Fri, 02/06/2006 - 06:56
Equity markets have over reacted but are likely to remain nervous until the outlook for both inflation and growth looks a little more certain, says Barclays Global Investors chief economist Haydn Davies.
In recent years, a combination of low interest rates and buoyant economic growth has fuelled a speculative tide seeking ever more exotic investment opportunities. This has driven up emerging markets and pushed many commodity prices to record highs. As well as growing accustomed to abundant liquidity, the markets have come to expect policymakers to underwrite economic growth, cutting interest rates as necessary to boost activity. However, the Bank of Japan signalled the era of cheap money was drawing to a close when it indicated that it was preparing to raise interest rates.
There is also mounting evidence that inflationary pressures are beginning to build, so policymakers - particularly in the US - will be unwilling to cut interest rates at the first sign of an economic downturn. As a result, the environment has turned less favourable and speculators have rushed to take their money out.
It was not just the frothiest markets in gold, aluminium and emerging market equities that suffered as investors rushed to cut back their risk, but also developed equity markets and the US dollar. The dollar has waned in response to the growing evidence that the US economy is cooling and that policymakers may not need to raise interest rates much further. In addition, the prospect of weaker US demand coupled with a falling dollar has undermined sentiment towards the recoveries in Europe and Japan. However, with inflation accelerating, US policymakers will welcome a spell of weaker growth to keep the economy from overheating. Moreover, the economic upswings in Europe and Japan look in far better shape to weather any ill wind from the US than they have in years.
Anyway, growth in the US looks set to cool to a rate that would still be considered a boom in Europe. Equity markets may have lost the cushion of low bond yields, and the markets are likely to remain nervous until the outlook for both inflation and growth looks a little more certain. However, the underlying economic climate remains supportive, suggesting investors may have been too hasty and equity markets should cautiously recover the ground they have lost.
Don't write off the US dollar just yet Along with commodities and emerging market equities, the US dollar was quick to feel the turn in investor sentiment. The dollar's troubles began in late April. The communiqué issued by the finance ministers of the G7 Group of the world's seven largest industrialised countries called for greater exchange rate flexibility and coordinated action to reduce countries' growing trade imbalances. The statement was aimed largely at China and other Asian markets with large trade surpluses. However, investors also took the statement as swipe at the US' deficit with the rest of the world, which has now reached 7% of its annual economic output, as well as a tacit endorsement of a weaker US dollar. This perception was reinforced by the growing protectionist rhetoric emanating from the US administration in recent months.
The US dollar has also been undermined by the uncertainty over the interest rate outlook. Over the past two years, the Federal Reserve has raised interest rates 16 successive times, making policymakers' next move exceptionally predictable. However, with interest rates now at 5% (a level considered broadly neutral for economic activity) and economic growth cooling but inflation picking up, the interest rate outlook has begun to look a little murkier. Policymakers at the Federal Reserve have also sounded less sure of themselves, at first hinting that there might not be much need to raise interest rates much further, then suggesting that they still thought they had some work to do. The burgeoning evidence of a downturn led by the housing market also eroded support for the US dollar. However, with inflation looking a little less meek and new Fed Chairman Ben Bernanke feeling under pressure to bolster his inflation-fighting credentials, markets may have been a little premature in anticipating an end to the cycle of higher interest rates. As a result, the US dollar has begun to stabilise. Moreover, with the currency still enjoying a substantial yield premium over other currencies, the dollar does not look nearly as wounded as the doomsayers portend and appears well placed to stage a rally.
Nevertheless, with activity already beginning to slow, the Federal Reserve ought not to have too much extra work to do to take the heat out of the economy. The slowdown is still most apparent in the housing market, although April new home sales appear to have benefited from an Easter uplift. The National Association of House Builders reports sales are at their weakest in 11 years, while consumers polled for the University of Michigan's consumer sentiment survey report that it is currently the worst time to buy a home since the last slump in 1990. The downturn in the housing market is likely to spread in the months ahead, particularly as swings in new home sales have historically foreshadowed turns in consumer spending. At the moment, any slowdown looks set to be a mild one, sufficient to cool inflation but not trigger a recession.
With a downturn already underway, government bond yields are likely to stabilise following their steep rise in recent months.
However, the more moderate economic outlook is not very promising for Wall Street and most economic indicators recently have failed to meet even economists' downgraded forecasts.
Investment analysts have also become more cautious about the profit outlook. As a result, Wall Street looks likely to lag other equity markets.
Europe's economic upturn not jeopardised by weaker dollar European markets suffered particularly heavily during the shakeout in world equity markets. With activity such as industrial production and retail sales failing to quite live up to the surge in some surveys of business confidence, sentiment towards the euro zone markets had already begun to wane before global equity markets began to tumble. Moreover, the European Central Bank had once again asserted its vigilance on the inflation outlook, a hint that it is preparing to raise interest rates at its next meeting in early June. This raises the possibility that it could be so anxious to return interest rates to a more neutral footing that it stifles the recovery before it has really started. The appreciation of the euro against the US dollar, therefore, has only compounded the sceptics' fears that the economic upturn may not live up to expectations.
Although the US dollar's slide will dampen export orders, the UK is the euro zone's most important market, not the US. The euro has remained fairly steady against the pound and while activity has started to cool in the US, it has begun to reaccelerate in the UK. While activity has failed to match the leap in the most optimistic surveys of business confidence, growth has picked up as surveys of new orders and business confidence in general would have predicted, contrary to widespread perception.
Industrial orders have risen almost 10% over the past year and are still accelerating, while unemployment has fallen to 8.1% of the workforce, just a shade above its low of 7.8% reached in 2001.
Together with a pick up in consumer confidence, therefore, the economic indicators suggest the recovery is on track -and continues to favour European equity markets. However, growth is likely to peak in the autumn. With investment analysts also very upbeat on the profit outlook, European equity markets should resume their outperformance.
The upbeat economic climate and the prospect of further rises in interest rates are the main factors in favour of the euro at the moment. However, at the current exchange rate the euro looks overvalued and strong commodity prices, already undermining business confidence, are also an impediment. This suggests that the euro is likely to give up a little ground. Long-term bond yields also look too low as inflation is nudging higher and euro zone bonds are set to continue underperforming other government bond markets.
UK economic outlook brightens Ever since late 1996 when, in the space of 12 months, the pound surged 20% against the currencies of its main trading partners, the UK has been saddled with a two-speed economy. Consumer spending and services have boomed, while manufacturing output stagnated as it was crippled by the strong exchange rate. In recent months, consumer spending has remained subdued, despite the pick up in the housing market, while manufacturing activity has begun to look noticeably healthier. The improvement in the fortunes of the manufacturing sector reflects stronger demand from Europe. Exports have jumped 8% over the past year, their fastest rate of growth since the technology bubble imploded in 2001, as activity in the euro zone accelerated. Policymakers would dearly like a more balanced economy, fuelled less by rising consumer borrowing and booming household spending, but boosted by stronger business investment and a more buoyant manufacturing sector. However, while manufacturers are enjoying a brief export-led revival, the longer-term outlook remains more downbeat. In particular, a lack of investment continues to hamper productivity and competitiveness, such that unit labour costs - the cost of producing one unit of output - continue to outpace those of the UK's main competitors. UK unit labour costs have risen 3% over the past five years, while US and German manufacturers have cut their unit labour costs by 3% and 7% respectively.
With the economy set to remain dependent on consumer spending, the better news is that household spending has begun to recover from its winter slump. However, the improvement in the housing market appears to be rolling over with mortgage approvals beginning to wane from their currently very high levels and house-price inflation failing to accelerate from its current 5% rate. So although household spending should strengthen further over the summer - boosted by the World Cup - any upturn is likely to moderate quickly. Nevertheless, the more upbeat economic climate should bolster the pound. Last month, one member of the 8-strong Monetary Policy Committee, former Goldman Sachs UK economist David Walton, voted for an interest rate rise, the first vote for a hike since May last year. With UK interest rates already attractive, the pound is unlikely to weaken just yet. The economic climate, though, remains more favourable elsewhere, suggesting that UK equities will underperform other equity markets despite a raft of upgrades to UK profit forecasts, especially given foreign investors continue to shun the market. At least the UK stock market still looks more attractive than government bonds, with profitability supporting valuations.
Japan's recovery loses its lustre Last year the Japanese economy grew 3.25%, its fastest rate of growth since 1991 and if economists are right the economy will grow another 3.00% this year. In addition, although economists are still upgrading their economic projections, the recovery looks as if it is beginning to lose a little momentum. Activity has continued to strengthen in recent months but since the end of last year, most economic indicators have failed to meet economists' forecasts.
Prices have stopped falling and bank lending is growing again while retail sales, employment, activity in the service sector all continue to grow at rates not seen for more than a decade. But with the exception of exports, which are booming, growth is no longer accelerating - activity in the service sector and industrial production are lower than they were at the start of the year.
Activity in Japan tends to move in fits and starts, so it may be that the economy reaccelerates in the months ahead. However, with the prospect of the Bank of Japan raising interest rates looming over the market, together with the stronger yen, the economic climate has turned against the stock market and Japanese equities are likely to drag their heels.
Despite the less upbeat economic climate, Japanese bond yields are likely to continue accompanying yields elsewhere higher.
Although the money markets expect the Bank of Japan to raise interest rates to 0.5% by the end of the year, 10-year yields at 1.9% make ample allowance for tighter policy and offer a substantial premium over inflation. As a result, Japanese government bonds remain better value than their peers elsewhere. With the Bank of Japan expected to hike interest rates only very gradually, the Japanese yen remains weighed down by its low yield. Despite improving sentiment, therefore, the currency is expected to lag.
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