Investors hold their nerve as geopolitical tensions deepen

Investors have held their nerve this week, even as geopolitical tensions appeared to deepen. Markets drifted along and traded within a fairly compressed range, but they remain within touching distance of all-time highs. The US continues to deliver solid economic data and comments from central bankers remain supportive, however reports from the Ukraine suggest that Russia now has troops operating across the border and this marginally dented optimism.

Investors now appear to be waiting for the next catalyst that could propel markets higher. Some believe that catalyst could come as soon as next week, as anticipation is growing that European Central Bank President Mario Draghi is set to go on the offensive and introduce a range of new tools to help bolster growth and raise inflation expectations across the continent. The Eurozone saw its inflation rate fall further in August to a fresh five-year low, of just 0.3% on an annual basis.

Another potential spark could come from the technology sector, which is gearing up for the world's largest consumer electronics show in Berlin next week. Expectations among technology enthusiasts are already running high as new products get set to arrive in time for Christmas. 

The increase in geopolitical tensions is concerning and in many cases truly tragic, but these incidents do not seem to be enough to unsettle the building economic momentum, particularly in the US and UK. Durable goods orders in the States jumped by the most on record and consumer confidence climbed to a seven-year high in August. This provides further evidence that the world's largest economy continues to strengthen.

The US Federal Reserve has stated that it is committed to supporting the ongoing recovery, even as its monetary policies are returning to normal. Here in the UK, the Bank of England is likely to be the first of the big central banks to increase interest rates. However, we think that there could now be enough evidence to suggest that the timing of that first rate rise might get pushed back a little given that the housing market is cooling off, inflation is sitting below target and real wage growth remains weak. 

Overall, we believe that there are plenty of encouraging signs that growth is improving and this is likely to benefit companies around the world. Ultimately, this should result in higher profitability and increased investment, which can help underpin the current positive momentum.

DISCONNECT IN GLOBAL ECONOMIC PROSPECTS

It has been another record setting week for equity markets. Despite summer normally being known as a 'quieter' period, the S&P 500 hit a new high, while bond yields retreated on the expectation that Federal Reserve Chair Janet Yellen would deliver a dovish assessment of US economic growth prospects

Summer trading volumes continued to be light, but that does not take away from the fact that investors appear to be in an optimistic mood and are increasingly favouring risk assets like equities. Corporate bond markets also moved tighter, relative to government bonds, but they remain more restrained than stock markets. Gold moved lower, falling 2% on the week and is crucially back below $1,280 a troy ounce, even as the US dollar fell on broad weakness (due to the strength of the Euro). US government bonds declined in the face of the strength of equities, with the 30-year yield down 3 basis points and the 10-year yield hitting around 2.4

Now that we have moved into the second half of 2014, it is becoming increasingly evident that different parts of the global economy are moving at different speeds. On a global level, the forward looking indicators are suggesting a further period of expansion is ahead, albeit within a fairly compressed range. However, the divergence in prospects for the US, UK, China, Japan and Europe could not be more clear. Purchasing Manager Indices show that the US and UK are powering ahead, while China looks to be re-accelerating as a result of stimulus measures and mildly accommodative monetary policy.

In contrast, the fortunes of the Eurozone and Japan appear more mixed. Japan has now essentially recorded almost no growth in GDP over the past year, as consumers come to grips higher sales taxes and businesses are seeing sluggish volume growth in exports, although a weaker Yen would provide a solid boost. Growth also seems to be elusive for the Eurozone, with countries stagnant or in outright recession. It is possible that the sanctions European leaders put on Russia could further dampen prospects in the near-term. Countries that have higher leverage to the Russian market are already calling for a moderation in the sanctions, as their economies are seeing export demand plunge and prices drop as supplies of agricultural produce, flood the market. German banks remain undercapitalised and their balance sheets loaded with sovereign debt, so any potential quantitative easing programme would need to be mindful of this fact

At some point, either European governments or the European Central Bank will have to bite the bullet and launch large scale structural economic reform (governments) or some form monetary stimulus (ECB), or potentially some combination of the two. All of the current ECB actions appear to have been designed to buy time and allow governments to enact structural reform. Italy's new youthful Prime Minister, Matteo Renzi has a large opportunity change the country for the better. Until some significant action occurs, the Eurozone may bumble along, flirting between mediocre growth and recession, like Japan did for nearly 20-years and this might act as a drag on the wider global economy.

TIME FOR A CHANGE OF STRATEGY

This week it felt like August picked up and continued exactly where July ended – geopolitical events overwhelming the positive macro-economic news front and driving equity markets lower. The one positive to record is that Israel ended its offensive in Gaza and US president Obama agreed to provide air strike support to Iraq to prevent the ISIS' extremists from further massacres of non-Muslims

The global capital markets media homed in on Russia's counter sanctions as the reason for the continued market sell-off. I would beg to differ and see these geopolitical tensions as the catalyst for the rout at this moment. I see the equity market weakness more generally as a precursor to this economic cycle entering a period of rising interest rates. In the past, during such periods of rising interest rates, equities (and bonds!) have sometimes suffered sustained losses, when central banks misjudged the strength of the economic momentum and rather than cooling it down to prevent overheating, have prematurely choked it off through too fast and large a rate rise, causing recession. This is what market participants are currently most frightened of. 1993/1994 was one of those relatively rare negative occurrences of such policy errors, whereas normally the economy continues to expand (and in its wake equities) while interest rates are slowly adjusted upwards from a post-recession level back to more normal long running averages. This time around one could argue that last year's 'taper tantrum' of parallel equity and government bond value declines was this cycles' 'rate-rise-prospect-wobble'

However, I have to admit that quantitative easing (QE) on top of extremely low interest rates make the onset of monetary tightening (interest rate rises) in this cycle particularly unnerving for market participants. As a result I am observing what can only be described as policy error paranoia. Despite the US and UK central banks continually reassuring markets that they will not prematurely raise rates, the market chatter and action in this respect has been relentless. I take comfort from the macroeconomic and company results news flow, which tells us that the economy is steadily expanding with increasing momentum and companies are able to improve their results. Last year we saw equity markets fret the beginning of the QE reduction (taper), but when it actually began they moved on and actually rallied substantially following the announcement (just before Christmas). It is possible that the first actual rate rise may have the same effect, but on the basis that history never quite repeats itself exactly it is just as possible that markets move on earlier. In this regard we observe that shorter term yields rates have already gently moved up in anticipation of an also gentle rate rise, which is a far more proportionate reaction by the bond market than the indiscriminate and sudden upwards jolt of the yield curve over the taper tantrum last year

Matters like these were discussed at length this week in preparation and during Tatton's monthly investment committee meeting. The outcome of this comprehensive review of the medium term economic prospects and anticipated market reflection has resulted in a decision to adjust the fixed income investments of the Tatton portfolios to take account of the anticipated environment ahead. In summary we have come to the conclusion that as a consequence of the past years' desperate search for yield of so many investors, corporate bonds have now reached a level of overvaluation as we previously experienced with government bonds at the beginning of 2013. The distinct difference between government bonds (gilts) and corporate bonds (investment grade, high yield and junk bonds) is that gilts only carry yield curve risk (that yields will rise and fall), whereas corporate bonds additionally introduce an element of company risk exposure, which is akin to stock market risk. It has become all but consensus that the yield uplift corporate bonds provide in return for the additional company risk is now so low that the combination of the underlying components or government bonds (yield curve) and a smaller proportion of equities (corporate) generate a very similar risk characteristic, but at the moment with a much improved return profile. So while we have avoided government bonds for the past 18 months, we are now reintroducing them to the portfolios. After the gilts value declines of 2013 we now see a much reduced capital loss risk in them over the medium term, while they once again provide their extremely valuable risk counterbalance to stock market investments

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

As discussed in last week's edition, portfolio orientations which add value over the medium term, can sometimes lead to the opposite results over the shorter term, while day to day markets gradually oscillate between fear and greed towards a more rational valuation level. I am therefore bracing myself for the potential of some pain before the gains can be enjoyed. I so wish it was possible to refine the timing of these moves, alas, where short term developments are dominated by human emotions rather than the laws of natural science, only the investor for the longer term will look through the short term fluctuations as a necessary evil on their investment path. At Tatton, we are convinced that over the next 12 months it is a larger risk to long term returns to be underinvested in equities, than it is to be invested. In the shorter term this conviction may well initially face some testing times.

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.

UPWARDS JOLT(S) FOR GLOBAL STOCK MARKETS

The second quarter of 2014 ended with positive, albeit somewhat pedestrian investment returns. For UK investors, the rise in the value of £-Sterling by a near double digit rate, took some of the shine off overseas investments. Year-to-date (Ytd) lower risk, fixed interest investments have still generated slightly higher returns than higher risk equity investments.

This is very much at odds with last year's picture, when equity dominated investment strategies outperformed fixed income strategies at a rate of 3:1. Despite this, the first days of the new month and quarter have seen a surge in stock markets around the world as various economic news items persuaded investors that equities may have more upside potential than recently thought. On the one hand much improved industrial output and falling unemployment figures in the US and UK provided more evidence that the Q1 slip was indeed caused by adverse weather and not a reversal of sentiment. Just as important for market dynamics were comments from 3 of the 4 major western central banks (US, Eurozone, UK), that they would not let excessive market valuations dictate monetary policy for the real economy. I.e. they would not raise rates even if perceived asset bubbles started to build. Markets would have to deal with the volatility they seed and central banks would use their macro prudential intervention tool sets (E.g. mortgage restrictions et al) to prevent turbulence spill over from becoming a systemic threat for the financial sector. What felt like a concerted action by the central bankers (which probably was not), combined with the reassurance of the sustained growth scenario acted as a jolt for the lacklustre stock markets of late. US stocks hit new all-time highs while UK and Eurozone markets reclaimed previous 2014 highs. Central bankers may have felt obliged to clarify their position after the Swiss based Bank for International Settlements (BIS) called for a hike in interest rates. This was to prevent further asset price increases, which they see as being driven by the continued low interest rate and QE driven monetary environment. The BIS is often portrayed as the 'Central Bank of Central Banks' although it's role is more that of a global central banker association rather than having meaningful authority towards national central banks. The BIS has changed tack from warning about the inflationary pressures of QE to warning about the destabilising potential of asset price inflation. With deflation currently being the far more relevant issue, it feels as though we are witnessing a growing divide between 'Germanic' and 'Anglo Saxon' central banking perspectives. From my standpoint I side with the 'Anglo Saxon' side, with a focus on getting the real economy properly back on the growth track, while using regulatory oversight measures to reign in potential excesses in the financial sector. To be clear, the 'near death' experience of the 2008/2009 Financial Crisis is in my opinion likely to prevent bank excesses for the foreseeable future on its own (See UK banks own mortgage tightening long before the BoE became active). The so called shadow banking sector of credit and loan securitisation for investment by the general public is a slightly bigger concern, because the decision makers here are not finance professionals. It is therefore not surprising that the US Fed's chair Janet Yellen singled out leveraged-loan debt securities and corporate bond valuations as areas where macro prudential oversight measures may be used to prevent potentially destabilising market developments. 

To summarise: As the expansion of the global economy picks up momentum again, company earnings will improve which helps justify higher stock market levels and thereby investment portfolio gains. As a side effect and late rumble of the financial crisis, the unusually low interest rate levels at this stage of the cycle, have the potential to confuse valuation measures compared to the very straight forward metric just mentioned. This is highly likely to result in more volatile asset prices than we are historically used to. Temporary overshooting and undershooting within the longer term positive trend of an expanding global economy is going to be an on-going market characteristic for the foreseeable future. Itwill be quite risky to anticipate and even out from a portfolio management perspective. At Tatton we will do our best to steer client's investment portfolios through these choppy markets, but have to advise that investors are likely to have to withstand having to bear more short term ups and downs in order to reap the longer term higher return rewards of capital market investments, than they may have been historically used to.

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BANK OF ENGLAND GETS DOWN TO BUSINESS WITH UK HOUSE PRICES

Equity markets retreated slightly during the past week as the second quarter of 2014 draws to an end and investors are nervously awaiting whether the Q2 economic results will have made up for the poor winter quarter. Meanwhile the big news for the British public was (not football) that UK's central bank, the Bank of England (BoE) walked the talk and introduced what we had been expecting for a while: A set of direct mortgage lending restrictions on banks, with the objective of slowing the further rise in UK residential property prices without having to begin raising interest rates. The restrictions will only apply if house prices continue to rise at a rate which would amount to more than 20% over 3 years (roughly 6.3% p.a.). Mortgage lenders would then not be allowed to lend more than 15% of their mortgage book to mortgagees where the LTI (loan to income ratio) exceeds 4.5%. They will also have to make sure borrowers would be able to afford a 3% rise in mortgage rates from their discretionary income component. On the basis that not a single lender currently breaches these limits, they are more a message and warning from the central bank, than an outright market intervention. However, I noted with great interest the threshold level of an additional 3% for the mortgage affordability stress test. This strongly suggests that the BoE is not expecting that they will be raising interest rates above 3.5% during this economic cycle – well below the long running average of 5%. During a BBC Radio4 interview on Friday morning the bank's governor Mark Carney became even more explicit and said that their expectation was for interest rates not to exceed 2.5% at the end of the cycle. The implication of this is that the public's rate expectations are probably too high, while the markets are potentially now for the first time underestimating the potential for rate rises over the coming years. This would also explain what seemed to many observers as confusing and apparently contradictory statements by the bank's governor Mark Carney over the past 2 weeks (more on this below).

I was delighted to learn that UK business investment is further accelerating, exceeding last year's levels by a strong 10.6%, having now grown for a consecutive 5 quarters back to pre-recession levels. Reviving business investments into productive capital is very important for the longevity of this economic cycle and I have stated since the end of last year that only a meaningful pick up in company investment will extend this recovery into a meaningful expansionary cycle in which equity valuations can gain far more headroom than they have had so far. Economic news flow in the US continued to be strong for the current environment, which is to some extend a catch-up and rebound from the economic contraction the frozen out first quarter produced. Europe has no such excuse and the fact that the recovery there has begun to lose momentum, gives me hope that the Eurozone's central bank (ECB) will pick up the courage and engage in similar extraordinary monetary support that has lifted the US and the UK out of recession. This will be good for the Eurozone economy and by virtue of our high trade volumes also provide a further boost to the UK – watch this space! 

US FED WEEK

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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