What's the outlook?
It’s August, how is it August?
The answer to this remains a mystery, but August it is and with it comes our latest investment committee meeting to review the Parsonage portfolios.
We’ll post the factsheets in a separate blog, but we thought you may like to read the outlook summary from Steve following our meeting.
Domestic Outlook
Andy Haldane is due to leave his post as Chief Economist at the Bank of England in September after 32 years on Threadneedle Street. June, marked his final meeting as a member of the Monetary Policy Committee (MPC).
During that meeting, his was the only dissenting voice. While there was unanimity on Bank Rate (held at 0.1%) and on the stock of non-financial sterling corporate bonds (held at £20 billion), it was the planned purchases of government bonds that drew an objection from the head economist.
In an effort to support the economy more broadly and the financial markets more specifically, and as part of a raft of new measures, the Bank increased its stock of government and corporate bonds from a pre-pandemic level of £435 billion to £645 billion during a special meeting in March 2020. Not long after, during the August meeting of the MPC, the target was further increased to £745 billion with an additional £150 billion unanimously approved in November. That last amount is currently being acted upon and ought to bring the stock to a total of £895 billion some time around the end of this year.
Andy Haldane’s vote reveals that he would rather see that amount shaved by £50 billion, meaning that the extra stimulus the Bank is applying stops sooner (perhaps by August) and shorter (at £845 billion). Of course, he is content with as low a policy-rate of interest as is possible (for now at least) and £50 billion is a splash in the ocean with asset purchases approaching £1 trillion, but Andy Haldane is at least sounding a note of caution. And we have to admit to being sympathetic to his argument.
He set out his views, shared along with some fascinating memories of his time at the Bank, in a speech given at the Institute for Government earlier today (30 June). His case, as we understand it, begins by acknowledging a lack of hard evidence (in the form of market-based and/or survey-based indications) that inflation expectations are becoming ‘durably or significantly de-anchored’ from the 2.0% target. That’s the good news. But his feeling is that ‘those expectations and monetary policy credibility feel more fragile at present than at any time since inflation-targeting was introduced in 1992’. That is because he expects inflation to be nearer to 4.0% than 3.0% by the end of this year. That ‘increases the chances of a high inflation narrative becoming the dominant one, a central expectation rather than a risk’. ‘If that happened, inflation expectations at all maturities would shift upwards, not only in financial markets but among households and businesses too’. In turn the Bank’s MPC would be forced to ‘play catch-up to re-anchor inflation expectations through materially larger and/or faster interest rate rises than are currently expected’.
Those risks are heightened by what he perceives to be a ‘dependency culture around cheap money’. And he is right when he notes that ‘only a minority of those with a mortgage have ever experienced a rise in borrowing costs’ and ‘fewer still have significant inflation in their lived experience’. That means that for policy makers ‘easy money is always an easier decision than tight money’.
And that is where our concerns coincide with those of the outgoing chief economist. If we are reading the bond market correctly, prices reflect interest rates which are sustained below 0.25% for at least another year, and below 0.50% for another year after that.
Of course, the market is reflecting the dovish tone set by the Bank and it would be unwise to discount the risks to the downside. Nevertheless, expectations for rates which barely rise to 1.0% even at the 5-year horizon, cannot be right.
There are differences between the crisis we face today and that which we faced in 2008 and which stirred the Bank into making those early rounds of asset purchases (totalling £435 billion). Back then, the damage to the financial system was so extensive as to hugely hinder the pace of economic recovery. Indeed, it took around 6 years to make back the 6% of output lost in the Credit Crunch. That is why monetary conditions were left so loose for so long. And rightly so. Today though, our banking system is strong and the market for capital is functioning as it should. There is no reason to believe that we will see anything other than a full and vigorous recovery. As the recovery rolls on, the Bank’s tone will shift. And so too will longer term interest rates.
International Outlook
Looking ahead into the third quarter, we notice the calendar is peppered with political events. September represents something of a feast in that regard.
Perhaps the most important is the Federal Election in Europe’s powerhouse economy, scheduled to be held on 26 September. After close to 16 years at the helm, and at the age of 67, Angela Merkel will step down from her post and cease to be the most powerful woman in the world. Her successor as Chancellor will very likely be Armin Laschet. Mr Laschet is the second choice ‘continuity candidate’ having replaced the gaffe prone Annegret Kramp-Karrenbauer as leader of the traditional centre-right Christian Democratic Union (CDU) in February last year. We are guessing that the CDU will win the most seats with the left-of-centre Greens in second place and the right-wing Alternative or Germany (AfD) in third. Don’t expect an outright CDU victory though; there hasn’t been a single-party majority since 1957. Instead, a coalition will slowly form. How quickly that will happen is anybody’s guess. If the right-of-centre Free Democratic Party (FDP) surprise in the polling, such a deal might be considered oven-ready but it will be a slow-cooked affair if the CDU is to negotiate with the SPD again, and slower still with the Greens. There are nuances that we are failing to pick up, but we do not think there are significant implications for the market for German equities or bonds whichever way the coalition forms. Needless to say though, the quicker a stable government is settled upon the better but the outlook for Germany is stable enough.
The International Monetary Fund (IMF) has pencilled expectations for growth in the region of 3.6% for this year and 3.4% for next. That might strike seem low compared with expectations for France of 5.8% and 4.2% and for Italy of 4.2% and 3.6% but muted gains in Germany reflect the extend to which those economies were harmed in 2020. Output in German fell 4.9% last year compared with 8.2% inf France and 8.9% in Italy. Worst hit was Spain with a decline of 11.0%. The euro area as a bloc fell 6.6%.
To the east of Germany, Elections are due in Russia too, though they will be far less meaningful than those in Germany, being as they are for seats in the State Duma, the lower house of the Russian legislature. It’s very likely that the pro-Putin United Russia party maintaining a majority isn’t it.
Equally foregone, though perhaps more consequential, will be the Committee Elections due in Hong Kong when the Chinese Communist Party will assert even greater control over the city. That, coupled with ongoing human rights abuses (most notably in Xinjiang but also in Tibet and Inner Mongolia) and a growing appetite for a more thorough investigation about the origins of SARS-CoV-2, will add to tensions with the United States. As a result, the chances that we will see any significant progress toward a trade deal are low. That’s a headwind for equities that will become more apparent as and when the pandemic is finally behind us.
The extent those tensions might be expected to affect the Chinese economy is confused in the short term. The IMF expect the Chinese economy to grow around 8.4% this year, after slowing to 2.3% in 2020. Prospects for growth next year are expected to reach 5.4%.
The Outlook for Bonds and Equities
In the meantime there are a few more immediate issues that are occupying our thoughts. The first concerns interest rates and the second concerns equity price valuations.
On interest rates and connected inflation expectations, sentiment in the equity and bond market has yo-yoed between over-reaction and complacency. First inflation was a threat, and then it wasn’t. You can see that pattern clearly in US treasury yields. Six months ago, the 10-year treasury yielded 1.08%. From there, and coinciding with peak concerns about the prospects for high and sustained inflation, yields rose sharply to 1.74%. At the end of June, the 10-year bond yields 1.29%; a decline of 45 basis points and more than the lion’s share of the prior 66 basis point increase. The swing in market-implied rates of inflation over the 10-year period has been less pronounced. The relevant breakeven rate had declined from a coincident peak rate of 2.54% to 2.31%.
As it happens, we are not entirely uncomfortable with a 10-year breakeven rate around 2.3%. The 5-year breakeven stands at close to 2.5% and the 5-year/5-year forward equivalent is registered at 2.1%. All three of those numbers taken together describe inflation in the US which is peaked in the near term – consistent with ‘transitory’ pressures – and which is reasonably well-behaved later on.
That is in line with our own expectations. We think the US economy will increase somewhere between 6.5% and 7.5% for 2022 as a whole and slow to between 3.1% and 3.4% next year. Coinciding with that hump in growth we expect consumer prices to ease a little from around 5% currently to between 3.9% and 4.3% by year end, easing further to between 2.4% and 2.6% by the end of next year.
What we are less comfortable with is a 10-year bond yield at 1.29%. We’d be much happier if it were closer to 2.0% and happier still if shorter-term rates reflected higher yields too. While the 12-month treasury forward rate, for example, stands at 0.28% today (implying a modest rise in the Fed Funds rate by this time next year), the 2-year rate is glued to the floor at 0.62%. And the 3-year rate, at 0.97%, is unfathomably low. Indeed, forward rates barely get beyond 1.5% at the 5-year horizon.
Is it reasonable to expect the Federal Reserve will maintain a Fed Funds rate at less than 1% for the next 3 years? Or that it will remain at less than 2% for the next 5 years? We don’t think so. That being so, market-set interest rates are too low and some adjustment in necessary. Such an adjustment might come about gradually or it might come about quickly.
Our second, and not entirely unconnected, concern relates to measures of ‘value’ in the equity market specifically. The Cyclically-Adjusted Price-Earnings Ratio (otherwise known as CAPE or ‘the Shiller P/E’) is not a very effective tool for decision-making, but it’s not a metric we wish simply to ignore. As it stands, the Shiller P/E is measured at 37.0. That’s higher than at any point in the 140 year series barring the spectacular run up during the technology bubble 20 years ago. Whilst the Shiller P/E is limited in its analysis to larger US-listed companies, the message it highlights has a broader truth. Valuations are at their loftiest in and among the US market, but there are very few pockets of ‘good value’ to be found in equity markets more broadly.
Of course, stock prices can march higher irrespective of our estimations of ‘fair value’. Indeed, without wishing to sound too optimistic about their prospects, that is exactly what we expect. But the more stretched valuations become, the more vulnerable prices are to sharper and more persistent declines during times of market stress.
These twin concerns of ours are reflected and accounted for in our portfolios. We think we have struck a good balance; harnessing those risks we feel will be matched with good returns and mitigating those we think are not.
We hope you find this useful, any questions…….please don’t hesitate to get in touch.
*Please note, the above communication is for information only and does not constitute advice.