International Fixed Interest and Equities Outlook – 2014 September

The outlook for global fixed interest will depend on three issues - geopolitical stress, monetary policy and the extraordinarily expensive starting point for international fixed interest; the world economy is still growing but the level of risk to the outlook and consequently share prices has risen in recent months.

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International Fixed Interest – Outlook
The outlook for global fixed interest will depend on three issues.

The first is the (largely unpredictable) potential for further geopolitical stress. As the latest few weeks have shown, bonds (and particularly the bonds issued by the major central banks) retain a strong insurance value when issues such as the Ukraine or ISIS flare up. Many investors will see some value in continuing to hold bonds, however low-yielding, so long as political hotspots have the potential to rattle investor confidence.

The second is the outlook for monetary policy. In two of the major economies, interest rates will gradually set off towards more normal levels over the next year. The Bank of England is likely to be the first out of the blocks, with its first rate rise in the northern hemisphere spring. Indeed, two of its policy committee members have already voted for a rate increase this year, given that the economy is growing strongly and that UK house prices are soaring (prices have risen nationally by 11.7% in the year to July and by 19.1% in London). The Fed will not be far behind. The latest poll of US forecasters by The Wall Street Journal shows that most expect the first interest rate rise to happen in the first half of 2015 (most likely in the June quarter). They expect that bond yields in the US will also gradually head north to reach 3.6% by the end of '15 and 4.0% by the end of '16. In the eurozone and Japan, however, there is likely to be a long period of ultra-low bond yields as the Bank of Japan continues with, and the European Central Bank starts, extensive programs of bond buying.

The third is the extraordinarily expensive starting point for international fixed interest, which means that eventually, as rates normalise – sooner in the US and the UK, later (maybe much later) in Japan and the eurozone – there is potential for serious capital losses. Yields everywhere have fallen to levels that bear little or no relation to the degree of longer-term risk, whether it is the risk of peripheral eurozone economies (Portugal's 10-year bonds yield only 3.2% and Ireland's less again, at 1.9%), corporate debt (global corporate bonds yield only 2.6%), or the iffier end of the credit quality spectrum (European "high yield" bonds are paying only 4.5% and more dubious credits such as Ghana have been able to get bond issues away). The normalisation of yields may still be some distance off but it may be nasty when it happens.

International Equities – Outlook
The world economy is still growing but the level of risk to the outlook and consequently share prices has risen in recent months.

The Economist, which calculates an index of global GDP covering some 90% of the world, found that world GDP grew by 2.6% in the year to June. The good news was that the world economy continued to grow but the bad news was that the growth rate was the slowest in a year and was heavily dependent on fast growth in China, which contributed nearly half (45%) of the total rise in world output. More recent data for July and August from the JP Morgan Global PMI compiled by Markit and which aggregates individual country performance indices into a global total, shows that the global growth rate has picked up a little to around the 3% mark.

Among the developed economies, the US and the UK are doing well – the unexpectedly weak August jobs report in the US seems to have been more of a blip than any permanent setback – and Japan seems to be coming out of its post-sales tax difficulties. The eurozone, however, remains very weak. Even in Germany, the best off of the larger eurozone economies, recent business surveys from ZEW and IFO (two German research organisations) have shown a drop-off in performance. Among emerging markets, ongoing rapid growth in China is making up for recessions in Brazil and Russia.

All going well, the world economy will continue to grow at a modest rate, which would provide some support for equity markets but the risks to everything going well have been rising against a background in which shares are already arguably on the expensive side.

In the US, for example, shares are trading on a P/E ratio of about 20 (on Thomson Reuters calculations), which is not easily reconciled with the modest growth in profits that companies are actually achieving. According to official statistics, rather than the numbers companies publish, after-tax profits for American businesses rose 9% in 2012 but by only 4.1% in 2013 and this year profits have been harder again to come by, with profits in the first half of the year running below last year's levels.

Consequently, reasonably expensive equity markets are vulnerable to real risks of setbacks. Europe in particular is in a fragile state. According to the OECD's latest forecasts, the eurozone is expected to grow by only 0.4% this year and to pick up only modestly to 1.1% growth next year. While the ECB's more active plans for monetary stimulus will provide some increased degree of support, it would not take very much to derail what is already a rather anaemic outlook. There are several potential issues that could do it, notably the financial ramifications of an independent Scotland, a worsening of the already fraught tensions with Russia over the Ukraine, or policy missteps (at one extreme excessive austerity, at the other failure to reform policies in underperforming economies).

Outside Europe there are also question marks about whether China will be able to maintain its very rapid rates of growth. Most forecasters reckon it can, or as near as makes no difference. The OECD, for example, expects China to grow by 7.4% this year and by almost as much (7.3%) next year. But with about half of global output growth dependent on China continuing to rattle along at a very rapid clip, any interruption would have worldwide ramifications. Markets did not take kindly, for example, to the recent news that the latest data on Chinese industrial production were softer than expected (up "only" 6.9% on a year earlier in August, compared with the 9% recorded in July).

The issue for the international equity markets is that they are trading on valuations that may be overcomplacent about one or more of these risks (or others, such as the ISIS conflict in Syria/Iraq) coming home to roost. The odds favour further volatility along the lines seen in recent weeks.

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