Deflation fears rise in the eurozone and fall in Japan

In this week’s bulletin:

  • The Fed will start to taper quantitative easing (QE).
  • The UK’s economic recovery is household and consumer-driven.
  • Deflation fears rise in the eurozone and fall in Japan.
  • The strong run for equities could continue in 2014.
  • This is the final Market Bulletin of the year. The next edition will be issued on 6 January.


Journey of the Magi

Financial historians will record 2013 as the year in which central bankers led the developed world towards economic recovery and global financial markets nearer to an endgame for ultra-loose monetary policy. The year started with uncertainty mixed with hopes for the main global markets and economies and ends in optimism doused in caution. The US Federal Reserve’s Ben Bernanke, the Bank of England’s Mark Carney, the European Central Bank’s Mario Draghi and Haruhiko Kuroda at the Bank of Japan, as the year draws to a close, remain on an unprecedented policy journey characterized by easy money, risks of inflation and deflation and low interest rates. And, along the way, their bright star has been the rise of global equity markets.

But it is the strong, even wise, leadership of the Fed in its centenary year that has led the way and defined world markets at the close of 2013. Last week, Bernanke, in his final Federal Open Market Committee meeting before he makes way for his successor Janet Yellen, set the agenda for global markets in 2014 with his decision to start the roll-back of the Fed’s monthly asset purchases. In January, the US central bank will add to its holdings of mortgage-backed securities at a pace of $35 billion rather than $40 billion per month; and add to its longer-term Treasuries at $40 billion, down from $45 billion. Further tapering of the third round of quantitative easing (QE3) is expected through the year with the programme likely to end in late 2014.

In the five years since the Fed put in place emergency borrowing rates and started to buy bonds in these huge quantities, Wall Street and other equity markets have had an outstanding run thanks to the steady flow of easy money. Despite the doubt over whether the strength of equity markets will be matched by a resurgence in the real economy, the improved US employment data in recent months opened the way for the taper to begin. Central bankers will now need to guide markets from the temporary reality of QE back to more normal interest rates and economic growth. When President Woodrow Wilson founded the Fed on 23 December 1913, his vision was for a central bank that would support the wider economy and not just Wall Street. It’s as tall a task for the Fed now, and its new chair Yellen in 2014, as it was in 1914; but one it is well placed to deliver for the US and, a century on, for the global economy.


QE finite

When 2013 opened, the talk was of ‘QE infinity’ and the open-ended nature of QE3 introduced in September 2012. At the Federal Open Market Committee’s last meeting of 2012 the purchases were increased to $85 billion a month up from $40 billion, spurring a flight of money from all corners of the emerging markets. When Bernanke suggested in June that the end of the QE programme could start as the US economic recovery strengthened, the easy money flowed at a faster pace back into the US and developed markets. Last week’s announcement brings a finite schedule for markets to adjust to the end of the era of QE, which was first instigated in 2008 to get America’s economy working again in the aftermath of the financial crisis.

And after fits and starts over the last couple of years, the US economic recovery is entering a phase of sustained expansion. Last week, growth figures were revised upwards for the third quarter to an annualised rate of 4.1%, up from 3.6%. Data for the fourth quarter have also been strong, with growth in new jobs running close to 200,000 a month, and upward movement of retail sales, industrial production and homebuilder confidence. The steady stream of positive data suggests that the US economy will continue to experience sustained growth in the New Year.

Wall Street reacted positively to the growth figures and the Fed’s QE decision. The S&P 500 index ended the last full trading week of 2013 up 0.5% at 1,818 points. Markets responded well to the Fed’s guidance that the interest rate will be held at the historic low of 0.25% even when the US unemployment rate falls below 6.5%, which it expects could be reached by late 2014. The first US interest rate rise is widely expected later in 2015. In the meantime, the S&P 500 has gained 24% this year and is on track for its biggest yearly gain since 1997.


Faith and recovery

Further evidence also continues to emerge on this side of the Atlantic that the economic recovery is firmly underway. Last week brought predictions from the Confederation of British Industry that growth could rise by 2% this year. If the economy grows at this pace, it would be the fastest rate of growth in six years and beat the Office for Budget Responsibility’s (OBR) forecast for a 1.4% expansion in 2013. The Office for National Statistics (ONS) confirmed that the UK economy expanded 0.8% in the third quarter with higher output across the manufacturing, services and construction industries. The July to September period was also the eighth quarter in a row of rising household consumption, financed by a small rise in incomes and lower saving.

Britain’s recovery is a curate’s egg. ONS figures show that Britain’s current account deficit – the money received from exports minus the cost of imports – widened sharply in the third quarter to £20.7 billion, up from £6.2 billion in the second quarter. Households have driven the UK recovery by spending more, while income and living standards continue to fall and debt rises, according to the OBR. Meanwhile, businesses are gripped by caution in an environment of low interest rates and are still hoarding cash rather than investing. With the Bank’s MPC holding the interest rate at its historic low of 0.5% since March 2009, the onus is on households and consumers to power growth, and that will require many to spend savings or investments. This cannot last forever and a more robust long-term recovery requires the business sector to begin investing.

Markets can have faith in Carney’s clear position, however, that the Bank will not consider raising the interest rate until unemployment falls below 7% – and, even then, he has said that a rate rise is not guaranteed. With the unemployment rate at 7.6% and inflation falling to 2.2% in October, economists believe there is little pressure on the Bank to raise rates at this stage, despite the strengthening of the economy. In London, stocks responded positively to US developments. The FTSE 100 index ended the week up 2.6% at 6,607 points and has gained 9% since the start of the year.


Two-speed Europe

The eurozone ends 2013 in a mixed condition with parts of the region undergoing recovery – Spain and Ireland emerging from recession and bailout respectively – while concerns linger over the performance of its German and French powerhouses and southern economies. French business activity contracted in December, although figures for the rest of the eurozone improved. And deflation remains a major concern across the region with fears of a replication of what happened in Japan in the 1990s.

The major development for Europe last week was the approval of a deal to close or downsize failing eurozone lenders and set up a cross-border €55 billion emergency pool. “That is what banking union is about: stopping financial crises from happening again and, if there is a bank failure, preventing the entire European financial system from being attacked,” said French President François Hollande. However, critics have warned that the system is too dependent on national government and does not have a large enough pot of financial reserves.

Meanwhile, the rating agency Standard & Poor’s warned that the eurozone has improved but is still weak, business confidence remains fragile and company profit margins are under pressure. However, the FTSEurofirst 300 index has gained 11% over the last year, and European equities are considered good value compared to the US. Last week, European equities also gained on the hopes that the US economy is strong enough to withstand the tapering of the Fed’s bond-buying programme. The FTSEurofirst index had its best week since April and rose 3.6% over the five-day period and 0.5% on Friday to close at 1,288 points.


Abe’s aim

Japan is eight months into its loose monetary policy launched by Prime Minister Shinzo Abe, with its first two ‘arrows’ aimed at beating the country’s long-term deflationary problems and generating 2% inflation in the next two years. The reform programme – known as ‘Abenomics’ – has strong support from both the government and the Bank of Japan. But the third arrow, which concerns economic growth, is proving difficult, as it has in other developed economies.

The Bank of Japan believes that a planned sales tax increase due in April next year will not jeopardise the nation’s moderate economic recovery. There have been concerns that the world’s third-largest economy and its consumers could take a sharp hit from the tax, which aims to prod an upsurge in spending before April. The problem for policymakers is to persuade Japanese citizens to set aside ingrained attitudes and spend.

Equities have gained from the new policies, with Japanese corporate earnings also enjoying a brighter outlook, reflecting the weaker yen, improved exports and increasing levels of consumption. Fund manager Schroders’ head of Japanese equities, Shogo Maeda, observed that, with the gradual exit from deflation, “We have a macroeconomic environment that is conducive for companies to boost their earnings growth.” Meanwhile, the Nikkei 225 Stock Average has reflected this positive development with a 48% gain in 2013. The Tokyo index closed last week up 3% at 15,870 points, which was just 0.5% shy of its 52-week high in May. The advance reflected the positive stance taken by Japan’s central bankers and their counterparts in the US.



So, as 2013 closes, the prolonged farewell to QE has begun, and the effects of this experiment will be the focus of economic study for decades to come. We know that ultra-loose monetary policy has helped asset prices rise, and we also know that savers have lost out while borrowers have gained from exceptionally low interest rates. But, with the signs of improvement in the US economy in place, the Fed’s decision is an early declaration of victory, and an indication that we’re entering another period of economic and financial transition.

The problems for emerging markets this summer after Bernanke raised the prospect of QE tapering – and easy money took a sharp reverse out of developing markets – were a warning that the exit may cause difficulties outside the US. Emerging markets were the focus of concern last week but the disruption does not look as bad as it was earlier in the year. Many believe that tapering will be a non-event and the focus instead should be on interest rate rises as the real test for a tightening in monetary policy. In the US and the UK, as we have noted, this is unlikely to occur in 2014. A UK Treasury survey of 22 institutions found that just two – Bank of America and Santander – believe that the Bank base rate will rise to 0.75% by the end of 2014.

Markets will begin to price in the effect of the retreat from QE and the impact of rising interest rates. And, as the Fed has maintained since June, the exit will be managed and incremental. Fund manager BlackRock’s head of strategic asset allocation, Richard Urwin, believes that the “extraordinary” recent performance for equities, if backed by a growth in corporate earnings, could have further to run, and the asset class still represents better value than cash and bonds. Whether or not equity markets remain the bright star they have been in 2013, an orderly retreat of QE – which is a vindication of the US and UK economic recovery – should sustain the positive sentiment of markets and investors as 2013 draws to a close.

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