Robert Farago Head of Asset Allocation
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The US Federal Reserve announced a rolling programme of purchases of residential mortgage-backed securities. The Bank of Japan also increased its bond purchase programme. Meanwhile economic data remained subdued, but has stopped surprising on the downside.
Economic data produced few major surprises over the quarter. The US economy expanded at just 1.3% in the second quarter, while inflation declined to 1.7%. European activity slowed which meant slower growth in Germany and a deepening recession in Southern Europe, while activity in the UK was broadly flat. Asian expansion also declined, with the main trading economies feeling the effects of slowing trade with Europe.
The growth rate in China fell to 7.6%, its lowest level since 2001 excluding the six month plunge in activity after the demise of Lehman Brothers.
Japan also slowed as the rebound from last year’s devastating earthquake and tsunami is now largely behind us. Inflation remains subdued in the developed world but inflation is still stubbornly high in parts of theemerging world even as growth is slowing.
For example, growth in India has slowed from 11.2% in March 2010 to 5.5% in June2012 while inflation has proved sticky, withconsumer price inflation coming in at over 10% in August. The combination of reduced fears of a euro break up and additional money printing by the US Federal Reserve led the euro to strengthen against the US dollar. Indeed, the dollar weakened against almost all currencies. The Chinese renminbi was a notable exception as the weakening Chinese economy led the authorities to maintain the exchange rate steady against the dollar.
Equity markets moved higher, led by Europe and, in particular, by the stock markets of the stressed peripheral nations. In general, companies more exposed to the economic cycle outperformed the more defensive names. However, materials companies lagged behind industrials and consumer cyclicals as these stocks are seen as more exposed to the ongoing slowdown in China. Indeed, the Chinese stock market was a notable exception, with the Shanghai A-share index falling 6% over the quarter.
The prices of government bonds in the UK, US, Germany and Japan fell modestly and yields rose as the rally in risk assets led investors to reduce exposure to these perceived safe havens. In contrast, the prices on riskier bonds rose across the board, whether they were issued by stressed European sovereigns, riskier companies or emerging economies (see chart 4), pushing yields lower. The low level of interest rates has helped keep defaults below average levels. Commodities prices rallied strongly. The oil price reversed the entire decline experienced over the previous three months. Agricultural commodities have led returns this year, with corn, wheat and soya all soaring due to the severe drought in America. The gold price hit all time highs measured in euros and in Indian rupees, a key market for the metal. The HSBC Gold Mining index, which measures the performance of gold mining shares, rose 19% over the quarter.
UK commercial property prices posted modest declines, putting total returns just in positive territory, following the pattern of the previous two quarters. Global capital flows continue to support pricing in London, where an estimated 70% of transactions in 2012 originated from foreign investors.
Hedge funds generally posted positive returns. Low market volumes and the gradual withdrawal of investment banks from proprietary trading activities have allowed short-term traders to profit from pricing anomalies. Macro trading has focussed on events in Europe with mixed results, but those on the wrong side of the trades have managed their risk well. Trend following strategies have mostly treaded water in choppy markets.
Outlook
Turning to the outlook, our economic forecasts are broadly unchanged. We continue to expect slow economic growth across much of the developed world over the coming year, but this forecast relies on escaping a fall over the fiscal cliff in the US , the euro area staying largely intact and avoiding a military conflict in Iran. The euro area is forecast to endure another year of shrinking activity while growth in the emerging world is forecast to stabilise at below historic growth rates.
ECB to the rescue
The actions of the European Central Bank are a step in the right direction but not sufficient to end the crisis. In its favour, confidence in Europe was so low that there is a chance that their actions will indeed mark the low for prices in peripheral bond markets. The reduction in current account deficits across the periphery is also a sign of progress. However, the sums required to prop up the Spanish banking system are daunting. There are no signs yet that the outflow of bank deposits has ended. A Greek exit is a very real possibility and it is hard to be confident that sufficient firewalls are in place. European equity and bond markets offer attractive valuations but these are commensurate with the risks. The US Federal Reserve (the Fed) announced a third round of quantitative easing, this time via a monthly purchase of mortgage-backed securities. In contrast to previous measures, this one is open ended, meaning the purchases will continue until unemployment comes down to acceptable levels.
Too much of a good thing?
The effectiveness of monetary policy in the current environment is debateable, and this debate is live even within the Fed. Ben Bernanke, its president, claims that the measures taken to date are responsible for the recovery in economic activity and improvement in employment. His colleague
at the Dallas Fed, Richard Fisher, doubts that this additional monetary easing will persuade firms to increase capital spending and hiring owing to their concerns over the long-term outlook. His view is that “Democrats and Republicans alike have encumbered our nation with debt, sold our children down the river and sorely failed our nation. Sober up.
For unless you do so, all the monetary policy accommodation the Federal Reserve can muster will be for naught.” Bill White, a respected economist from the OECD, goes further and highlights the unintended consequences of ultraeasy monetary policy: weakening growth over time, reducing the health of financial institutions, threatening the functioning of financial markets and the independence of central banks, as well as the undesirable social impacts of favouring debtors over creditors. Despite this, we see little chance of a change in policy and this strengthens the argument for holding some gold and gold mining companies in portfolios. Nor is the impact on equity markets clear. Indeed, stock markets have sold off in the aftermath of the latest moves by the Fed.
However, this was after rallying strongly in anticipation of action by both the US and European central banks.
We see inflation trending lower in 2013, but we continue to expect problems to arise in the future. At some point the huge amount of monetary stimulus and the lack of investment in new capacity will trigger a rise in prices. This is likely to occur at a time when unemployment remains high and overall indebtedness in the UK, US, Europe and Japan is excessive. This will mean that central banks are likely to be slow to raise rates. The fact that a dose of unanticipated inflation would be convenient for highly indebted sovereigns makes it more likely that policy tightening is gradual. We continue to be cautious on government fixed income securities that are offering yields below historic, current and expected future levels of inflation. They offer an appropriate hedge against another deflationary scare for more defensive portfolios but in general we prefer inflationprotected bonds. These can perform well if inflation picks up but central banks keep interest rates low, a scenario we see as likely at some point.
Central bank actions to keep government bond yields low have also brought down yields on corporate and emerging market debt, in some cases to historic lows. The strength of balance sheets within the corporate sector means that we see room for investment-grade corporates to enhance portfolio yields. Overall we see better value in equities than bonds, with the yield on equities in many markets exceeding their government bond equivalents .
For equities, earnings expectations for this year have been revised down while prices have risen, meaning valuations are less attractive in absolute terms. Earnings forecasts for 2013 have remained unchanged and look vulnerable to downgrades. However, economic forecasts have been pushed lower to more realistic levels and therefore the disappointment in earnings may already be factored into investors’ thinking. We see upside to equità markets in our baseline scenario.
The search for yield in equities
The focus of investors on safety and incombe has pushed valuations on some companies that tick both boxes to excessive levels. However, we can still find good quality companies, when measured by balance sheet strength and profitability, trading at attractive valuations.
We continue to favour developed markets over the emerging world. We note, however, that emerging markets have lagged for two years, which means relative valuations have improved. In addition, our cautious view on China has become more mainstream. This creates scope for the new administration, due in October, to surprise us on the upside.
There are also tentative signs that India will embark on necessary reforms, not least to its power sector, which caused severe disruptions to electricity supply this year.
The Japanese market has proved particularly frustrating since we turned more positive, initially because of the devastating earthquake and tsunami and then more recently when the Bank of Japan failed to follow through on its announcement of more inflationary policies. While the growth
outlook remains subdued, the market is particularly cheap on both book value and cash flow measures, it offers a higher yield than the US and is the one market that should really benefit when inflation does eventually surprise on the upside. The first quarter of next year will see the appointment of a new governor at the Bank of Japan.
This provides Japanese politicians with the opportunity to appoint a governor who will follow more expansionary policies, matching his peers in Europe and the US. This would be positive for the equity market and negative for the yen.
The outlook for oil prices has improved over the quarter as supply has been less than expected and demand has increased despite the sluggish economic environment.
In contrast, the outlook for industrial metals is very much tied into the outlook for the Chinese investment cycle and has worsened over the last three months. We expect gold to remain well bid following the unprecedented policies being pursued by both the Fed and the ECB.
We see modest further downside to UK commercial property prices over the balance of the year. We remain cautious about the prospects for rental growth in most occupational markets, as demand remains subdued in the wake of continued economic uncertainty. Further out, we see returns broadly in line with yield minus depreciation costs, which makes property attractive compared to bonds. We continue to see an important role for a small number of hedge funds where they offer both the potential for both long-term returns and, in particular, a strategy that can profit from an increase in volatility. This typically occurs at a time when equity and other risk asset markets are struggling.
Conclusion
In conclusion, the European Central Bank has reduced the odds of a catastrophic collapse of the euro. Still, the crisis is far from over. The US Federal Reserve has also upped the ante with open-ended intervention in the mortgage market. This has boosted confidence in the short term, but the warnings are getting louder on the negative long-term consequences of its actions. We see upside to equities and other risk assets in our baseline scenario.
However, over the next year we will need to see the real progress in the US towards a sustainable tax and spending policy and further moves towards a federal Europe. This agenda will ensure volatility. The story this year has once again been “don’t fight the Fed” or indeed the European Central Bank. Still, when a Fed insider tells you they are out of bullets, it is right not to be complacent. We continue to balance equity risk with holdings of inflation-protected bonds, gold and selected hedge funds.
We hold some cash in order to profit from periods of market stress.
Important information: Past performance is not a guide to future performance. You should remember that Investors may not get back the amount originally invested as the value of investments, and the income from them can go down as well as up and is not guaranteed.
Exchange rate changes may cause the value of overseas investments to rise or fall. This document is intended to be for information purposes only and it is not intended as promotional material in any respect.
The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for investment advice or recommendations. Opinions stated are matters of judgment, which may change. Information herein is believed to be reliable, but Schroder & Co. Ltd does not warrant its completeness or accuracy. This does not exclude or restrict any duty or liability that Schroder & Co. Ltd has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. For your security communications may be taped or monitored. Issued and approved by Schroder & Co. Limited, 100 Wood Street, London EC2V 7ER, which is authorised and regulated by the Financial Services Authority. w42275
Source: ETFWorld – Schroders Private Banking
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