2nd Quarter 2015

“An expert is someone who knows the price of everything but the value of nothing” comes to mind as we contemplate the likelihood that “lift-off” within the US economy has been postponed, and that there is the potential of QE4 to be seen on the 2015 horizon!

Last Quarter Review

During the last quarter of 2014 (the latest data available) US Gross Domestic Product (GDP) expanded at an annual rate of 2.20%. In the same period, GDP in the UK expanded 0.60%, and the Eurozone 0.30% (which included Germany, the world’s fourth largest economy growing at 0.70%). In Asia, the world’s second largest economy China expanded 1.50 % while GDP in Japan, the world’s third largest economy contracted 0.40%.

Base interest rates in most developed markets remained unchanged during the last quarter, with the exception of China as the People’s Bank of China (PBOC) reduced the benchmark one year lending rate by 0.25% to 5.35% on the 1st March. Meanwhile, official unemployment in both the US and the UK continued to fall steadily to 5.5% and 5.7% respectively, which when taken with some of the official comments from both the US Federal Reserve and Bank of England, resulted in continued market speculation that this year would see the first base rate rises in both economies since 2009. However as the first quarter ended, the latest economic data (and most especially concerning inflation and energy) seemed to suggest an increased likelihood of interest rates remaining as they are, or exceptionally even having to go lower to counter the growing global deflationary trends.

Financial markets were somewhat mixed with equity markets in the US broadly flat and Treasury Bonds continuing to provide positive returns. Elsewhere, European equity markets soared on the back of the commencement of Eurozone quantitative easing (QE), whist Japanese equities declined despite the increased QE from the “Abenomic’ policies of the Bank of Japan. In the UK, the FTSE 100 index briefly went through 7000 to set a new record, but finished the quarter well off its best as concerns surrounding the outcome of the May 7th election, together with a mixed economic outlook dampened expectations.

In local currency terms, the S&P 500 in the US rose just 0.95% during the quarter to close at 2067.89, while in the UK the FTSE 100 rose 4.35% to end March at 6773.04. In Europe, the German Xetra Dax rose 22.03% to close 11966.17, while the Euro Stoxx 50 rose 17.93% to close at 3697.38. In Asia, the Shanghai Shenzen CSI 300 index in China rose 14.67% during the quarter to close at 4051.20, while the Hang Seng in Hong Kong rose 5.99% to close at 24900.89. The Japanese Nikkei 225 fell 10.69% during the quarter to close at 19206.99, while the Sensex index in India rose 1.85% to close at 27957.00.

Key Economic & Market Data 4th Quarter GDP 12 month GDP Base Interest Rate at End March 2015 Equity Index Returns Over Last 12 Months Sovereign Bond Index Returns Over Last 12 Months
% % % % %
USA 2.20 2.40 0.25 +12.72 +6.05
UK 0.60 3.00 0.50 +6.68 +13.96
EuroZone 0.30 0.90 0.05 +21.16 +13.11
China 1.50 7.30 5.35 +92.46 N/A
Japan -0.40 -0.80 0.00 +31.75 +3.15
Germany 0.70 1.60 0.05 +25.22 +11.50
NB. GDP Data to 31st December 2014; Interest Rate, Equity & Bond Index data to 31st March 2015; Equity Indices used: US – S&P 500, UK – FTSE 100, Eurozone – Euro Stoxx 50; China – Shanghai Shenzen CSI 300; Japan – Nikkei 225, Germany – Xetra Dax. Sovereign Bond Indices courtesy of Bloomberg.

Current Considerations

Trying to follow and analyse the nuances of statements and comments made by a few key Federal Reserve (Fed) governors and other major central bank heads has become a full time occupation for financial strategists and advisers.

The decision of Fed Chair Janet Yellen and her fellow Federal Open Market Committee (FOMC) members to remove the word patient from the minutes of the last Fed meeting, while emphasising in the same press release that this did not mean they had now become impatient when it came to normalising interest rates, is a classic example of how sophisticated (or complicated) “forward guidance” from central bank policymakers has become. Another statement made by Janet Yellen following a Fed conference in San Francisco at the end of March was also a classic example, when she said "The actual path of policy will evolve as economic conditions evolve, and policy conditions evolve, and policy tightening could speed up, slow down, pause, or even reverse course depending on actual and expected developments in activity and inflation."

It is however all too easy to doubt the sincerity of the Fed's inference that base rates will rise either in June or September of this year. US base rates have remained at 0.25% since March 2009, which coincidentally was when the current equity bull market on Wall Street began, and it is difficult to see based upon the most recent economic data, as well as the inherent strength of the dollar (which of course damages US exporters) how rates can rise anytime soon. Additionally, Wall Street bond and equity markets begin faltering whenever talk of interest rate rises appears to be taken seriously, and consequently Janet Yellen's primary weapon would appear to be continuing to talk the talk, while hoping she can indefinitely postpone having to walk the walk on base rates.

Arguably however, the biggest reason why the Fed's interest rate options are limited is the US housing market. While we hear little but positives on the subject in mainstream media, data from several sources indicate that as many as a third of existing homeowners are either in negative equity or have too little equity (20% or less) to effectively move up the housing ladder, and any rise in interest rates would be certain to reverse this market's fragile confidence.

A report from Bloomberg towards the end of the first quarter surmised the dilemma facing US policymakers, 'A booming job market and cheaper fill-ups at the gas pumps should be giving millions of Americans more reasons to spend. Instead, they're still salting away their extra savings. The savings rate jumped in February to 5.8%, the highest since December 2012 and up from 4.4% just three months earlier, government data showed Monday.'" Food for thought indeed while elsewhere in the world, economic data and policy developments don't appear much better as Japan's factory output in February dropped by 3.4% from January, despite the Bank of Japan's increased monetary injection of Y80 trillion ($667 billion) a year.

Richard Koo, the highly respected chief economist at Nomura Research has for some time maintained that western economies are in a balance sheet recession, which no amount of quantitative easing can necessarily resolve. Speaking on CNBC during March, Richard said, "The US and UK embarked upon asset purchase, or quantitative easing (QE) programs, following the 2007-2008 financial crisis. Japan joined the QE club in 2013 and the European Central Bank began its 1 trillion Euro ($1.06 trillion) bond buying stimulus this week. Both the US and Europe are facing the same problem - which is that they are in a situation where the private sector in these economies is not borrowing money at zero rates or repairing balance sheets following what happened in the crisis. When no one is borrowing money, monetary policy is largely useless."

This apparent impotence from policymakers is even more worrying when we consider that despite all the rhetoric about austerity and supposed regulatory improvements to curtail further reckless debt expansion since the collapse of Lehman Brothers in 2008, total global debt has increased by an incredible $57 trillion to $199 trillion, while debt as a percentage of GDP has risen from 269% to 286%! This extraordinary increase in global debt was revealed in a recent report from the McKinsey Research Institute.

While the Fed and other central banks await an inflationary miracle to destroy the deflationary economic winter now wreaking havoc globally, a small but significant minority of economists question why deflation is so bad when the majority of ordinary people would benefit enormously from lower real prices while incomes remained constant as had been the case in Japan for the best part of twenty years prior to the launch of Abenomics in 2013. Of course those with excessive debts such as the governments and some major banks etc. would suffer as the real value of their borrowings would increase, which we suspect is the real reason why we are constantly told by policymakers that deflation is a demon.

For more than a century and a half, the Austrian School of economics which has included renowned scholars such as Carl Menger, Ludwig von Mises, and Friedrich Hayek, has argued laissez faire policies and sound money principles work best in capitalist societies, allowing the business cycle to play out naturally without interference or manipulation (e.g. during 2008, none of the banks or institutions such as Fannie Mae which were insolvent would have been bailed out). This approach ensures only solvent and soundly run businesses survive economic downturns, while interest rates are solely determined by the markets.

For now at least, it seems unlikely these alternative ideas will be given serious consideration while economists trained in the Keynesian and monetarist schools hold sway in mainstream policy making, and we can only hope their strategies eventually succeed in bringing back genuine economic growth without destroying the essence of the underlying markets.

Forward Outlook

For now, and arguably for the rest of 2015, any further talk of “lift–off” in the US economy and interest rates rising can be ignored. Despite all the rhetoric to the contrary, both the Fed and central banks elsewhere appear to be losing the battle against deflation. Regardless of how much additional money is created by QE, the inflation required to lessen the huge debt burden remains stubbornly subdued as many would be consumers and businesses remain more intent on paying down their own debt, or saving for a rainy day than borrowing to spend more.

Most of the QE money created since 2008 has found its way into equity, fixed income and property markets, and this is likely to remain the case during 2015. However the indifferent performance from US equity markets during the first quarter together with some lacklustre economic data that has resulted in the postponement of “lift-off”, suggests to us that QE4 in the US is on the horizon.

Here in the UK we have the added risk of an election result in May that could necessitate a more complex political coalition than the current arrangement, with one or more of the fringe parties effectively holding control. This combined with the uncertainty of the UK’s continued membership of the European Union, could potentially make the UK much less attractive for international investment and business.

Finally the prevailing deflationary forces that currently hold sway mean that the thirty year plus bull markets in US Treasury and other blue chip government bonds almost certainly have further to run. A combination of the current US Dollar bull market, and the large differential between the yields on medium and long dated (i.e. ten years plus) US government bonds and their German and Japanese equivalents suggests Treasuries offer the best value here, but there will also potentially be selective opportunities in gilts and other investment grade UK fixed income once the May election has past.

Overall, we remain cautiously optimistic that key policymakers remain in control, and that there will be attractive opportunities during 2015 in major equity and bond markets.