Market Outlook: The European Central Bank comes out of hibernation

Haydn Davies, Chief Economist, Barclays Global Investors, believes Europe's brighter economic outlook encouraged the ECB to raise interest rates.


Policymakers these days do not like to surprise the markets unnecessarily. In recent weeks the ECB, which has not changed interest rates in 2 1/2 years, has been preparing investors for an interest rate hike. Headline inflation has accelerated to 2.5 per cent, above the ECB's target ceiling of 2.0 per cent, although underlying inflation, which ignores swings in oil and food prices, remains just 1.5per cent.


Nevertheless, the acceleration in inflation means that real interest rates are negative. This is an exceptionally loose policy stance that the ECB no longer feels is appropriate when activity is looking ever more upbeat. Manufacturers' order books are their fullest since the collapse of the technology bubble and construction orders are also their strongest in four years. Activity in the service sector has begun to pick up too, but consumer spending remains sluggish.


The continued listlessness of consumer spending should not be cause for concern. Europe's labour laws, which make it difficult to lay off workers, mean that firms are reluctant to hire new staff until they can be sure that any pick up in activity will be sustained. As a result, it tends to take much longer for employment to recover than it does in markets such as the UK or US, where labour laws are less onerous. In addition, because hiring is slow to respond to a pick up in activity, consumer spending also tends to lag. Unemployment has been falling for a year now and this should continue, given the economic outlook. As the jobs market continues to improve, consumer spending will accelerate further fuelling Europe's nascent recovery.


The better economic environment and the outlook for interest rates suggest diverging prospects for European bond and equity markets. Profit growth, which has been driven by heavy cost cutting over the past couple of years, has recently begun to slow. The economic upswing, though, should give profits a further boost. As a result, European stock markets, which have risen strongly this year, should continue to outperform even if they no longer look such good value.
Low bond yields also keep equities attractive.


However, European bond markets have looked out of line with markets elsewhere -- and the pick up in inflation globally -- for some time. They have sold off in the past couple of months, pushing 10-year yields up to 3.5per cent. Nevertheless, yields still look relatively low compared to yields elsewhere, particularly given that the money markets expect interest rates to climb to 3.0 per cent by the end of next year, compared to the 2.25 per cent rate they were discounting just three months ago. The prospect of higher interest rates has not stemmed the euro's slide and yields are likely to remain low by international standards. Although the inflation outlook should support the currency, it remains overvalued.


Confidence returns to Wall Street


While European and Japanese stock markets have leapt 20 per cent and 35 per cent respectively this year, the US S&P 500 Index has managed to climb only 5 per cent higher. Taking account of the US dollar's appreciation puts the US market's performance in a better light, but US investors could be forgiven for wondering why their market has found it difficult to make much ground this year. While it is true that profits are growing more slowly than a year ago, they have still grown 15 per cent over the past year and are now a third higher than their previous peak at the height of the technology bubble. Nevertheless, profits in Europe and Japan have grown even more quickly. German profits are 45 per cent higher than their level at the height of the technology bubble, while Japanese profits are 80 per cent higher. Moreover, while the US economy has continued to outpace both Europe and Japan, it has grown no more quickly than expected. Economists, on average, expect the US economy to grow 3.5 per cent this year, exactly what they forecast at the beginning of both this year and last. In contrast, the turnaround in the European and Japanese economies has come as a surprise to most investors and economists have been revising their forecasts higher.


To compound Wall Street's problems, there are a couple of clouds on the US economic horizon. First, the possibility of a downturn in the booming housing market and secondly, the recent fall in new car sales following the summer surge.


Economists expect the recovery to lose a little steam next year. However, while the economic news has been a little weaker than expected in recent weeks, underlying consumer spending remains remarkably upbeat given the rise in energy prices over the past couple of years and the lacklustre jobs market. Moreover, the Federal Reserve has begun to sound more dovish, raising the possibility that it may hike interest rates only a couple more times before pausing for reflection. That would leave liquidity conditions still very supportive for equity valuations. The fall in oil prices to under US$60 a barrel also boosts the economic climate, as well as alleviating the danger that inflation could get out of hand.


As a result, although activity could be stronger, the economic climate remains favourable for US equities. Moreover, while investment analysts have begun downgrading profit forecasts again, investor sentiment has improved, with investors returning to the market and risk appetites recovering. Wall Street does not look particularly cheap compared to markets elsewhere, but it continues to offer good value compared to government bonds. In recent weeks, confidence has returned to Wall Street and US equities should recover a little lost ground in the coming weeks.


While the US stock market has lagged all year, the US dollar has appreciated sharply, undeterred by the improving economic climate in Japan and Europe. Although European interest rates are set to begin rising in December and Japanese rates some time next year, the premium offered by US money-market rates remains substantial. It is more than sufficient to attract sufficient investors to finance the US deficit with the rest of the world, which has now swollen to more than 6 per cent of its annual economic output. Moreover, with inflation beginning to ease and expected to continue doing so, the US dollar is set to remain strong. The outlook for US bonds, on the other hand, does not look so promising. Given the outlook for US interest rates, 10-year bond yields offer a very low premium over short-term rates, particularly compared to markets such as Japan.


Sentiment continues to propel Japanese equities higher Over the past six months, foreigners' net investment in Japanese equities have surged to the strongest level in more than a decade, helping to explain why Japan's stock market has leapt almost 40 per cent since its low back in April. An upturn in consumer spending and hiring has kindled hopes that this time Japan's recovery may be sustained, while its export-dominated stock market is expected to benefit from a global upswing.


However, for much of the year exports have been shrinking and although firms have reined in production in response to dwindling export sales, stocks of unsold goods have still been increasing. An upturn in overseas machinery orders - particularly for electronics - suggests the export outlook is at last improving. Moreover, the Japanese yen's 15 per cent fall against the US dollar this year - with the currencies of many of its Asian neighbours also tied to the dollar - should give a further boost to exporters.


Nevertheless, in the short term the inventory overhang is likely to weigh on growth as firms meet demand from their inventories rather than by expanding production. Hiring is also likely to suffer, undermining the pick up in consumer spending. Therefore, in the short term the economic climate remains very fragile and retail sales have already begun to cool. Nevertheless, further upgrades to profit forecasts mean that sentiment is upbeat. On balance, therefore, the Japanese stock market should continue its recent outperformance, despite the still uncertain economic climate.


One worry for investors is the danger that the pick up will encourage the Bank of Japan to raise interest rates too far, too quickly, strangling any recovery before it becomes established. The Bank of Japan has always said it would wait for deflation to come to an end before beginning to tighten policy, so the news that prices nationwide have stopped falling appears to bring Japan's first interest rate rise since 1990 one step closer.


However, the only reason goods prices have stopped falling is because of higher oil prices, while the prices of core services are still sliding. With deflationary pressures still persisting, it is likely to be late next year at the earliest before the Bank of Japan raises interest rates above 0 per cent. As a result, Japanese government bonds still look good value, even though 10-year yields are only 1.5 per cent, and should outperform government bond markets elsewhere. While the interest rate outlook is favourable for Japanese government bonds, it will continue to weigh on the Japanese yen. Moreover, with the currency still looking a little overvalued, the Japanese yen will remain under pressure.


Stable UK interest rate outlook saps the pound Ever since the Bank of England cut interest rates in August in response to the sharp slowdown in consumer spending, investors have been wondering whether or not UK interest rates have peaked.


The pound's fall from favour -- the currency has fallen 5 per cent against the US dollar since August -- and the recent lurch lower by 10-year government bond yields suggests investors increasingly think the Bank of England's next move will be a cut. However, the money markets are discounting no change in policy for the foreseeable future. The Bank of England's latest Inflation Report strengthened the case for an interest rate cut; the Bank still expects inflation to ease over the coming months, as energy prices stabilise, but it no longer expects inflation to reaccelerate again afterwards.


At the same time, the housing market continues to strengthen moderately and there are tentative signs of a recovery in consumer spending. In recent weeks, the department store chain John Lewis, whose weekly sales reports make it a useful lead indicator of sales across retailers in general, has reported a distinct pick up in spending, particularly on flat-panel televisions and other electrical goods. Moreover, there are likely to be several reasons why the UK's sustainable growth rate is likely to be lower in the future than in recent years. These include large consumer debt burdens, low unemployment and weak productivity growth to name but a few.


There are also signs that firms are using strong profits to strengthen their pension funds, rather than invest in new premises and equipment. As a result, there may not be that much slack to absorb stronger demand before the economy overheats and inflation reaccelerates. Consequently, the outlook remains very uncertain and policymakers are likely to leave interest rates unchanged for now.


But while consumer spending and activity in general may be recovering, the stock market is unlikely to reap that much benefit.


Despite strong economic growth, over the past decade the oil and financial sectors have accounted for all the UK market's profit growth.


The sharp fall in the oil price, therefore, will have a more noticeable impact on profits than any pick up on the high street and UK investment analysts are distinctly more downbeat than their international peers. Moreover, foreign investors continue to shun the UK market. The attractive valuation against bond yields looks sufficient to keep the market supported, but UK equities are likely to lag markets elsewhere.


The prospects look better for UK government bonds. The recent plunge in 10-year gilt yields to 4.25 per cent means that UK bonds do not look particularly cheap -- although they look fairly valued relative to equities. However, given the stable interest rate outlook, UK yields look good value compared to markets elsewhere. Euro zone yields remain an unattractive 3.5 per cent in comparison, even when underlying inflation rates are similar. With US interest rates likely to catch up and maybe even leapfrog those in the UK early in 2006, the pound looks likely to continue its slide against the US dollar. However, although sterling remains overvalued, the interest rate outlook appears sufficient to support it against most other currencies.


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