International Fixed Interest – Outlook
The very low yields available on mainstream, high-quality bonds in the developed world have led to fixed interest investors chasing the higher yields on offer in other parts of the fixed interest marketplace. The result is that there is increasingly poor value on offer as investors bid up the price of alternatives to large developed economy bonds.
Portugal, for example, which only recently emerged from a debt bailout, now pays only 3.4% on its 10-year debt. Greece, which still offers a smorgasbord of severe economic, political and debt problems, is paying under 6% on its 10-year debt, 4% less than it was paying at the start of this year. New sovereign borrowers are able to issue debt in large volumes at relatively low cost. Kenya, for example, has just raised US$2 billion of five- and 10-year debt, the largest initial debt raising of any African country, and was able to issue the debt at lower than expected costs in a heavily oversubscribed sale. And Ecuador, which defaulted on its debt in 2008, is in the process of raising new debt and (according to media reports) is experiencing strong demand for its issue.
Both high-grade developed economy fixed interest and higher yield alternatives are now offering yields that are low in absolute terms, low relative to the historical record and to the risk involved. It is possible that this situation could persist for some time.
The ECB and the Bank of Japan are highly likely to keep bond yields very low and as both the Ukraine and Syria/Iraq have demonstrated this year, there is enough political risk around to keep up a healthy level of "safe haven" demand for high-quality bonds (and hence a high price and a low yield). It is also possible that the developed world is in for an extended post-GFC period of slower than usual economic growth and lower than usual inflation, which would be consistent with bond yields staying low for an extended period.
Nevertheless, the fundamentals of the international fixed interest markets are unprepossessing and may be vulnerable to setbacks as and when some of the major central banks decide that their economies no longer require the same degree of monetary policy life support.
The UK, in particular, seems to be getting closer to that point. The governor of the Bank of England, Mark Carney, said this month that the first interest rate increase “could happen sooner than markets currently expect”, which resulted in a change in expectations for the first interest rate increase to later this year from early in 2015.
And in the US, economists (as surveyed in the latest Wall Street Journal poll) reckon that while the first interest rate increase is still some way off, it's now on the visible horizon. Roughly 60% of the economists are picking the second or third quarter of next year, which agrees with the wording of the Fed's June decision, where it said it would keep rates low until "some considerable period" after it has finished its bond buying program, which is likely to happen around November. The economists correspondingly have a forecast for the US 10-year bond yield to rise to 3.2% by the end of this year and to about 3.75% by the end of 2015.
With the starting point for interest rates so low, even a relatively small increase from current levels has the potential to lead to painful capital loss. In addition, as was seen in late 2013, the prospect of higher yields becoming available in the developed economies can lead to a crush at the exits from developing and low-quality debt. Markets in emerging and low-quality debt are less liquid and large numbers of investors simultaneously trying to sell (say) their Kenyan debt and go back home can find few takers at acceptable prices.
International Equities – Outlook
The outlook for global economic activity remains modestly supportive for corporate performance but it remains unclear whether this moderately positive outlook justifies currently expensive equity valuations, particularly against a background of political uncertainties.
In the US, most of the recent evidence points to ongoing growth in the economy. As was widely noted in the media, the 217,000 new jobs created in May meant employment in the US, however slowly and belatedly, has managed to get back to its pre-GFC levels and industrial production, for example, rose by a larger than expected 0.6% in May. While this year's GDP growth will end up wearing the effect of a terrible winter in the northern hemisphere – the Fed, in announcing its latest policy decision, said it expected GDP growth would turn out to have been only 2.1-2.3%, compared with the 2.8-3.0% growth it had been expecting when it last ran its numbers in March – 2015 is looking distinctly brighter. The Fed expects economic growth of 3.0-3.2% and the forecasting community is in the same ballpark. The latest Wall Street Journal poll of American forecasters shows they expect growth to pick up to 2.9% next year from 2.2% this year.
In the UK, economic performance has been significantly stronger than expected. The quarter to April saw the largest number of new jobs created (344,000) since the data started to be collected back in 1971 and the unemployment rate has dropped to 6.6%, its lowest level in more than five years. As a result, forecasters are raising their estimates of how well the UK will do this year and next. The Economist's latest (June) survey of international forecasters has revised up the consensus forecast for 2014 to 3% and for 2015 to 2.6%
In the other main developed economies, the growth outlook points to a more modest improvement. The eurozone (on the Economist poll reading) is likely to grow by 1.5% next year, a little faster than this year's expected 1.1%, and some of the previously most embattled economies look to have turned the corner, with Spain, for example, expected to grow a little this year (+0.9%) and a bit faster next year (+1.4%).
Japan has been somewhat hard to read as the economy has been suffering from the introduction of a higher sales tax in April, which led Japanese households to spend up before the tax increase and to close their wallets and purses since. Markit's Purchasing Manager Index (PMI) for Japan suggests the economy likely contracted in April (significantly) and May (marginally). The forward-looking indicators within the Market PMI, however, are looking more positive, with employers looking to hire and being modestly upbeat about their business prospects over the next year. The Economist's poll expects that Japan will also manage modest growth, of 1.3-1.4% this year and next.
Emerging markets are a mixed bag, with Markit's latest Purchasing Manager Indices suggesting uphill conditions ahead for Brazil and, especially, Russia. On the brighter side, India's new administration is expected to begin to deliver more growth-friendly policies. And the major concern over the emerging markets – the state of the Chinese economy – looks to be easing, with assorted recent data showing the economy appears to be stabilising at quite a high rate of economic growth, likely to be in the 7% a year region this year and next. Markit combines the emerging and developed markets surveys it compiles to form the JPMorgan Global Purchasing Managers Index, which is signalling that the world economy has been picking up pace (to its fastest growth rate since September of last year).
As it has been for some time, the question remains whether this reasonable, though far from impressive, outlook justifies the kinds of valuations equities now command. There is considerable evidence of frothy conditions in the major equity markets, as shown not only by quite high P/E ratios (the S&P 500 is trading on close to 19 times earnings) but also by the extremely high prices being paid for tech listings – reminiscent of the headier days before the tech wreck of 2001 – and by the upsurge in mergers and acquisitions, where companies clearly are of a mind to put their shares to some productive use while they are still so generously priced.
