Crunch time...

Crunch time…

Posted on 5 June 2015

"Most of the people who want jobs have jobs, and wages are starting to turn up more appreciably economy-wide as a result."

“We have so much time, and so little to do! Strike that. Reverse it.” – Willy Wonka (Charlie and the Chocolate Factory)

No more than a pothole

Data out this week have convincingly squashed worries over whether the weakness seen at the beginning of the year in the US economy had morphed into something more sinister – the new orders component of the trusty ISM manufacturing survey, the longest running and most reliable cyclical lead indicator for both the US and world economy, perked up noticeably. Meanwhile, US auto sales jumped 8% month-on-month in May, with light vehicle sales hitting a nine-year high in the process. With car purchases the most discretionary of all purchases, this May figure points to a consumer that remains in buoyant mood, trumping April’s more lacklustre reads on US consumption. This buoyant mood is well supported by a jobs market that is now nearly healed, as evidenced by today’s employment report. Most of the people who want jobs have jobs, and wages are starting to turn up more appreciably economy-wide as a result.

As we’ve pointed out on several occasions, it is not so much the starting point of interest rate hikes that is important for investors to try and work out (in the US, this looks more likely to be September now), but the path of interest rates from there. This is part of the story, alongside developments in Europe, explored in more detail below, that is exerting significant downwards pressure on bond prices (and therefore upwards pressure on bond yields), with some eye-watering moves this week. Even after this week’s correction, we would suggest that the fixed income universe has a way to go before it more accurately reflects the underlying economic reality as we see it and therefore the path of interest rates over the next few years. As before, the advice remains to tread carefully and lightly within the bond market, while keeping duration short of the benchmark. We are surely significantly closer to the end of this incredible multi-decade bull run in bond markets than we are to the beginning. Equities remain relatively attractive, even in the context of lofty valuations, by merit of the prospects for continuing profits growth amidst those improving prospects for global growth and inflation.

Greece – nearing the endgame.

While European economic data continues to point to faster growth in the pipeline and a diminishing risk of a damaging bout of inflation, the political backdrop remains noisy.
There was very tangible progress in Greek negotiations this week after the euro group tabled proposals that contained important concessions to Greece’s current plight. Less onerous budget targets, a little more flexibility on pension and labour market reforms as well as even whispers of the future prospect of some debt relief may provide the contours of a palatable agreement for the Greek government. An agreement here admittedly only gets us to the next stage of negotiations over the third Greek bailout, but if this does come to pass, it will represent an important step forward; one that may allow markets to focus elsewhere for a little while, as the moves this week in the euro may pay some testament to.
In the last couple of weeks, we’ve also had regional elections in both Spain and Italy. Neither can be said to be necessarily positive for markets, though the implications are not especially negative either. In Spain, the emergence of Ciudadanos, a centre-right party, provides a helpful counterpoint to the more extreme left represented by Syriza’s sister party, Podemos. Meanwhile, although Matteo Renzi’s Democratic Party (PD) didn’t quite perform to expectations at last weekend’s regional elections, a turn in the Italian labour market and the beginnings of a more helpful economic backdrop may help Mr Renzi maintain some reform impetus.
Elsewhere, escalating violence in Eastern Ukraine may hint at the beginning of the end of the much derided Minsk agreement. If this does represent the start of a Ukrainian separatist campaign to take Mariupol, long seen as essential to provide the separatists with a measure of economic independence, next level sanctions against Russia from the US and Europe will almost certainly follow.

Investment conclusion

This week has provided another taster for what we’ve long expected would be a more volatile period of capital markets. Bond markets have already moved a long way in the last 2 months, adjusting to a world where the prospects for growth and inflation are looking less flaky than they appeared amidst the US economy’s winter soft patch and the plunge in oil prices over the second half of last year. While bonds and equities may well suffer together for a while, investors in equities would do well to remember that a little less pessimism on the economic outlook suggests decent profits growth for the remaining leg of this economic cycle. This, in combination with dividends, still makes equities the most attractive major asset class even if valuations should struggle to make further headway amidst rising interest rates across the curve.
For their part, US equities may also fare a little better in the second half of the year amidst that more helpful economic backdrop. Though valuations here are fuller and the prospects for earnings growth are less stellar with profitability having already bounced back well from lows plumbed earlier in the crisis.Continental Europe remains our favourite region with regards to equities. Of course, there remains much for equity investors in the region to worry about, even if this does turn out to be genuine light at the end of a long, hard tunnel for the long suffering Greek people. Nonetheless, revenues for the quoted corporate sector in Europe should soon start to reflect the more helpful economic backdrop, and profits will follow from their more depressed base.

William Hobbs, Head of Equity Strategy, Europe

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