We expect interest rates to rise in 2014 – Invesco’s Mustoe and Greenwood

Nick Mustoe, CIO at Invesco Perpetual, and John Greenwood, Chief Economist at Invesco, provide their economic and investment outlook for 2014

Introduction
The following summarises the main points of discussion from a live webcall with Nick Mustoe, Chief Investment Officer at Invesco Perpetual, and John Greenwood, Chief Economist at Invesco Ltd, which took place on 21st November 2013. Nick and John answered questions put to them by Paul Burden, Independent Financial Journalist, with questions provided by the intermediary community. To listen to the full recording of the webcall please visit: www.invescoperpetual.co.uk/investmentintelligence.

Spotlight interview

Paul Burden
Hello, I’m Paul Burden. Is the global economic recovery sustainable? When will central banks start to tighten monetary policy? What does that mean for equity and bond markets? These are some of the issues that investors are worrying about. I’m joined today by John Greenwood, Invesco Ltd’s Chief Economist, and Nick Mustoe, Chief Investment Officer at Invesco Perpetual.
Welcome to our programme and thank you for joining us. We have already received a lot of questions from our advisors’ panel, so let us go straight to our first one. It comes from Charles Dickson of Charles Dickson Financial Planning, and he asks a question for John: The overwhelming concern right now is around the ill effects of quantitative easing, which happens to be the front lead on the Financial Times this morning, so what will happen when it all unwinds?

John Greenwood
Well, the impact will depend on two things which are related: first of all, whether or not balance sheets are properly healed; and, in turn, related to that, whether or not the commercial banks are creating liquidity. Quantitative easing is, essentially, liquidity-creation by the central bank, and they’ve been doing that to substitute for the failure of commercial banks to create liquidity. So, if, so to speak, the baton has been handed over from the central banks to the commercial banks and, by the middle of next year, they are creating loans and making liquidity in ample quantity, then I don’t think that the tapering is going to have much effect, and that’s the reason, I think, why the Fed decided not to taper in September. At that time, during this last summer, US banks were making minimal liquidity available, so, if the Fed had started tapering then, there would have been a significant impact.

PB

And balance-sheet repair, the other issue to which you refer?

JG
Well, the willingness of banks to lend and the willingness of borrowers to borrow depends on the state of their balance sheets. If they’re still repairing balance sheets and paying down debt, they’re not likely to want to borrow. So, balance-sheet repair comes first, and then commercial-bank willingness to lend and, equally, private-sector willingness to borrow, comes second.

PB
Let’s turn to a question from Nick Barber of Brewin Dolphin. He asks: The general consensus is that the US will continue to lead the developed markets out of recession. To what extent are you concerned that tapering will stall or derail any progress?

JG
Well, it depends, as I say, on the progress in private-sector deleveraging and balance-sheet repair, and we’re doing reasonably okay in the US and the UK in that respect. Of more concern to me is the policy question. The Fed has approached this in a kind of ad hoc way of should they taper by, let’s say, an amount of 20 billion or 15 billion or 10 billion – that amount has been uncertain – and then we’ve also had the additional uncertainty as to when they’re going to start. I would much prefer to see the Fed adopt a policy that said, ‘We will taper by $5 billion per month over 17 months.’ That would deal with the 85 billion per month that they’re currently purchasing. In that way, the markets would have certainty and there wouldn’t be this angst in the markets every month – ‘Will they, won’t they?’ – or before each FOMC meeting, as we go through next year. So, it would be much better to taper slowly and gradually over a period of time, but the Fed won’t want to do that until they’re confident that underlying economic recovery is strong enough.

PB
Nick, is this something on which you would concur with John?

Nick Mustoe
Yes, I think that markets really are looking for this transition, and it’s better to start it early and gradually, because this is all about weaning markets off the positive effects of QE. And remember: QE has had a profound effect on financial markets rather than underlying economies, so there has to be a way of taking some of the steam out of markets and begin the process of long-term interest rates gradually rising, and a focus, really, for equity markets on what the underlying earnings growth is going to be.

PB
A question from Bernard King of Charterhouse Financial Planning, John. He says: The global recovery seems to be gaining traction. What are the main risks of derailment?

JG
Well, I think that the recovery is improving, certainly in the US and the UK, if you take a two-year-to-three-year perspective. The US has recently weakened a bit because of fiscal tightening but, in general, the private sector in both areas is healing. I have much more concern about the eurozone. Although we had a recovery in the second quarter, the figures in the third quarter have, again, been weaker and, in some cases, actually, negative; for example, in France. The eurozone, it’s not so much a recovery as a bottoming-out and bumping along the bottom. That’s how I would describe it. So, I think that there is still scope for problems in the eurozone. A second potential area for difficulty is the fading or weakening of Abenomics in Japan and, thirdly, the possibility still exists for credit problems in China. So, those would be the main risks to derailment. So, they’re not coming from either the US or the UK, in my view.

PB
We’ll come to all of those three issues in due course, but can I take a question now from Ian Price of Heron Wealth Management? He asks: Where will interest rates rise first – in the US or in the UK?

JG
I don’t have a clear view on that, frankly, and I don’t think it matters a lot, because, essentially, London UK is the capital market for Europe and, obviously, the other major capital market in the world is the US, and I think that the rate rises in both countries are likely to be very close together. The important thing is that the tapering of US asset purchases – or Fed asset purchases – is completed. There will then be a sort of interim period when the Fed is not supporting the markets, and then I think they will start to raise rates. An important thing to say, actually, about this tapering is that I don’t believe that either the Fed or the Bank of England will start to sell their assets into the market, so that’s not one of the risks that I foresee. I think they will simply continue to hold those assets and allow them to mature gradually over time, running them off the balance sheet. So, I don’t envisage either overt sales by the Bank of England or by the Federal Reserve.

PB
Do you have a timescale in your head about when all this is going to happen and when we may see that rise begin to occur?

JG
As Nick said just now, I think that longer-term rates will start to rise and start to normalise with the tapering process, but the Fed and the Bank of England are unlikely to raise short-term rates until at least the second half of 2015, and possibly even 2016, so I think there’s quite a long way to go before we get to rate rises.

PB
Nick, you’re nodding your head in agreement. That, broadly, would be your picture as well, would it?

NM
It would. I’d also just add that there are other ingredients that we need to see in terms of the recovery for it to become more profound and well-founded. The key, really, is getting wage growth, getting capital investment from companies. These are two key ingredients that we haven’t yet seen, and I think central authorities are going to play it careful and be fairly cautious about doing anything to derail that next stage of the recovery.

PB
Can I put to you a question, Nick, from Ben Wattam of Mattioli Woods? He asks: Is inflation or deflation the greater risk, and which would be of greater concern for equity markets?

NM
Well, I think the obvious lesson is, really, from Japan: that deflation is the biggest risk for equity markets. It’s obviously a very difficult environment for companies to make progress. If you have a modestly price-increasing environment, you actually have the chance to increase profitability, whereas it’s very tough if prices are actually going down. The backdrop that we have, deleveraging is inherently deflationary; we have weak labour markets, so there’s no wage growth in the system; the move by the ECB very recently to cut interest rates, highlight the data points that are showing that inflation is not the problem, but potentially deflation. We’re a long way off from that actually being the case, but it’s clear that authorities are focused on making sure it doesn’t get there.

PB
Can I ask you, John: does the question of deflation keep you awake at night?

JG
I think it’s a real possibility for the eurozone. I don’t think it’s a risk either for the UK or for the US. The willingness of the Fed and the Bank of England to conduct QE asset purchases will ensure that things continue to expand and that we don’t get too near the deflation-risk scenario, but that is not the case in the eurozone. The inherent opposition on the governing council of the ECB to asset purchases, or particularly bond purchases, and the reluctance to do further LTROs – long-term repurchase operations; that’s lending to banks – those things have meant that the amount of credit and money growth in Europe is really minimal. We’ve got 2.1% growth of broad money, and bank-lending is currently declining right across Europe. Those are not conditions which are conducive to a recovery. So, deflation in the eurozone, I’d say, is still a possibility.

PB
Do you completely dismiss the risk of inflation at this stage?

JG
It’s certainly not a problem for the next two years. It takes at least two years for money and credit growth to show up as inflation. Now, will we get rapid money and credit growth in the UK and the US over that time horizon? Frankly, I doubt it. There’s so much deleveraging going on, there’s much caution, and the growth of wages and spending power in the consumer sector is still very limited, so all of those things mitigate against a rapid rise of inflation.

PB
A question from Neill Boulton of Neill Boulton Wealth Management about market valuations, Nick, for you: Are equity-market valuations still attractive or are we in an equity-market bubble?

NM
I don’t think we’re in an equity-market bubble at all, but it has to be said that we’ve had a very strong period of performance. The MSCI has delivered 21% year to date, so that’s a very good result for most developed markets particularly. If you look at underlying valuations, you’d have to say that they are probably in line with the long-term average, so we’re talking about mid teens, typically, in terms of price-earnings ratio, so not the bargain that they were a year to 18 months ago. We now need to see earnings growth coming through from companies to actually justify some of the valuations, but it is fair.

PB
John referred earlier to the risks in Japan. We’ve got a question from Bill Cope of Best Practice IFA. He asks: How is the experiment with Abenomics – if I pronounced that rightly – progressing in Japan?

JG
Close enough.

PB
Thank you.

JG
Abenomics is described as having three arrows. In fact, the Prime Minister, Shinzō Abe, describes it in that way. But what I would say is that, regrettably, really only one and a half arrows have been fired. That is to say that fiscal expansion, number one, that’s working, although that’s going to be partially reversed next year, when the consumption tax increases from 5% to 8%.
The second arrow is monetary expansion. Now, this is where they’ve got half an arrow. It’s easy for them to expand the balance sheet of the Bank of Japan – that’s what they’ve been doing. The big question is whether the commercial banks will take up the stimulus and increase lending and money growth for the economy as a whole. So far, although there’s been a modest improvement, we’ve only seen a very small increase in commercial-bank balance sheets. Broad money has increased from 2.8% at the beginning of the year to 3.8%, and nobody could say that was a big move.
The third arrow has not been fired at all. In fact, he’s put the arrow back in its quiver. This relates to structural change. He had promised changes in labour-market legislation, changes in agricultural trade protectionism – reducing trade protectionism – and participation in the transpacific trade negotiations which are going on with the United States to create a free-trade zone in the Pacific region. Now, Abe and his team have backed off from all of those, so it looks as though even that part of the scheme is not being implemented. So, so far, they’re only scoring one and a half out of three.

PB
Does that mean that, effectively, Abenomics will not work, or is it going to half work, if I can put it that way?

JG
It’s going to half work. We’re seeing better growth at the moment, but growth is already slowing from the more rapid pace earlier this year. If the yen doesn’t weaken any further, then it could be that we just revert to 1-1.5% growth, with inflation at or below 2%, so we’re not going to get sustained stronger growth and higher inflation. In order to see that, you would need credit growth, I would estimate, between 4% and 6% per annum, and a continuing programme of structural changes, so that’s why those other two arrows are important.

PB
Do you think the Japanese authorities recognise the need to see the yen fall in value? Is that a nettle they’re prepared to grasp or are they backing off from that?

JG
They’re backing off because of the political realities. The Liberal Democratic Party, which is Abe’s party, has always depended very much on the rural vote – the farmers – so you can see why he’s not going to back cutting the price of rice – the support price of rice – drastically, and you can see why he’s not undertaken these labour-market reforms, which would also have damaging effects on some of the segments of the population that support the LDP.

PB
Nick, sorry, you have a view on Japan.

NM
Yes. The key thing, really, is that it’s had a very material impact on company profitability. Obviously, the weakness of the yen from Abenomics has made exporters very competitive, particularly compared to their Asian rivals. We’ve seen very strong earnings growth, year on year up something over 30%, so the corporate sector is actually benefiting very dramatically from this, and you can see that carrying on. Forecasts looking out a year ahead are still very much ahead of their peers in the rest of the developed world, so it is working, so stock-market investors are actually getting some payback from this.

PB
One of the consequences of all that, as we’ve seen, is a pretty strong performance by the Nikkei, but do you believe – and this is a question which has come out of our research – that the equity market can continue to rise from where it is?

NM
I think so. If you look through the individual valuation of companies, the key context here really is that everyone has been very jaundiced about any economic or market recovery in Japan for a long time, so, over successive years, Japanese companies just got de-rated, so they just got too undervalued as of last year. All that’s happened is we’ve seen a little of rerating but a lot of profit recovery, and valuations still look very attractive. There are a number of sectors that still look very undervalued. Inherently, companies and analysts tend to be pretty cautious about moving their forecasts, so, yes, there is still a lot of room for Japan to do well.

PB
A question from Stuart Sutton of SG Wealth Management, John. He asks: Are emerging economies shifting from reliance on inward investment to domestic demand quickly enough, or do they remain at risk from the flight of capital?

JG
They do remain at the risk of capital flight, and they haven’t decoupled sufficiently from developed markets in order to be able to grow independently of what is happening in the developed western nations. The main feature of the last few years has been a big carry trade – a movement of capital from the developed countries, where interest rates have been very low, into the emerging markets, where rates were much higher and more attractive, and that meant that huge flows accumulated in those countries. Starting in May this year, when Ben Bernanke made his testimony about the possibility of tapering later in the year, there was a sudden outflow of capital. I don’t think we’ve seen the full outflow; there will be further outflows, particularly when US rates start rising further.
So, the outflows will continue and, as I say, I don’t think that they’ve done enough yet to restructure away from export-oriented growth. In fact, we’ve seen very low growth of global trade. One of the reasons why the emerging markets are suffering is because even countries like Taiwan, Korea and China are seeing negligible growth of their exports at the moment, and their export-oriented growth model is, therefore, stalling on this tripwire.

PB
We’ve had pretty big announcements from China on all kinds of things, including the number of babies that families can have, but important announcements suggesting that they are awake to the need to move to, if you like, a more developed state. How optimistic do those announcements make you, or do we not know enough yet?

JG
Well, we know the direction but the real question is how much they will implement those plans. Many of them are very difficult politically. They involve undermining the position of the privileged state-owned enterprises, allowing foreign competition in a number of sectors where it’s, essentially, been prohibited, so those kinds of things will arouse domestic opposition, and I think we have to be very cautious. The Chinese authorities have frequently laid out goals, they’re very good at spelling out aspirations; they’re much less good at implementing.

PB
Not too optimistic. A different question. Andrew Thompson of Close Asset Management asks: Do you think that emerging-market equities are more attractive following the recent pullback? Nick, let me put that to you.

NM
Yes, I think they are. They’re definitely getting interesting in valuation terms. Obviously, as John says, we still have this period to go through during tapering and post that, but the combination of a big currency fall for most of the markets, and equity-market falls, means that there are a lot of companies looking pretty attractive. It’s really been a role-reversal: we’re used to talking about the BRIC economies being the strongest markets, with the strongest growth, and we’ve really seen the developed world, actually, far outstrip them in terms of equity-market performance. So, now is a time to start looking long-term but not to rush.

PB
I thought BRIC had been replaced with another acronym, which I’ve now forgotten for the moment.

JG
BIITS.

PB
Which is…?

JG
BIITS, which is Brazil, Indonesia, India, Turkey and South Africa.

PB

Having got that out of the way, more of that later. John, let us turn to something you’ve referred to already, and that is Europe. Bill Cope of Best Practice IFA asks: Is the euro crisis over?

JG
Sadly, not. I think we’ve seen major sticking plasters applied which have succeeded in stabilising things, but many of the mechanisms that have been put in place would, I think, be subject to market-testing in extreme conditions again. For example, the plan to rescue banks is dependent on this EMS – the European Monetary Stabilisation mechanism. Now, that is, in my view, a poor substitute for having a federal European government that could step in and underwrite or rescue banks, if need be, and we still have very high levels of debt – sovereign debt – in a number of the countries, which is not really running down. Furthermore, we have high levels of debt in the private sector of many of the crisis economies, which is also being rather slow to be run down. So, the debt problem is not being resolved anything like as quickly in Europe as it is in the US or the UK, and that’s a function of growth being so weak, which, in turn, relates to the kinds of policies that they’ve adopted.

PB
A question which follows that up, from Martin Fishburn of Capital Ideas. He asks: Are there still significant hidden risks for investors in Europe? What kinds of risks do you think he’s thinking of?

JG
I wouldn’t expect anything that we haven’t already seen – the risks of non-repayment or solvency, those kinds of default risks. I suppose it’s possible that we could see some country have a takeover by an extreme wing of either the right wing or the left wing in political terms, and we came near to that in Greece, and we’ve seen a major protest vote, certainly, in Italy – 25% of the electorate voting for a party which, essentially, refuses to participate in the political process. So, those kinds of risks are still there, and I think that the result is that we’ll get gradual growth in Europe but it means that the areas, I would say, of interest are going to continue to be those that are externally focused and, on the domestic side, really only those things that are ridiculously cheap.

PB
A question which follows up that issue of whether there are still skeletons in the European cupboard. Chris Purkis of RHG Investment Services asks, Nick, putting this to you: Is the worst behind the European stock markets, or are there still things we have to fear?

NM
I think the worst is behind us. I’m probably a little more optimistic than John, at the margin. I think that the period of stability that we’ve had, from Draghi’s actions bringing long-term interest rates down, Italian and Spanish bond yields getting down to 4%, that has given the backdrop for decision-makers to actually do things within companies, and that is why I think the data has been a bit better. There’s still a long process to go through in terms of deleveraging, clearly, but I think that can happen still within this context.
There are lots of underlying reforms that have also happened to make some of the individual economies more competitive, which is all part of the ingredients, so I do think that we have a reasonable basis of outlook for European stock markets. We don’t need a strong-growth environment for European companies to do well. The lesson from the last few years has been it’s all about efficiency, it’s about managing a low-growth environment, it’s about extracting good returns from capital, and European companies have really got on with that, so I’m reasonably optimistic.

PB
A question from Chris Purkis of RHG Investment Services. John, he asks: Is what the UK government is doing in the housing market just going to end in tears?

JG
Not necessarily. I think, first of all, it’s important to recognise the scale of it. It’s still very, very small. Yesterday, I saw headlined a huge increase in mortgage lending, but that was a sort of increment in lending. If you look at the total figures for mortgage-lending, they’re barely growing at all. Some people are still repaying mortgages, while the new lending is kind of replacing some of that replacement. Now, that’s new because, previously, we had overall mortgages declining, so I wouldn’t exaggerate the extent of the angst about these housing measures. I think that the weakness of wage growth, continuing high levels of unemployment and the fact that property prices, certainly outside London, are still well below their previous peaks, all those things mean that the market can move quite a long way before we need to get concerned about any kinds of overheating.

PB
Nick, are you similarly reasonably unconcerned about the housing-market situation?

NM
I think it very much depends on where it goes to from here in terms of if we see an acceleration of prices, then we’re partly delaying some of the readjustment that needs to be happening in terms of deleveraging the economy. But as it stands now, it’s had a positive impact and has been well received by the equity market. It’s just a question of where it goes to.

PB
Well, after skeletons in the European cupboard, a question from Peter Clarke of the Abbott Partnership: What potential crocodiles are waiting around the corner – if crocodiles wait around corners – to trip up the gathering economic growth in the UK?

JG
Well, I think the main one would be another downturn in the eurozone, but I don’t think that’s likely. I think, as I say, we’ve seen that. What caused the double dip in the UK was a sharp drop in manufacturing output and in construction, and both of those were associated with the weakness in the eurozone, and I don’t think we’re going to see a repeat of that. So, I’m not concerned about a triple dip, if you like. On the other side, also I don’t think we’re going to get a sharp spike in interest rates or the Bank of England sharply raising short-term rates, because the growth of spending power, the growth of liquidity, are simply not enough to fuel that. So, on either side, I think the risks are reasonably balanced and I’m not expecting a nasty snap of the jaws on either side.

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