start last week as reports showed China’s factory sector contracted for a second month in September and manufacturing surveys pointed to a European recession. In the UK, the latest quarterly study from the British Chambers of Commerce (BCC) of more than 7,500 companies reported flat domestic sales and slowing export growth. “The picture is of general stagnation and there is nothing in these results that points to sustained economic recovery,” commented David Kern, the BCC’s chief economist. The service sector, which accounts for around three-quarters of UK output, saw flat domestic deliveries and slightly declining orders offset by exports holding up. However, the manufacturing sector experienced a sharper fall in business conditions last month, with the survey’s output index dropping from 48.7 to 47.6, with any number below 50 indicating contraction. Inflation may be on the way back as companies reported higher costs for chemicals, energy, food products, metal, oil and plastics; although weak demand, coupled with fierce competition, was enough to keep the prices manufacturers charge steady for now.
Overseas it seems to be a similar story. In Japan, where its industry is very export-dependent, companies are struggling with a strong currency that is hurting business. With the yen still near its record high against the US dollar – despite a further round of QE announced last month – many Japanese exporters are finding it difficult to compete against cheaper Asian rivals, with the situation exacerbated by a slowing Chinese economy and a moribund Europe. France is a good example of why the outlook for growth in the eurozone is diminishing. In his recent Budget, president Hollande announced sweeping expenditure cuts together with huge tax rises as part of his austerity measures to assuage the bond markets and Germany. But the package offered little in the way of how he intended to boost growth in the eurozone’s second-largest economy. Over the last decade, France’s share of eurozone exports has fallen from 17% to 13%, its balance of trade has gone from surplus to a deficit of 2.4% and public debt is around 90% of GDP. Mr Hollande believes his budget will safeguard jobs and that the fiscal burden will fall on the rich with a top rate of tax of 75%, but many economists doubt the effectiveness of such policies. For now though, the eurozone will need to rely on the likes of Germany to bolster growth prospects.
Battle of the Titans
- US manufacturing bucks global trend and boosts economic growth
- Signs of American recovery spread as consumer confidence grows
- China likely to see boost to its economy following political power change next month
The growth debate centres therefore on the world’s two largest economies – those of the US and China. Last week’s US data seems far more promising than many had hoped for and rightly boosted expectations. The jobs data should not, though, have come as a complete surprise because other data giving an insight into the health of the economy have also been turning more positive. US manufacturers bucked the global trend last month, managing to expand even as their rivals in Asia and Europe suffered. After three consecutive months of contraction, the growth in manufacturing lifted the economy as orders and employment picked up. The sector’s supply management index rose to 51.5, the first gain since May; and the new orders measure, an indicator of future demand, rose to 52.3 from 47.1 in August; any number above 50 indicates growth. Consumer confidence is also up, reflected in booming car sales – up 12.8% in September – and a recovering housing market where prices are rising and new home sales up 28% on last year. There is also a wall of money sitting on the sidelines and waiting to be deployed: private equity has $1 trillion looking for deals and corporations have a $2 trillion cash hoard, waiting for clarity as to future tax and regulatory policy, which should be more likely after the presidential elections.
In contrast, economic data from China continues to show a sluggish economy, with growth slowing again in the third quarter, dragged down by falling private investment and a challenging export market. Chinese growth has slowed for six successive quarters and is now at risk of undershooting the government’s target of 7.5% for this year. Economists like Liu Li-Gang of ANZ believe that more action is needed, saying, “The policies implemented so far have failed to arrest a cyclical economic downturn.”
Three months ago the central bank of China cut interest rates; and government officials have announced a string of large investment plans. Expectations are that, following the handover of political power next month, monetary easing and fiscal policy implementation will be accelerated. And it is worth putting China’s current position into perspective; even though the economy has slowed from its breakneck speed of 10% (maintained for nearly three decades), its current growth rate of 7.5% dwarfs that of the developed world. Over the last decade average incomes have more than tripled, putting a better quality of life within the grasp of most Chinese, and the job market remains tight, making unemployment a distant concern. The country has a burgeoning middle class, estimated at around 450 million people, with significantly enhanced spending power. By the end of last year, 430 million people had basic health insurance – a tenfold increase from a decade ago – and some 257 million citizens are covered by a basic pension. Few believe the economy is likely to grind to a halt and, despite slower growth, most Chinese appear content with their lot.
Worth the risk?
- Despite significant global headwinds, shares continue their silent rally
- The de-rating of equities means the asset class has become more realistically priced to reflect the current financial and economic environment
Stock market volatility of recent years has been the subject of much debate as investors weigh up the prospects of owning the asset class. On the one hand, worries over what might happen to the euro, the US ‘fiscal cliff’, geopolitics et al have unsurprisingly deterred investors; yet, as mentioned last week, there have been many opportunities to make money from owning equities. Of course, this should be as part of a diversified portfolio and in line with risk tolerance but, notwithstanding this, there are some persuasive arguments for revisiting what has become, over the last decade or so, an unloved asset class. Firstly, just as a reminder – despite all the eurozone woes, the slowdown in global growth and general gloom – the relative optimism of financial markets has gone almost unnoticed. The MSCI World Index is up 14% this year, as is the STOXX Europe 600 Index, despite these obvious headwinds. The simplest explanation is valuation: in other words, after years of de-rating, shares may have reached a point where they now reflect the economic stresses and associated risks caused by the financial crisis.
It is worth noting that, over the very long run, the equity risk premium – the extra annualised return achieved over a risk-free asset (such as gilts) – has been 4%. Of course this has not been delivered in a straight line and is never likely to be, but it illustrates the possible outcome over the long-term for an investor who is prepared to take extra risk by owning shares. As recently as July, this risk premium has been as high as 9%; although it has fallen to 8% following the recent rally, it still stands above its long-term average, indicating further scope for capital appreciation. Growth is unlikely, as we have discussed, to be very strong next year but risk assets like shares tend to perform in anticipation of better growth ahead i.e. markets discount the improving prospects along the way, rather than waiting for data and earnings to necessarily reflect improved economic growth. Of course, there will almost certainly be future bouts of volatility along the way, but with the caveat of taking a medium to long-term view, investors may want to think about reviewing their exposure to what has become a very unfashionable asset class.