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Broadgate: Weekly Briefing 23/7

23 July 2013

“Big Three” Economic Moves Could Have Global Impact – In the past few years, economists and investors have called for the following actions from the world’s three biggest economies:

• The U.S. should stop printing so much money.

• Japan should print more money.

• China should get speculation under control.

As the saying goes, be careful what you wish for.

The U.S. Federal Reserve has suggested it may begin to phase out quantitative easing, Japan is printing money at a great pace, and China appears willing to risk an overnight lending crisis to flush out speculation.

The collateral damage from such actions to emerging markets should come as no surprise. A strong dollar is fuelling domestic inflation in emerging markets, while a weak yen is blunting what would otherwise be a clear win for emerging-market exports. Any slowing of growth in China would put downward pressure on commodity prices, which would likely depress emerging-market growth.

Developed nations may be affected as well. The U.K.’s recovery is particularly tenuous—manufacturing unexpectedly shrank in May—and the recent rise in rates provoked by the Fed’s move toward tapering QE hasn’t helped. Western Europe is in the same boat.

But the greatest risk to the global economy is that the policy actions of the U.S., China and Japan could fail. A success in the U.S. appears, at this time, the most probable of the three. Economic indicators are moving in the right direction and the Fed has clearly said that it won’t pull back any stimulus unless the economy is strong enough. China’s ability to orchestrate a soft landing to a slightly slower growth rate is far less certain. And the jury is still out on Abenomics in Japan, where failure could leave the government with an insurmountable debt problem.

The best-case scenario would be reasonable and sustainable growth in the developed world and China along with modest weakness in emerging markets. Any alternative could be a lot worse for the big three and the entire world alike.

Where Has The Inflation Gone? – Bond markets entered June in some disarray, and none more so than US Treasury Inflation-Protected Securities (TIPS).

Although the sharp rise in real yields has been attributed to all the talk of the beginning of the end of US quantitative easing, the real cause has been the rapid disappearance of inflation in the US.

Falling inflation has been a global theme. Between January and April the pace of price increases in the US has fallen by around 0.5 percentage points; the same move down has been seen in Sweden, France, Italy and the UK. In Japan prices are still falling 0.7% per year even though the new premier has told the Bank of Japan to deliver 2% CPI.

The OECD measure of inflation in the G7 shows prices are rising by just 0.9% year on year, the lowest reading since November 2009. A year ago the figure was over 2%.

Outside the US the focus is understandably more on anaemic or absent economic growth. Posting performance the rest of us just dream of, the US saw its economy expand by 2.4% in annualised real terms in Q1. This appears to be an economy well on the way to normalisation.

Why then is inflation running at such low levels? The reason is in part the sharp weakness in oil and clothing prices as well as falls in air fares, all driven by faltering global demand. With food and energy prices still falling, the downshift looks set to continue.

Central banks have all been following the script drafted by Ben Bernanke in 2002. Back then he was explaining how to avoid falling into a Japanese-style deflation trap; he has stayed on message. Nonetheless after several years of extreme monetary accommodation and the recovery of animal spirits in financial markets (at least until very recently) the deflationary pressures are as intense today as they have been at any time since the market seizure of 2008/09.

Against this backdrop all talk of reining back monetary policy in the US seems premature. In truth, and given the sustained loss of inflation in the US, one could easily ask why the US Federal Reserve is not redoubling its monetary efforts.

The monetary largesse still represents latent inflation – a huge well of buying power for a limited supply of goods and services in the future. The risk for investors remains, inflation expectations are once again buoyed by central bank actions and, in the wake of the recent market turmoil, they deem physical investments a better store of wealth than financial assets.

Investor Sentiment: A Tale of Two Sides – Investor optimism has improved over the past six months and UK and international shares in particular have become more attractive investment prospects. Demand for UK shares has increased by 12 points since the start of the year meaning it remains the most popular investment class, according to data provided by Core Data’s i-Sight survey.

International shares saw the biggest surge in investor appetite at 14 points, putting them one point behind UK shares in terms of investor confidence.

Sentiment towards property increased seven points, but remains negative overall, while alternatives inspire the least confidence, with a negative sentiment reading of -17 points.

The MENA and Eastern European regions remain the least attractive regions, while BRIC lost eight points during the first half of the year as confidence in India dropped by three points. Despite the its stuttering economy, sentiment towards China remained unchanged.

Global and Asia Pacific ex-Japan both recorded a small increase in sentiment, while Latin America consolidated some of the gains it made in the first half of the year, adding two points to the 24 it had gained at the start of 2013.

All nine IMA sectors have seen a fall in sentiment during the second half of 2013. UK Equity Income was the most popular sector, but a 12 point fall in sentiment has seen it drop to second place behind UK Equity Income & Growth.

Sentiment towards bonds and fixed interest has continued its decline, which has worsened following the US Federal Reserve’s QE announcement last month.

Spotlight On: Developed And Emerging Market Growth Going In Opposite Directions

While global growth in Q2 looks set to considerably outdo that of Q1, we are starting to see a divergence between the growth forecasts for developed and emerging countries, points out Andy Brunner, head of investment strategy and asset allocation for Morningstar OBSR.

Global growth in Q1 was 2.5% though growth in Q2 is expected to push towards 3.25%. However, Brunner says: “What is clear, however, is a growing divide between the developed and emerging economies with a number of the former countries seeing definite signs of improvement while the latter have experienced downward revisions to growth forecasts virtually across the board.”

He cites the reason for this as a combination of the Federal Reserve signalling the gradual end to QE that has tightened global financial conditions largely through higher bond yields. At the same time China continues its own reform path and is content to see growth fall from close to 8% in Q4 last year to 7.5% in Q2 this. “A number of EM countries were already facing domestic difficulties, including some of the largest such as Brazil, India and Indonesia, and recent capital flight has only added to bond market and exchange rate volatility,” he added.

The end result was that by the end of June, most fixed income markets had seen losses as yields on corporate and government bonds rising. The Bank of America Merrill Lynch Global Broad Market index recorded a loss of 1.4% in June, concluding the worst quarter on record. All types of bond fund have seen huge outflows, with emerging market debt hit particularly hard – yields ended June averaging 7%, up from 5% in April. Emerging market equities also suffered, though local currency losses of 5.5% in May were on a par with those of the UK and Europe.

While fixed income and equities both produced negative returns in June, developed markets significantly outperformed their emerging country peers in common currency terms. “With commodity prices under pressure again only UK commercial property and cash produced positive returns,” Brunner said.

So what does this mean for asset allocation? According to Brunner the global economy is set to remain in a period of sub-par growth through the autumn but with the prospect of a gradual return to at least trend growth towards year end. Equity risks remain, however, and the correction already underway may have further to run. Even so, economic and financial trends have resulted in policy responses from governments and central banks that should ensure economic recovery becomes entrenched. These actions helped lower perceived systemic risks and, despite recent turbulence, should encourage investors to gradually rebuild equity weights. An overweight equity position is therefore retained. The recommended strategy is to focus on decent quality companies with healthy balance sheets and strong cash flow but to buy exposure to growth markets irrespective of country, sector and size. Yield will also remain important in a still low interest rate world and higher yielding stocks, but only those with growing dividends, remain preferred.

Relatively weak economic data and specifically financial repression had kept bond yields at extraordinarily low levels that bore little relation to fundamentals. Recent Fed comments, indicating an earlier than expected end to asset purchases, rocked the market and raised government 10-year yields by nearly 100bp. Near term, the move is probably overdone, but the bull market in bonds is over and the long run trend is towards higher yields. Hiding in safer short duration bonds is the most popular strategy for now and, while corporate bonds offer better inherent fundamental value, given expected default rates, turbulent times involving a change in Fed policy favours liquid assets near term versus very illiquid corporate bond markets.

A global economic background of relatively low growth and, in particular, the reform and rebalancing of the Chinese economy towards consumption, with a consequent significantly lower trend growth rate, presents a considerably more difficult medium term backdrop for many commodity producers. This represents a departure from the structural bull market witnessed during the last decade and will lower potential returns until capacity tightens again. This is not a new story and commodity indices have been underperforming equities for nearly two years. A large part of the prior upturn in commodities was driven by speculative activity but interest in this “asset class” has lost steam. This has become increasingly evident in gold and, although there is upside for the oil price, and possibly even copper, the consensus expects lower long term price structures.

As with most assets, the US Fed timetabling of a hoped for end to its large scale asset purchases (QEIII) has generated another bout of currency market volatility. Emerging market currencies have been affected most and, while there may be some shorter term rallies, prospects for many countries have deteriorated. The dollar should continue to trend higher during what could be an extended period of uncertainty. Consensus views on the euro and sterling suggest underperformance for both against the dollar. The big bet remains the yen where the consensus forecast is for a further 5-10% devaluation versus the dollar.


The information set out herein has been obtained from various public sources and is by way of information only. Broadgate Financial can accept no liability of any sort in relation thereto and readers should obtain their own verification of any statement before making any decision which may have any financial or other impact.

Neither the information nor the opinions herein constitute, or are they to be construed as, an offer or a solicitation of an offer to buy or sell investments.