Economic & Market Review - Mid Year Update 2014

by Gavin Graham, Chief Strategy Officer August 14, 2014
Notice: This newsletter is intended as a general financial market outlook, and should not be relied on as investment advice.
2014 was supposed to be the year that developed economies such as the US, Japan, the UK and Europe saw their GDP growth accelerate from their somewhat lackluster performance of 2012-13. As a result, most observers expected earnings growth would increase and, most importantly, interest rates would finally begin to rise from the record low levels of 2008-09. This would first be seen in long term bond yields, which reflect investors’ inflation expectations, and then by central banks starting to raise short-term interest rates.

Reviewing economies and financial markets half way through the year, it is apparent that these expectations have been disappointing. Instead of GDP growth accelerating, GDP in the US in the first quarter shrank by 2.9% on an annual basis, the worst performance since the recession in 2009, although much of the weakness was due to the severe winter. Japan’s bold experiment with monetary policy to attempt to create inflation, the so-called Abenomics after the new Japanese Prime Minister Shinzo Abe, did see Q1 GDP growing 6.7% annualized, but this was largely due to Japanese consumers front loading purchases ahead of an increase in sales tax. Q2 GDP is expected to fall 4.4%.

Meanwhile, with the exception of Germany, which is forecast to grow its GDP 2% this year, the other major economies of Europe are only expected to grow between 0.5-1.5% as high unemployment and austerity measures constrain growth. Only the UK, which is not part of the Euro, is forecast to see its GDP grow more than 3%. At the same time, unemployment in the US, Canada and the UK have fallen sharply. The US rate in June was 6.1%, down from 7.6% a year ago, and is the lowest since the recession began in 2008. Inflation is forecast by one of the US Federal Reserve governors to reach 2.4% by 2015, is in fact ahead of the Fed’s 2% target, and is running at 3.4% in Japan, partially driven by the 20% fall in the yen against the UIS dollar in 2013.

In the face of these signs of stronger growth, and the special factors that led to weak numbers in North America and Japan, most investors would have expected stocks to do better and government bonds to do badly. Instead, most major stock indices are only marginally ahead of where they began the year, and long term bonds have seen their yields decline, leading to a rise in their price. The benchmark US Treasury 10 year bond has seen its yield fall 12 basis points (0.12%) to 2.53% over the last year, and by 0.45% since the beginning of January. The 10 year German bund yield is down 0.46% to 1.2% over the last year and the 10 year Japanese Govt. Bond (JGB) yield is down 0.31% to 0.54%. This comes after bonds in the US experienced their worst year since 1994 and 2013 as yields rose by 1% or more as investors expected interest rates to finally rise in 2014.

Meanwhile, stock markets have been fairly lackluster, with the S&P 500 up 7.4% year to date, the German DAX and the FTSE100 flat and Japan’s Nikkei225 down 6%. Only Canada, with the S&P/TSX up 12% so far this year, is showing signs of a strong performance. This is largely due to the rebound in resources, mainly gold miners on the back of political uncertainty and energy stocks due to the oil price remaining above $100 per barrel.

What is now apparent is that central bankers are unwilling to raise short term interest rates this year. As with the US Fed, they may be withdrawing some their extraordinary stimulus through the tapering of Quantitative Easing (QE), as well as reducing the $85 billion a month of US Treasuries and mortgages by $10 billion, with the program ending in October this year. Both Mario Draghi at the European Central Bank and Mark Carney at the Bank of England have ruled out using interest rate increases in the near future and the Bank of Japan is committed to beating deflation, which involves an even bigger QE program than that of the Fed.

Eventually, central bankers will achieve their goal and manage to raise inflation rates. It will be a case of “Be careful of what you wish for” as once inflation expectations are aroused, they are very difficult to subdue, as experienced in the 1970s. Five years after the end of the Great Recession of 2008-09, with unemployment rates in North America, the UK and Germany back down to their pre-recession levels and high commodity prices due to political uncertainty in Ukraine, Iraq and East Asia, inflation rates are showing signs of strength. With central banks reluctant to raise interest rates sooner than they absolutely have to, the danger of a spike in inflation such as occurred in 2007-08 is growing.

In the meantime, investors managing balanced portfolios containing both fixed income and equities should continue to rebalance portfolios to take account of changes in prices. In 2013, stocks did much better than bonds and it made sense to reduce the increased weight in equities into bonds. Now the opposite situation is true and reducing bond weightings makes sense. What also makes sense is considering increasing exposure to non-correlated assets, such as private equity, absolute return funds, infrastructure and emerging and frontier markets, all of which can be held in Personal Pension Plans, but some of which are difficult to access for conventional Registered Retirement Plans.

Sources: as of July 10th 2014