Quarterly Market Update – July 2014

The rays of optimism remain and after a flat start to the year, the last few weeks have been positive.

Markets are irrational; positive sentiment reflects the feeling that the global recovery is taking hold, and investors would be forgiven in thinking that against this backdrop markets would continue to deliver positive returns.

January started full of optimism only for returns to fall away and despite a rally in February the overall quarter was flat.

The second quarter seemed to be heading in the same direction but for market ebullience in May and the beginning of June (in direct contrast to the gloom of May 2013) which helped deliver positive returns for the first six months.

Looking at the markets there has been a reverse in fortunes with those that were strong in 2013 struggling in 2014, and those that were weak posting strong returns.

As an example, the Emerging Markets Index was down nearly 8% in 2013; in the first quarter of 2014 it was down nearly 2% but this reversed in the second quarter up nearly 3%. Asia also posted strong returns in the second quarter as did Emerging Market debt. After two years of negative in-flows, slowly investors are returning to these regions.

The extent of political tension should not be underestimated; the impact of the Russian annexation of Crimea seems to be minimal but disruption to the supply of gas and oil through the Ukraine could be and the uncertainty in Iraq has the danger of spreading across the region.

Against this backdrop we will unpick some of these themes.

Cash

Cash remains king; according to a recent survey, by BlackRock, 42% of mass affluent investors still prefer cash. The principal reasons being guaranteed and known returns as well as capital preservation.

Since 2008, low interest rates and ‘high’ inflation have delivered negative real returns for investors. Although inflation is now below 2% the average short term savings rate is 1%.

Against this headwind cash investors haven’t changed habits for the last six years and are unlikely to change this because it means moving money into riskier assets.

The hope is that rising interest rates will be the saviour for cash investors and there is light at the end of the tunnel. Carney has indicated that rates are likely to rise sooner than expected (possibly the end of this year). However, increases are likely to be small and gradual and it is probable that it will be some time before cash savers feel any benefit from this – so what are the alternatives?

The new Super ISA has arrived; currently some of the top rates for fixed terms of between 2 and 5 years are 2.75% (above inflation but hardly earth shattering). The new pensioner bond is expected to be around 3% but again will be fixed for a specified term.

The new banks (or challenger banks) may offer higher rates to encourage investors. Tesco Bank has already set the benchmark offering those with a current account with them up to 3% on cash. The problem is that this is capped at £3,000 and for those with significant cash savings this isn’t really going to work.

Unless cash investors habits change and they are prepared to take some additional risk they need to accept that returns will be lower and they will continually need to search out the best returns to ensure that their savings are working in the most efficient way.

The Markets

Below we will look around the globe and provide an overview of the key messages coming out from fund managers.

USA

The speed of the recovery during 2013 abruptly halted in the first quarter with the big freeze slowing key growth indicators and driving down forecasts for the year.

The fundamentals behind the recovery remain strong and quarter two showed it had spread across a wide array of sectors. Many banks have generally returned to health, house prices are rising, car sales have reached pre-recessional levels and unemployment has fallen.

Despite what would appear to be a positive backdrop for the US economy there are still challenges.

Obama has seen a significant drop in popularity. Areas of unhappiness include health care reforms, and security risks and in particular the exchange of prisoners.

The OECD has raised concerns that the labour market is not yet back to normal. Many discouraged workers have stopped looking for a job altogether and many part-timers would like to work longer hours. Finding a job remains a challenge especially for the long-term unemployed.

They have also raised concerns around the downside risks to recovery including a renewed weakness in the housing market, financial market turbulence and a possible weakening of production growth.

Political risks also weigh heavy Putin seems to have won the posturing in the Ukraine as Pro-Russian forces continue to strengthen their grip in the Eastern Parts of Ukraine, with Russian tanks appearing to enter Ukrainian territory. More worrying appears to be the developments in Iraq which appear to be systematic of a wider regional concern covering Iran, Turkey, Israel, Syria, Lebanon, Jordan and Saudi Arabia.

Intervention has demonstrated little perceived value and the challenge for the US is how they respond to these challenges and what impact if any this has on both the recovery in the US and the wider global markets.

2013 was good for the US markets but the first quarter of this year was sluggish with quarter 2 positive in line with the global market. The long term outlook remains positive especially the “energy renaissance” which is turning the country into the largest producer of natural gas in the world. However, there are challenges and how these are tackled will determine the pace at which the recovery continues.

Europe and UK

The recovery in the UK has picked up to a robust pace; low interest rates and an improving labour market have helped to support household consumption. Headline inflation has fallen below 2% and unemployment is below the target 7%.

On paper this would support a rise in interest rates but there are underlying factors which need to be considered to ensure any rise doesn’t derail the recovery.

Unemployment is falling but real wages have still not seen any significant shift in a positive direction. Consumer spending is increasing but there is evidence that this is supported by savings and therefore there needs to be evidence of a shift in spending habits.

Housing is a big topic and concerns of a housing bubble don’t seem to be going away. The reality is that much of the boom is centred in the South East and in particular London where over a third of buyers use cash. Against this little can be done to slow down the market.

Outside of London there is evidence that the housing market is slowing partly due to the new mortgage tests (approved mortgage applications are down for the third month in a row), and supply is limited (there are simply not enough houses being built).

Timing of any rate rise is crucial and many debate when this will be. Some expect them to be before the US in early quarter 1 2015, some expect them to rise towards end of 2015. However, Carney has indicated that the rise is likely to be sooner than expected leading many to suspect the rise could be this year.

The reality is that they need to rise at some point but real wage growth needs to start coming through, there needs to be a more sustainable job market and savings habits need to be changing. An early move could unwind the path to recovery.

The All Share Index was strong in 2013, negative in the first quarter of 2014 but bounced back in the second quarter. The general view is that the UK continues to climb the recovery curve but there are challenges.

The euro economies appear to be turning the corner towards a slow recovery but they are treading a very thin tightrope. High debt and tight credit conditions especially in the vulnerable countries is effecting the pace of the recovery as is weak private sector balance sheets and high unemployment.

The recent cut in interest rates and financial stabilisers highlight the fear of deflation in the euro economies.

Within the Eurozone some economies are responding more positively than others. Spain for example, is still suffering from high unemployment but there appears to be greater optimism for the future whereas France, Italy and the Netherlands continue to struggle.

2013 was a strong market for investors but much of the growth was driven by a re-rating rather than fundamental growth. A lot of the winners were poor quality companies (low growth potential, high debt and high dividends), the likes of Italian and Spanish banks. This re-rating has started to slow and there does appear to be a move back to quality.

The Eurozone posted positive returns in the first quarter but dropped into negative territory in the second quarter.

The Euro elections reflected general unrest across all economies about the scale of austerity measures and therefore saw sweeping gains for many far right and anti-euro parties. However, the scale of the victories was not as high as anticipated and the pro-euro parties still hold the upper hand and it is this that is needed to ensure the path to recovery continues.

Although troubles in the peripheral economies should not be ignored there is now less of a concern over the potential break-up of the Europe. However, Ukraine remains a concern as they have significant control over gas and oil supplies from Russia which could force up prices causing strain to any recovery in Europe and the UK.

In the summary the UK is certainly ahead of the Eurozone in terms of the recovery curve but challenges are faced by both. In the UK the underlying fundamentals behind the recovery will determine when interest rates go up whereas in Europe interest rates have gone down to try and stop deflation.

Asian, Frontier and Emerging Markets

We can’t fail to notice the World Cup in Brazil and the unrest seems reflective of challenges facing many economies in Asia, Emerging and Frontier Markets. From a holistic view point the picture is not pretty; unrest in the Ukraine, Iraq, Thailand, Turkey, Brazil, Nigeria and Kenya would appear to add weight to the argument that investors should stay away from these markets.

However, some of the strongest bounce in terms of returns this year has come from Asia and Emerging Markets. This is because investors are starting to identify that this is not one holistic group and within this varied market there are some good stories playing out.

The reforms in China are seen positively by the market, although there are concerns with the shadow banking sector. Growth is expected to fall below 7% and move towards a level of 5% to 6% to reflect a consumer driven society.

India saw a surge in their stock market after the reformist party of Modi won the elections. Egypt has also seen positive change and although Thailand appears unstable with martial law being imposed on 20 May it was no surprise to the markets. It is expected to be temporary to restore a sense of order.
Elsewhere Korea and Taiwan are well placed to capture growth from an upturn in US demand.

A sector truly unloved for nearly 3 years is just starting to see investors return and there are many positive stories. However, there are also challenges that developed economies do not have and these regions will always have greater volatility. It is early days but we indicated an upturn at the end of quarter one and this this has continued through quarter two. The noise on the ground is positive and there appears the momentum to keep this going. But with these markets anything can stop it!

Japan

The start of 2014 has been disappointing for investors, however little has changed.

An export slowdown has moderated expansion but improving market conditions and stronger business confidence will offset the impact of fiscal tightening scheduled in 2014 and 2015, notably due to the consumption tax hikes. An upturn in exports, as world trade picks up, will also support expansion and push inflation up.

The need for change is best highlighted by gross public debt surpassing 230% of GDP and the requirement to achieve a budget surplus by 2020. The consumption tax will increase again in 2015 and other bold structural reforms are all part of the drive to achieve this surplus.

Challenges have always been there but the difference is the desire to tackle these head on and on the ground there is a real sense of optimism for the future.

The first quarter was a complete reverse of 2013 but the second quarter started to post positive figures. Markets will be impatient but it is normally the patient investor who is rewarded however no-one should underestimate the challenges ahead.

Conclusion

The rays of optimism remain and after a flat start to the year, the last few weeks have been positive. There has been a reverse in fortunes where those regions which did the best last year seem to have done the worst and those that did the worst are doing the best.

Emerging markets seem to be on a positive upward trend but we would air caution because of the various political challenges facing some (but not all) economies. There is no change in Japan although the markets might indicate otherwise. Both the UK and the US will be subject to interest rate debate, the latest rise appears to be 2015 for the US and possibly 2014 for the UK.

Europe balances ever closer to deflation and moves to lower interest rates demonstrate the desire to stem this. The results of the elections were a wakeup call across Europe as to the general anti EU feeling and return to more nationalistic states. The reality is that the pre-European parties still hold the upper hand and it is this that is needed to drive through reform.

The message remains the same; investors should not expect the same levels of return that have been enjoyed over the past five years. It is fairer to expect returns between 5 to 8% p.a. but with a higher degree of volatility. The risks facing the global recovery are complex as no-one knows what will happen when QE stops and interest rates rise and the political unrest could weigh negatively on the markets. But there is positive optimism in the air and that has to be good news!

Source: Data sourced from BlackRock, Schroders, Templeton, Threadneedle, Standard Life Investments and the OECD.

 

NOTE: This is written in a personal capacity and reflects the view of the author.  The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.

 

 

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