Although hardly offering good value, the weaker economic climate means that European bond markets look more attractive than equities and other bond markets. However, the European Central Bank is unlikely to cut interest rates anytime soon, despite the prospect of a marked slow down. Soaring oil prices are pushing up inflation – German inflation has climbed to its highest level in 13 years and with the unemployment rate 7.4%, its lowest level since the 1980s, policymakers are worried that wage claims could accelerate. This risk is highlighted by the strikes in France and the strike by German railway workers, originally seeking a 30% pay rise before privatisation. Therefore, the interest rate outlook remains favourable for the euro and the money markets are pricing in no cut at all next year. But with growth cooling, foreign investors have lost their appetite for European equities, a burden for both the euro and the region’s equity markets.
Bank of England to wait for concrete evidence of a slowdown
In its latest quarterly inflation report published last month, the Bank of England more or less confirmed that its next move in interest rates will be to cut them. Crucially, the timing of the cut remains to be seen. The money markets are pricing in the first interest rate cut before Christmas, another cut by the spring and then another early in 2009. Those on the Bank’s Monetary Policy Committee pushing for an early interest rate cut can point to the credit squeeze and the slide – albeit a modest one – in house prices since the autumn. Moreover, although higher oil and food prices are expected to keep inflation above the Bank’s 2% target all next year, the Bank predicts inflation will drop back to 1.75% in 2009 if it leaves interest rates unchanged. In other words, the Bank itself expects inflation to slip below its inflation target unless it cuts interest rates.
There are also other strong arguments for waiting. Although the housing market has weakened there is no sign it is having an impact on consumer spending. If anything, household spending has strengthened since the summer and the volume of high street sales has grown 5% over the past year, although only because of heavy discounting by retailers. Second, the measure of inflation targeted by the Bank of England may have fallen back below 2%, but headline inflation is still 4% and 3% ignoring the contribution from higher mortgage rates. As far as most households are concerned, therefore, their cost of living has risen sharply over the past year. With the New Year wage round fast approaching, policymakers will be watching for any rise in wage inflation. Moreover, there are concerns that the official measure of earnings growth is understating the level of wage inflation, which may be as high as 5%, above the level the Bank considers consistent with its inflation target. The Bank is also worried that the economy has been growing faster than its sustainable rate for the past 18 months, and a moderate slowdown would help to alleviate the build up of any inflation pressures.
There are, therefore, good reasons for waiting to assess the inflation outlook before cutting interest rates. Even policymakers acknowledge to outlook for growth is exceptionally foggy at the moment. Activity is likely to slow noticeably as the downturn in the housing market picks up speed, but it is not clear the extent to which this helps to cool inflation. The downbeat economic climate, with economic indicators now falling short of economists’ forecasts, suggests UK equities are likely to underperform stocks elsewhere, as investors reassess the economic backdrop. The expectation that the Bank of England will trim interest rates has tarnished the pound’s lustre a little, but the economic climate still supports the currency. At least gilts look better value than other government bond markets given the likely path for inflation and short-term interest rates.
ETFWorld
