The Malaysian Airlines tragedy has reminded everyone of the conflict in the Ukraine while the situation in the Middle East is a complete mess. Aside from the massive loss of life, the most concerning aspect from an economic and market perspective is that the West and Russia (who are making new friends in the East by the way) are moving further apart. The fuelling of anti-Russian sentiment by Western governments via the media and the imposition of sanctions only serves to make a bad situation worse. There is a little bit of ‘keep your friends close but keep your enemies closer’ needed with Putin, who apparently took three days before accepting a call yesterday from UK Prime Minister David Cameron. Overall, I believe the latest events have merely highlighted Europe’s weaknesses on the geopolitical stage with a cacophony of voices from individual member states rather than a unified and strong single European voice.
I suppose it is no surprise really that the official release from China confirmed that GDP growth met market expectations, expanding at a slightly faster than expected rate of 7.5%. Market participants, and it would seem the Chinese hierarchy, are not willing to accept the lower economic growth rates that are a necessary sacrifice for a more sustainable rebalancing of the Chinese economy.
The latest GDP growth has been driven by the government’s stimulus measures and a further expansion of credit at a time when concern is mounting over China’s growth model and possible defaults in the Chinese financial system. Last week, Bloomberg reported that the Chinese building company Huatong Road & Bridge Group Co. said it “may miss a 400 million Yuan ($64.5 million) note payment due July 23”. Yet the market remains unperturbed by the risk of defaults in China with investors being driven by an unrelenting faith in central banks and governments.
On the central bank front, US Fed Chair Janet Yellen’s semi-annual monetary policy report to Congress offered few surprises in terms of the outlook for monetary policy. The overriding message is that the Fed will continue to support the recovery as “too many Americans remain unemployed”.
Yellen did offer her opinion on equity market valuations noting that “valuation measures for the overall market in early July were generally at levels not far above their historical averages, suggesting that, in aggregate, investors are not excessively optimistic regarding equities”.
However, she did concede that valuations looked “stretched” in lower rated corporate debt, small cap companies and some social media and biotechnology stocks.
UK consumer price inflation rose to 1.9% in June, up from 1.5% in May and above the consensus forecast of 1.6%. Prices of clothing and food items were the key drivers behind the surprise increase, pushing inflation closer to the Bank of England’s 2% target.
Subdued inflation has provided central banks with significant leeway for their expansionary monetary policy in recent years. However, inflation now appears to be on the rise in the UK and the US which could force the Bank of England and the Fed to expedite their plan for raising interest rates.
If inflation was to continue to move higher central banks could risk being caught behind the curve on inflation. But their economists can always “strip out” clothing and food items from the inflation measure. After all, who eats food and wears clothes these days!
With Germany (Bayern Munich) bringing an end to an exciting World Cup last night the countdown is on for the new Premier League season. Last week, Luis Suarez gave us Liverpool fans the classic ‘I love you but I am not in love with you’, lured by what he sees as a more attractive Spanish proposition.
The appeal of Barcelona is unquestionable. However, Luis may regret walking away from the unadulterated love of all Kopites, who stood by him through some dark moments, into a cauldron of fickle Barca fans who frequently boo their own players. As well, the Catalans have already found their ‘one’, Messi, and whatever Suarez believes he will now be just the bit on the side.
Still, good luck to him!
Volatility crept back into global equity markets last week after shares in Banco Espirto Santo, one of Portugal’s largest banks, were halted following a sharp sell-off that spread to other markets. The issue relates to concern over the bank’s potential exposure to the non-financial businesses of the Espirito Group, the holding company which missed payments on short term debt last week. Portugal’s PSI 20 equity index fell over 4% on Thursday while all the major European indices closed lower on the week.
The cautious tone in markets saw strong demand for perceived safe-haven investments such as gold/silver while the 10 Year German Government bond yield fell to 1.17%, close to the all-time low, before finishing the week at 1.21%. The Bank of England and the European Central Bank left monetary policy unchanged, as expected. The minutes from the most recent monetary policy meeting at the US Federal Reserve confirmed that the committee members expect to end their bond buying program by October.
European equity markets have opened marginally higher after a positive session in Asian equity markets. After the sell-off last week, the relative calm appears to suggest that the market believes the Portuguese situation is contained.
Key macro data this week includes industrial production and inflation data from around the globe. In Europe, the flash estimate of consumer price inflation is forecast to be 0.5% while industrial production is expected to slow. There is a host of data released from the UK with the focus on the labour market, a key barometer of the level of “slack” in the economy for the Bank of England. The most recent unemployment rate recorded was 6.6% with further improvement expected. US data will be closely watched as investors remain hopeful that the US economy is bouncing back from the slump in the first quarter. The official data release from China on Wednesday will cover the full spectrum of the economy, with GDP expected to have expanded 7.4% in line with the previous quarter.
On the central bank front the Bank of Japan meet on Tuesday and are expected to make no change to monetary policy despite some signs that the economy may not be weathering the impact of the April 1st consumption tax increase as well as expected. Likewise, the Bank of Canada are expected to leave policy unchanged when they meet on Wednesday. Also in focus will be ECB President Mario Draghi’s hearing at the European Parliament, US Fed Chair Janet Yellen’s semi-annual monetary policy report to Congress and Bank of England Mark Carney’s testimony to the Treasury Committee. Investors will be looking for further insight into the timing of any interest rate hikes.
The Indian government announced plans to put the economy back on the path of strong economic growth and reform, with 7-8% GDP growth expected within three years. The recently elected Prime Minister, Narendra Modi, was lauded by the economic press in the run up to the elections and many have declared his victory a new dawn for India.
International investors have responded with massive inflows into India which has driven equity markets higher; the BSE SENSEX Index has risen almost 24% since mid-February. However, he is now faced with the difficult task of delivering on heightened expectations with the initial response to his first budget announcement last week relatively muted.
Beginning the year the consensus outlook for global economic growth was more optimistic for 2014, to be driven by the high-income countries. This has not transpired as expected with the most notable weakness in the US, the world’s largest economy. Real gross domestic product (GDP) decreased at an annual rate of -2.9% in the first quarter but the inclement weather has been blamed.
However, while the weather is the excuse this year the chart below shows that that missed economic expectations is not a one off phenomenon.
This had not stopped financial markets moving higher over the same period. But it is worth noting that against this backdrop of weaker than expected economic growth the US Federal Reserve was ramping up its bond purchase program (QE). However, the Fed are now close to ending QE so it seems plausible that financial markets should become more sensitive to missed expectations once monetary policy support is removed.
Japan has endured 15 years of deflation with an average annual rate of price decline of minus 0.3% over that time. Bank of Japan Governor, Haruhiko Kuroda, recently articulated this deflation trap in a speech entitled “How to Overcome Deflation”:
“As actual prices declined due to those factors, deflationary expectations that prices will not rise but instead decline were generated among people. Subsequently, even if those factors that induced price declines diminished, once deflationary expectations became entrenched, people would make decisions and take actions on the assumption that prices would not rise. Through this process, deflationary expectations themselves created in a self-fulfilling manner an economy in which prices did not easily rise.”
The result is that higher real interest rates (nominal interest rates minus inflation) restrains business fixed investment and household spending, investors prefer to hold cash and safe haven government bonds over equities and other risk assets with people also less willing to take the risk of setting up new businesses. As Kurodo notes in his speech “Japan’s economy lost vitality and the growth rate declined, gradually undermined by by this moderate price decline”.
Why could Japan not overcome deflation? According to Kuroda “they fell short of showing a strong and clear commitment to achieve the price stability target by any means”. Draghi has made clear that the situation in Europe is different from the Japanese experience. However, if inflation continues to fall or even remains persistently low the ECB’s current strategy of just talking about the tools available to them will not be enough.
With many of the major equity indices at or near record highs it is natural to ask whether equity markets are overvalued. First of all valuations differ dramatically by geographical region and second, one’s estimate of fair valuation is to a large degree subjective. From an absolute perspective, determining whether equity markets are over or undervalued will depend on what valuation metrics are used, the time period selected for comparative analysis and most importantly the estimate of future earnings. Read More