Caution remains in light of US, Europe, China news, says Threadneedle’s Burgess
Mark Burgess, CIO of Threadneedle, is advising caution in light of the inflationary effects of further QE measures on fixed income and expectations equities may struggle given the threat to corporate earnings from the ongoing macro environment.
The three key regions driving global growth forecasts, the US, Europe and China, continue to see weaker data. There are some signs that the rate of slowdown may have improved, however on balance, the large overhang of debt in the West is still acting as a major drag on economic activity. This is also having an increasing impact on the developing world. We have had below consensus growth forecasts for an extended period and believe it is right to retain these views.
Against this difficult background, we have adopted a fairly cautious stance in our equity selection. This has favoured companies with strong balance sheets, those able to show reasonable growth and firms with business models well suited to today’s conditions.
The policies announced by the Fed last week were surprising in their scope, their focus and that they were potentially indefinite. A further round of Quantitative Easing or QE3 had not been expected by us for a number of reasons. First, the US economy is growing, albeit modestly but is still expected to be close to +2% this year. Second, financial markets are performing well with the S&P comfortably in positive territory year to date. Third and perhaps most importantly, this close to the forthcoming US election, it is seen particularly by the Republicans as too politicised a policy measure, specifically targeting a reduction in the level of unemployment. Pumping an additional $85bn a month into the bond markets, just under half of which will be used to buy mortgage-backed securities, indicates the heightened level of concern felt by the Fed at the weakness in the labour market. This is probably something the politicians should be addressing, but clearly the Fed thinks that so far the current administration has failed. It will be interesting to see if the electorate agrees with them. It will also be interesting to see whether the negative side effects of this policy, a likely rise in food and energy prices, have any influence on voting intentions.
Government bond markets have reacted less favourably to the news, with yields in core bond markets rising significantly. At some stage this level of reflation has to prove inflationary, and we may look back on this point as the end of the decade-long bull market in government bonds. QE3, along with the announcement that interest rates are going to stay at current levels for an indefinite period, is also likely to continue supporting yielding assets. We remain overweight in High Yield, Investment Grade and Emerging Market bonds.
In Europe, the ECB appears to be pursuing a middle path. QE is not currently within their remit, and so they have attempted to lower short-term funding costs for the periphery so they can start to function again from an economic perspective. For now this appears to have worked with a significant fall in short-term yields although no-one has so far signed up to the strict conditions necessary to enable secondary market bond purchases to take place. Nevertheless, investors are unlikely to want to be on the wrong side of this potential announcement and hence we may see a period of calm in Europe. Certainly the euro has responded well, rising significantly against the dollar.
However, the longer-term problems have not gone away. Much of Europe, the UK and arguably the US have too much debt and no real medium-term prospect of, or policies for, paying it back. Bond market investors face the prospect of default in some cases, or perhaps more likely now (in light of the recent policies announced) inflation eating away at their returns. Arguably this was always inevitable once we had reached this level of debt overhang. However, neither bodes well particularly given how bond-focused most investors’ portfolios are now.