In this week’s bulletin:
- Economic recovery is in the air with the US leading the turnaround.
- The eurozone has moved out of a recession that has lasted for six quarters.
- Central bankers continue to rebuke markets for anticipating a rise in interest rates.
- Emerging markets have lost their lure but offer long-term investment opportunities.
Summertime and the money’s still easy
Where America leads, the Old World often follows. Earlier this year, the US was the first of the advanced nations to show steady signs of economic recovery. In recent months, it has been the turn of the UK to display these stirrings. Last week, the eurozone surprised with figures suggesting it was also heading out of recession.
Economic recovery is in the late summer air, but the turnaround remains tentative and in its early stage. The US economy is growing faster than anticipated and is ahead of Europe. The eurozone emerged from its 18-month recession in the second quarter with forecast-beating growth of 0.3%, but its debt crisis remains and Europe-wide growth seems a long way off on the horizon. The UK, like the US, is showing signs of another credit- and housing-driven boom, if a year behind its cousin across the Atlantic.
Markets have reacted to the good news, however, as if it were bad. Bond sales drove up yields in the US amid further anticipation that more positive economic data will increase the likelihood that the US Federal Reserve will start to reduce its $85 billion-a-month bond-purchase programme as early as next month. The ten-year US government bond yield was up 27 basis points last week, gaining 8 basis points on Friday to close at a two-year high of 2.85%.
In the UK, ten-year gilt yields gained 24 basis points last week to close on Friday at a two-year high of 2.69%, also in anticipation that the pace of the UK’s recovery will bring interest rate rises sooner than the Bank of England governor Mark Carney is planning for with his ‘forward guidance’ policy. German Bund yields also rose sharply by 21 basis points over the week to end on 1.88% on Friday, reflecting the emerging Franco-German economic rally lifting growth prospects for the eurozone.
Global equities slid last week as traders took the positive economic data as likely to bring an earlier rise in interest rates and a reduction of easy money. The S&P 500 index was down 1.9% on Friday, closing at a five-week low of 1,661, although it has gained 17.7% over the year. The FTSE 100 was also down 1.27% over the week to just under 6,500, but is still up 13.2% from the start of the year.
Meanwhile, the FTSEurofirst 300 gained 0.2% on the week to close at 1,231, after a 0.3% rally on Friday, reflecting the mix of positive eurozone data and higher global bond yields. The Nikkei 225 Average in Tokyo lost 0.8% on Friday, but was up 0.3% over the week to 13,650, largely on reports that the government was considering a corporate tax cut. The Nikkei has gained 33.6% in value since the start of 2013.
Markets will continue to anticipate the outcome of the Federal Open Market Committee meeting in September, with Bernanke reiterating this summer that tapering does not spell a sudden end but a gradual reduction of quantitative easing (QE). However, the global market response to Fed tapering seems misplaced. UK markets look unwilling to take Carney’s forward guidance move on face value. European bankers have little room to adapt policy as fundamentals remain weak, if improving, in the eurozone. Central bankers this summer have done what they can to confirm that monetary policy will, for now, remain easy – but markets continue to want to hear what they fear.
Europe’s economy enjoyed a rare flash of good news last week. The release of the eurozone-wide second-quarter growth figures showed the bloc had moved out of a recession that has lasted for over six quarters. The development follows tentative signs over the last month that the bloc’s economy had started to stabilise.
The eurozone, after 18 months of recession, grew by 0.3% in the second quarter from early 2013, led by its two largest economies. Germany recorded 0.7% growth, while France surprised with growth of 0.5%. The German investor sentiment indicator ZEW pointed to more optimism in August, rising 5.7 points to 42 points, its highest level since March. Robust demand and an end to the recession underpinned the rise.
The Franco-German resurgence, although faint, is ahead of the larger southern economies of Spain and Italy, which continue to suffer national recessions and the threat of financial corrections. However, Spain’s recession looked bottomed out in the second quarter at a 0.1% contraction; while Italy’s eased to a 0.2% decline.
There are even signs of improvement for the periphery economies. Portugal enjoyed the fastest quarterly growth in the eurozone in the second quarter on strong exports. Greece’s industrial production was slightly up in June. However, some countries such as Cyprus remain resolutely in crisis and European unemployment is at a record high, with more than a third of the bloc’s jobless in Greece and Spain.
European Central Bank (ECB) president Mario Draghi can take some credit for the first signs of growth. He shored up the eurozone last summer with his promise to do “whatever it takes” with monetary policy to halt a euro break-up, and he has overseen a gradual relaxing of austerity across the region. The survival of the euro looks more secure, while structural reforms are underway across the region.
The recovery of the eurozone is of huge importance for UK business and financial markets. The bloc’s turnaround is a further positive for European equities which have reflected solid second-quarter corporate earnings and more stable business operating conditions. The FTSEurofirst 300 is up 10% since June, compared with the S&P 500 gain of 5%. Bank of America Merrill Lynch’s monthly survey for August found improved confidence and appetite for European growth.
Central bankers Carney, Draghi and Bernanke have not shied from rebuking markets for expecting a rise in interest rates as imminent. Carney’s stance last week brought some calm to the FTSE 100, before it fell 1.4% on Friday amid transatlantic concerns of early Fed rate rises following encouraging US economic data.
Some areas of the market judge the Canadian governor as taking a far too pessimistic stance on the UK economy. The Bank says it will not raise interest rates until unemployment falls below 7%, from a current level of 7.8%, which it does not expect to happen until mid-2016. Bond markets believe that better economic data and some of last week’s caveats are likely to spell an earlier UK rate increase.
Last week, strong retail sales, improving purchasing managers’ business confidence indicators and lower unemployment levels – down 4,000 in June to 2.51 million – fuelled recovery hopes and forecasts that interest rate changes will be sooner than 2016. UK labour data has been stronger than expected, which has encouraged markets to price in inflation; the opposite consequence Carney had intended.
The pound has reached a six-week high, opening the week at 1.56 against the dollar, and ten-year gilt yields hit a two-year high. This exposed Carney to criticism that he was not quite in command of his interest rate message as he had planned. It also showed that the London markets are as prone to expectations of US Fed action on official US data as they are to the Bank on figures from the Office for National Statistics.
However, Carney has been circumspect about the speed of the turnaround as “the slowest recovery in output on record”. The Bank has raised its growth forecasts to 1.4% from 1.2% this year, and to 2.5% from 1.7% for 2014 – and Carney does not think that this rate of growth is yet at the level of ‘escape velocity’ needed for real economic recovery for the UK. A slow and steady recovery will help sustain equity values too.
One consequence of Carney’s decision to hinge the Bank’s monetary policy on unemployment rates is that market reactions will be closely tied to this official statistic. As Bernanke has had to contend with in the US, this means that his barometer for the health of the UK economy is a spring for market reactions. And judging by reactions to the Fed and now the Bank’s assurances, markets are hearing what they want to fear.
The ECB and Bank’s use of forward guidance to persuade investors that interest rates will remain at historic lows is proving tricky. Markets are showing they will not be cajoled, even if they follow what as a herd they have decided to hear. Bernanke has spent recent months explaining with mixed success that policy will shift on economic factors, with markets widely anticipating a change in policy in September.
However, the US economy grew faster than anticipated in the second quarter at 0.4% over the three months, or an annualised pace of 1.7%, according to the US Department of Commerce. The US has also benefited from a more comprehensive change to the banking sector after the 2007/2008 financial crisis than in the UK and Europe, with lending available for business and households. The housing market is recovering, while consumer debt has been cut.
The US unemployed rate at 7.4% is at its lowest since December 2008. The pace of US consumer price inflation increased in July and pushed the advanced annual rate of inflation to the 2% rate targeted by the Fed. However, US producer prices were flat for July, which gives scope for the Fed to delay tapering its quantitative easing programme. The central bank largesse that has propped up asset values will on the strength of this data be able to shift to a reduced pace.
Watching for the end of QE continues to have a major impact on global emerging equity markets, as easy money moves back to Wall Street and the advanced nations. The MSCI Emerging Market index is down 9% this year, compared with an almost 18% rise on the S&P 500 since the start of January. Strong inflows into global emerging market equities continued into the early part of 2013, but there have been outflows of around $28 billion since mid-February.
A Bank of America Merrill Lynch survey last week highlighted the extent of this trend, identifying that fund managers are for now losing their appetite for emerging markets. Bank of America reported that allocations to Malaysia, India and Poland have seen the largest outflows. However, the world’s largest container shipping company, AP Moeller-Maersk, following strong quarterly profits last week, said it remains positive for emerging markets and anticipates an increase in global trade from these countries in tandem with the recovery of the US, the world’s number one economy.
Meanwhile, protests in Turkey and political upheaval in Egypt are further examples of the risks that many emerging markets pose for investors. With global markets expecting interest rate rises, the US dollar strengthening, investment outflows continuing and a slowing Chinese economy requiring fewer raw material imports, emerging markets have lost much of their recent shine. But, while the developed economies are back on the march, emerging markets continue to offer long-term potential growth as part of a wide spread of diversified investment opportunities.