World equities have broadly tracked the G7 monetary base (i.e. currency in circulation plus bank reserves) since the Federal Reserve launched QE1 in late 2008 – see chart. A wide gap, however, has opened up recently as markets anticipated a further US liquidity injection. …
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– The Fed has now launched QE2 by signalling an intention to buy a net $600 billion of securities by mid 2011, a development that may push the G7 monetary base to a new peak*. Based on the relationship to date, the projected level of the G7 base in mid 2011 suggests a further 6% rise in equity markets in US dollar terms.
– Bulls, however, may wish to consider the following qualifications. First, equities are currently at a level consistent with the projected G7 base in April 2011, ie markets may be five months ‘ahead of the game’. Secondly, the Fed could scale back its intended purchases if economic growth accelerates in early 2011. Thirdly, the Fed may sterilise part of the impact on the monetary base, as it did with QE1.
– Finally, US monetary base expansion may be offset by contraction elsewhere. The Eurozone base, already down by 20% from a summer peak, may continue to decline as the European Central Bank restores pre-crisis liquidity provision arrangements. Further rises in reserve requirements and official rates, meanwhile, are likely in China, where inflation has been driven higher by surging commodity prices caused in part by the Fed’s expansionary policies.
Economics
– The UK was a particular bright spot: the economy grew by 0.8% q-o-q in the third quarter, double consensus expectations, giving some relief to the UK government as it outlined the squeeze to departmental budgets in its austerity drive. The US economy expanded by 2% annualised in the third quarter while the Conference Board Consumer Confidence Index increased slightly in October. Pessimism about jobs however, continues to weigh on confidence.
– China announced that its economy grew by 9.6% annualised in the third quarter and that foreign reserves grew to US$2.6 trillion. The country’s large net exports continued to draw ire from the US, but a G20 communiqué promised to avoid competitive devaluations. Singapore surprised markets by widening the currency band to allow its currency to appreciate, while Thailand imposed a withholding tax on bonds to slow capital inflows as hot money floods into developing markets.
– Unemployment in Germany dropped below 3 million in October on an unadjusted basis, the lowest in 18 years. In a sign of improving business confidence, the European Central Bank announced that net demand for loans from businesses was positive in the third quarter (+7%), after more than two years in negative territory.
Bond and currency
– Government bonds generally underperformed other areas of the market over the month as risk appetite became ignited on expectations of further monetary stimulus in the US and the UK, although the unexpectedly strong Q3 gross domestic product figure for the latter and a more hawkish than expected inflation report reduced that possibility in the near term for the UK. In contrast, corporate bonds, and in particular the lower end of the credit markets outperformed, helped further by good company earnings reports during the month.
– Expectations of another round of quantitative easing (QE) in the US, and that the Fed would focus the greater part of its purchases on longer maturity bonds, lowered long-term yields in the days leading to the decision and flattened the spread between 10- and 30-year Treasuries. This was quickly reversed as details emerged that the Fed will concentrate on medium-term maturities and buy long maturity bonds at the same ‘pace’ as before (and not more), resulting in many investors shedding these bonds and widening the spread. Medium-term maturity bonds meanwhile outperformed.
– In Europe, the European Central Bank’s gradual draining of liquidity as it toughens the terms of its loans is continuing to put pressure on interest rates to go higher. Whilst this could be viewed as a good sign – that the health of the banks in the region has improved – it can have negative implications for peripheral European banks, which continue to struggle to fund themselves at lower rates. As a result, yields at the short end of the German yield curve have been rising.
Equity
– Equity and commodity markets continued their ascent, driven by hopes of further monetary stimulus around the globe. The earnings reporting season lent further support with companies generally beating expectations, although not to the same extent as in recent reports. Merger and acquisition activity, particularly in the UK, also remained a prominent feature.
– Signs are emerging that input price pressures have begun to escalate. Commodity prices have rebounded strongly from the rapid declines experienced in the financial crisis of 2008, at which time companies initiated massive cost cutting exercises and reined in spending in order to rebuild margins. Margins are now greatly improved, but as input prices rise what will be the next course of action? Will firms allow the surge in prices to cut into their margins or will they pass the increases onto consumers, ultimately leading to inflationary pressures? Next plc, the UK clothing retailer, has already said that it expects to raise clothing prices between 5-8% next year due to rising cost pressures.
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This document has been produced based on Henderson Global Investors’ research and analysis. The information is made available to clients only incidentally. Unless otherwise indicated, the source for all data is Henderson Global Investors. Any reference to individual companies is purely for the purpose of illustration and should not be construed as a recommendation to buy or sell or advice in relation to investment, legal or tax matters. Please remember that past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise as a result of market and currency fluctuations and you may not get back the amount originally invested. Tax assumptions may change if the law changes, and the value of tax relief will depend upon individual circumstances.
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Source: ETFWorld – Henderson
