Tuesday, 24 June 2014


Putting aside the drama of the football world cup (if that's possible!?), the week was characterised by two big stories; 1. Renewed concerns about energy supply disruption due to Iraq and the Ukraine; 2. The US central bank's policy setting Open Market Committee (the Federal Reserve's monthly meeting) left interest rates unchanged, continued to reduce additional monetary support, and downgraded their 2014 growth forecast.

Perhaps surprisingly over the week, equity markets rallied, reversing the last week's decline, and pushing some indices to new all-time highs. Markets seem to be pretty resilient, driven by continuing strong economic data flow and a lack of alternatives for investors (!) in light of continuingly low return perspectives on less risky investments.

The Iraq situation deteriorated towards civil war and Russia finally reduced gas flow to the Ukraine (and thereby the rest of Europe) because of massive outstanding payments. The resulting concerns over global energy supply security pushed oil prices up a good 5%.This is less than might have been expected; Europe has built up a gas reserve approximately equalling a year's supply from the pipes crossing Ukraine. Meanwhile, there seems to be a general expectation that the ISIS/Sunni forces in Northern Iraq will be stopped in their advance into the Shia-dominated oil producing areas. It is reassuring to see markets react relatively calmly. Still, the spread of the sectarian violence beyond the Syrian civil war into the wider Middle-East is an increasing geopolitical risk with the potential to disturb 2014's upsurge in the global economy.

After their meeting, the FOMC's written statements went down reasonably well. The Fed chairman Janet Yellen's comments in the press conference were received particularly positively.

While remaining confident about the US continued economic recovery, she noted that wage inflation remained "very low" at 2%. Markets took comfort in the expectation that, while short-term rates may rise, long-term monetary conditions will remain accommodative. With the impact of the US's cold winter on the first half of the year, it was no surprise that overall 2014 growth forecasts were reduced. The Fed still expects growth for the remainder of 2014 to continue at strong (weather-unaffected) levels. Indeed, the Fed's own expectation for the timing of first rate rise is now more hawkish (read: earlier) than the markets had priced before the meeting. This is a reversal of last year's situation, when the Fed guided that the first rate rise was likely to be later than the markets were anticipating. It appears that, as is often the case, markets have overshot the target on the other side now.

I see the Fed's communication as being similar to the Bank of England governor Mark Carney's Mansion House speech last week; an attempt to discourage credit being offered at too low a rate over the short term (0-3 years), while ensuring that longer-term rates (5-10 years) still stimulate capital investment. Both US and UK central banks seem to be concerned that cheap short-term money could rekindle market behaviours that led to the 2008 financial crisis. It is good to see our central bankers being proactive, which should help to bring stability over the medium term.

Of course, there is still potential for some volatility in risk assets over the coming months as investors try to get their heads around the confusing environment of strong economic growth accompanied by an unusually supportive monetary environment. Of particular interest for us, when looking at the overall construction of a client's portfolio, is the relative value of asset classes. Corporate bonds look increasingly expensive, driven by the huge base of captive "bond-only" investors and their need for extra yield. They now offer little incremental return over safer government bonds. Of course, this situation may remain for some time; if so, corporate bonds would outperform government bonds, albeit by a small amount. Whether that extra return is enough to pay for the extra risk is the question.

In other news this week, investors in Japan welcomed the Abe government's announcement of a 'third arrow' for their economic development program. Unlike the first two 'arrows' which were single initiatives, this was an array of smaller initiatives. It was greeted positively, despite being an attempt to change engrained Japanese company and individual behaviours. Getting companies to invest their cash piles and more women into work are worthwhile structural measures and can have big impacts, but such things take a long time to feed into the economy.

The prospect of another default by Argentina on its government debt somewhat unsettled emerging markets. In fact this episode is a remnant of the previous default and so Argentina shouldn't be in major trouble; it's a legal wrangle over the way the previous debt-restructuring, agreed by the majority bond holders, dealt with the rights of individual (minority) bond holders. Still, it will be important to watch this space – not so much because of Argentina – but because of the precedent it sets for restructuring processes in general, and the potential it has to add to future emerging market problems.

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