ECONOMIC AND MARKET OVERVIEW
AFTER a sharp rally from the lows at the end of June, developed world equity markets have now more or less recovered their year highs. Bonds, however, have yet to regain their poise, with gilts remaining close to 6% below their all-time high of May 2.
After the shake-out from the first intimations of tapering, risk markets have rallied. Can they sustain this performance through the summer? With tapering of QE in the US possibly beginning in September, will bonds fall, or equities rise?
On balance, the world economy is showing signs of resilience, which will moderate the degree of liquidity provision and hasten the advent of the aforementioned QE tapering. This may once again cause some volatility. But conditions remain generally sub-par: excesses are not fully worked through, and some of the recently more encouraging areas, such as US housing, are already flashing some early warning signs; refinancing activity plunged as 10 and 15-year bond yields rose by around 100 basis points (bps) in just two months. So we continue to expect such episodes of volatility.
Just as the recovery has ground gradually higher, pulling risk assets with it, so the normalisation of interest rates will be a glacial affair, punctuated – like the great glaciations of the Ice Age – with warmer inter-glacial periods, where investors will likely find the ride uncomfortable.
Company earnings for the first half of the year have been rather encouraging, with earnings per share (EPS) growth, and some useful dividend increments. While valuations in equities appear rather less attractive at these levels, the impact of the incremental returns that shareholders are gleaning from this growth, along with share buy-backs, ensure that they are not especially stretched. And the pull-backs we have seen in some of the quality names we like, have provided opportunities to pick up stock at more attractive levels.
Investors have been rotating into the more cyclical sectors with financials performing strongly during July along with industrials and technology hardware, following the becalming of markets after central bank comments highlighting any tapering of QE would be measured. Spain and Italy were the best performing local indexes after posting low double digit returns and the UK has also seen a robust return of more than 6% outperforming the S&P 500 (5.1%). Emerging markets continue to significantly lag the broader rally, as economic conditions have weakened and investors’ geopolitical, economic and currency concerns prevail. India slumped -2.1% and Brazil continues to struggle -1.5%. Elsewhere, Japan (1.0%) and Mexico (2.0%) performed poorly and South Africa’s (4.7%) monthly return was in the middle of the road.
Bond markets also recovered well in July following significant weakness across most bond asset classes in May and June. A concerted effort by central bankers to make more clear the distinction between the potential near-term tapering of QE in the US, where the traction on growth appears more solid, and the lower likelihood of near term rate rises in any of the US, UK, Europe or Japan assisted in seeing government bond yields and spreads on credit products move back to lower levels in July.
In the US, the Fed has made it explicitly clear that the timing and extent of QE tapering is very much dependent upon the incoming economic data. In fact, the latest Fed statement, on July 31, highlights particular reasons to be cautious; lower than desired inflation and risks to growth from higher mortgage rates. US Treasury yields are likely to remain volatile, and in a higher yield range than for much of the past year, as each important data point is scrutinised in ever greater detail over the coming months by market participants.
In the UK, all eyes remain on new governor Mark Carney and his colleagues at the Bank of England for any new policy direction. While they have eschewed more policy accommodation at Carney’s first two meetings, gilts are likely to be supported on a relative basis from anchoring of rate expectations and the technical supply/demand imbalance in August in particular. Inflation linked bonds offer relative value, in the anticipated environment. Recently announced regulations substantially enhance the likelihood of tenders/calls of non Basel 3/Solvency II eligible bank and insurance bonds. Inflation linked bond exposure could do well against a background of low global interest rates and improving economic growth. Emerging market bonds and currencies have proven to be much more volatile than anticipated recently, but we expect that with contained global interest rates and a higher starting point for yields, that valuations now look attractive.
The period of loose money is likely to continue for longer than generally appreciated because of the fragile state of economies in the developed world.
Short-term interest rates will remain low until a significant pick up in economic growth and employment.
While equity markets have risen, they are no longer so cheap against bonds, but the equity yield still remains attractive against 10-year gilts.
Charles Nicholson is head of the Newcastle office for Sanlam Private Investments
The views expressed above are based on information which we believe to be reliable, but are not guaranteed as to accuracy or completeness by SPI, and any expressions of opinion are subject to change without notice. This article is for information purposes and should not be treated as advice to buy or sell any particular investment.