“He that hath ears to hear, let him hear.”
Mark 4:9
At first glance, recent economic news seems to strike a series of discordant notes and as a result, markets have been trading in a volatile and directionless way. Yet beneath the surface there are connections that provide pointers for investment markets for the remainder of the year.
In his influential 1959 essay, “The Two Cultures and the Scientific Revolution”, C. P. Snow proposed that the divide between science and the humanities had resulted in poor communication, misunderstandings and the misallocation of resources. If anything this divide has widened to the extent that increased specialisation has built further barriers even within closely related disciplines. Cross-fertilisation of ideas, frequently a source of advance in the past, is increasingly difficult to achieve.
Something similar has happened in financial markets in recent years to the extent that what is clearly understood in one area is unknown or disregarded elsewhere. Within major financial institutions generalists, able to range across all asset classes, have become an endangered species.
Recent news falls into four main categories:
-
Central bank pronouncements
-
Eurozone developments
-
UK economic news
-
Company results
Many have noticed that financial markets are trading in an increasingly correlated way. One of the reasons for this is that central banks are pursuing similar agendas. After nearly four years of consistent action to support growth and ensure that financial markets are liquid, the last few months has seen a series of more hawkish, less accommodative statements. In the US, the Federal Reserve has indicated that encouraging economic news makes further Quantitative Easing less necessary. In Europe, after the injection of €1 trillion liquidity into the banking system, the ECB, although talking about a “Growth Compact” has essentially passed the buck back to Governments. Finally in the UK, the Monetary Policy Committee, hemmed in by higher than expected inflation, has backed away from providing more support. Only the Bank of Japan is making a decisive move in the opposite direction in an attempt to lift the world's third largest economy out of the deflationary mire. Markets sense that for the moment, they are on their own, which is why since mid-March, trading has been much more erratic.
The dysfunctional Eurozone remains a major concern to all. Recessionary forces are strengthening and no sensible solutions are close to implementation. In Spain, with recession drifting towards depression and unemployment near 25%, investors are heading for the exit, leaving the local banks, funded by the ECB, as the only material buyers of Government debt. Voters throughout Europe have, or will soon, exercise their democratic rights and are voting against further austerity.
The UK, as is frequently the case, is somewhere in mid-Atlantic. The depreciation of sterling and the freedom to print money through aggressive Quantitative Easing, means that economic conditions are better than might otherwise have been expected. Up until now, fiscal austerity has been balanced by monetary support, which is why investors have come to regard the UK as a safe haven in an uncertain world. Hence the extraordinary strength of the gilt market with ten year yields trading in a narrow range at just over 2%. By comparison, the French Government needs to pay 3% and Spain 6%, to borrow for the same period.
Recent UK news has, however, caused a murmur at the heart of the UK fiscal/monetary balancing act. For well over a year, the MPC has been forecasting that inflation will return to the target of 2% without the need to withdraw monetary stimulus, or even worse, raise interest rates. All seemed to be on plan until a slight increase in the CPI from 3.4% to 3.5% was announced. Economists and strategists alighted on this news with enthusiasm and a whole range of explanations were proposed, including the long delayed adverse effect of QE or the impact of inflation imported from rapidly growing Emerging Markets. Hard on the heels of these disappointing inflation numbers was the news that the UK economy was estimated to have contracted by 0.2% during the first three months of the year. As this was the second negative number in a row a technical recession was announced and this provoked a political firestorm.
Interestingly, the UK equity market has taken all of this news more or less in its stride, and this is because companies are generally matching or exceeding profit expectations, statements are positive and dividends continue to be increased at a rate in excess of inflation.
It is interesting to look for connections between these disparate and conflicting bits of news to see if any useful conclusions may be drawn.
What seems to be unreported, probably because most economists do not look at companies in sufficient detail, is that companies most closely linked to consumers are, after several tough years, trying to rebuild profit margins. For example, although wheat and cotton prices have fallen by 30% and 20% respectively over the last 12 months, manufacturers and retailers are trying to push through price rises. It seems that after years of price deflation, those with good brands believe that consumers will pay higher prices rather than trade down. No effort is being spared, with Kingsmill bread being rebranded Queensmill for the duration of the Diamond Jubilee celebrations. The link between good corporate results and higher than expected inflation is clear.
The big question now is will consumers pay up or will sales volumes fall? It is too early to say, but if the former and margins are sustainable, then investors should favour equities. If not, which given low wage inflation and declining economic growth globally is equally likely, then price discounting will allow inflation to return to a downward trend. The MPC could then consider a further round of QE which, as we saw last year, would support gilts and have a patchy impact on equities and sterling.
Other central banks may also find reasons to be more supportive. In the US, the political timetable could act as a catalyst for early action during the summer, particularly if growth starts to drift lower. After that, monetary policy is unlikely to change in the autumn in the run up to the Presidential election. In Europe, the consensus that austerity alone will work is under threat. It is too much to expect coordinated action by Eurozone Governments, but the ECB, as we have seen this year, may have more room for manoeuvre.
This is turning out to be the year to be a generalist. Although the news flow is discordant, more Schoenberg than Handel, those able to invest across a broad range of assets and who care to listen, are hearing harmonies that could illuminate a sensible path through these challenging times.