EUROPEAN BANK CONCERNS WEIGH ON MARKETS

Investors have been treated to a game of two halves this week. On the positive side the underlying economy continues to make progress, with the US and UK as standouts. However, on the negative side investors became concerned that we could be seeing the re-emergence of the Eurozone banking crisis. However, we have good reason to believe that these fears are overdone and markets somewhat stabilised later in the week as cooler heads prevailed.
We think one of the biggest plus points was that we now know that the US Federal Reserve plans on ending the tapering of its quantitative easing programme by October this year. We see this as an encouraging sign that the world's largest economy appears to be well on the path to returning to normal. Back in the UK, a new report from the British Chambers of Commerce [BCC] revealed that company bosses believe that the underlying economy is still improving and continues to move in the right direction, however, they signalled that growth may moderate from its current strong pace. We believe that slower but still robust economic growth actually helps to ease the pressure on Bank of England Governor Mark Carney to hike interest rates earlier, which could put at risk some of the progress made so far.
Events in the European banking system put a dampener on things, after Portugal's second-largest bank missed a repayment on its bonds. Investors reacted quickly and markets sold off, but we believe that fears over further bank contagion are overblown and the three factors highlighted below detail why we think this to be the case (more detail can be found in Background to Latest EU Bank turmoil below)

1. Portuguese bank assets account for 'just' 1.6% of the Eurozone financial system
2. Exposure of foreign banks to Portugal remains low
3. European Central Bank [ECB] guarantees remain in place, ready to assist firms in need of cash [or liquidity]

Stock markets recovered some ground towards the end of the week as investors further digested the news. Ultimately we think that the positives of the global economy will start to shine through with greater clarity over the longer-term. With the second-quarter earnings season upon us, the picture in Europe looks to be generally stable, along with a moderately weaker Euro. We think European companies will be broadly in line or perhaps even slightly better than some are anticipating. Whilst over in the US the consensus is calling for around 8% growth in earnings, but we believe that given improvements in consumer and business activity, that we may even see a decline in uncertainty, which may benefit investments for growth, along with mergers & acquisition activity.
The UK economy has been one of the stars of the ongoing global recovery, with rates of growth that have at times exceeded global peers. Encouragingly – in a strange way - the pace of growth looks set to moderate, after a strong surge in the first quarter, yet it should still remain stable in the second quarter. This should help ease the previously mounting pressure on the Bank of England to hike interest rates even as early as the end of 2014.
A new report from the British Chambers of Commerce [BCC] that surveys over 7,000 UK businesses suggests that company bosses believe that the economy remains strong and continues to move in the right direction, but some indicators point to a slight softening in the services and manufacturing sectors, following the strong pace seen in Q1. The BCC were keen to stress that the domestic banking system still needed more unclogging and further work to allow it to provide the loans that businesses need to finance themselves and any expansion plans they may have ready to go when the timing looks right. They warned Bank of England Governor, Mark Carney, not to make any 'hasty decisions' on increasing interest rates in the short-term.
The BCC said that any early rate hikes could drive up the cost of obtaining finance and crimp the 'growth ambitions' of fast growing firms, the very same businesses that the economy is counting on to help drive growth forward. The BCC believes that Mr Carney's priority should be ensuring that companies have the 'security of working in a low interest rate environment'
Another area singled out by the BCC was that of the strength of sterling, particularly for its impact on making British exports more expensive overseas. Talk of earlier than anticipated interest rate rises has led to the Pound being one of the best performing major currencies around the world.
We think two of the key things the Bank of England will be monitoring closely will be that of inflation and earnings. Inflation has currently moved below the long-term target and wage increases have clearly turned positive, but earnings growth still lags that of the rate of inflation, which may mean that Mark Carney is under less pressure to increase interest rates sooner rather than later. An early interest rate hike could act to dampen consumer demand and dent optimism at just the time when businesses are beginning to feel secure enough in the underlying economy to start expanding their firms in a meaningful way and we think this would help underpin economic growth over the long-term.
We believe that the Bank of England will take some comfort from this latest survey. We note that whilst UK economic growth has been relatively strong compared to its global peers, it does not appear that the country has reached the 'escape velocity' that may warrant higher interest rates just yet.