By Percival Stanion, Chairman, Strategic Policy Group
Baring Asset Management (Barings), London
(Barings is the Subadviser to the ASTON/Barings International Fund)
Despite a largely unchanged economic environment, markets have been in turmoil in recent weeks. There has been little change in macroeconomic factors, with the broad trend still one of gentle improvement in the U.S., Japan, and the UK, while activity in most emerging economies is still slowing. In Europe, conditions are still poor, but less acute in the South and improving slightly in the North.
The proximate cause of the sell-off was the US Federal Reserve signaling on May 22 that it may reduce the rate at which it purchases US government bonds this year, and probably end its quantitative easing (QE) program by the latter part of 2014. Even though Federal Reserve Chairman Ben Bernanke suggested that short-term interest rates would remain at effectively zero until 2015, the market response of a 100 basis point rise in government bond yields is an effective tightening of monetary policy by other means, as it will lead to rising borrowing costs for the private sector.
In support of this pronouncement, the Fed Chairman indicated his growing confidence in the U.S. recovery and the likelihood that the economy would be creating enough jobs for the unemployment rate to hit his 6.5% target by the end of 2014. We do not yet share this confidence, as we believe the impact of further automatic spending cuts—known as the fiscal sequestration process—has yet to bite fully, and may well cause slower demand in the second half of this year. Overseas demand is also weak, while the corporate sector is unlikely to increase capital spending aggressively when the resilience of consumer demand rests so much on record low interest rates.
We can speculate over Bernanke's motives. His imminent retirement may have induced him to give more room for maneuver to his successors, he may be genuinely fearful of excessive leverage in the credit markets, or he might want to protect his legacy by signaling the end of QE before he retires.
Alternatively, the Fed may have made a policy error in assuming the economy is strong enough to take the shock of higher interest rates when deflationary forces are still very powerful and the only sector in unequivocal recovery is housing—a segment that is critically dependent on mortgage rates priced off long-term Treasury rates. Experience teaches us, however, that it is better not to fight the Fed and, in the absence of flatly contradictory evidence from the real economy, to take its words at face value.
The other major jolt to investor sentiment has been the deliberate act of the Chinese central bank to engineer a very tight funding squeeze on the banking system by withholding cash from the interbank market. The key short-term lending rate soared to a peak of 28% at one point as panic set in. The central bank maintained the pressure for a few days before relenting and supplying enough funds, but not before delivering a very stern warning to banks to stop supplying credit to China's shadow banking system. This means that Chinese banks are almost certainly safe from further action, or indeed failure, as long as they toe the line. It will mean that entities in the real economy will be denied funding, however, and will fail as a result line. It follows a stream of policy developments that clearly show that the new leadership is more concerned with re-establishing discipline and the supremacy of the Communist Party and is quite willing to tolerate a lower rate of growth in the short-term to achieve this objective.
There have also been adverse developments in other emerging countries such as Turkey, Brazil, and South Africa. With growth from exports to the developed world now increasingly elusive, it seems that domestic sources of demand may not be enough to satisfy populations that have come to expect an increasing standard of living. Those economies which did not invest enough in expanding capacity, or building up foreign reserves, are now facing current account deficits that need to be financed by foreign portfolio flows. With emerging equities and bonds currently out of favor, though, the tide of foreign capital could recede at just the wrong time. Given the political instability developing in some countries, we cannot rule out one or more suffering a loss of international investor confidence.
Against a backdrop of very volatile market conditions, we maintained most of our top-down views on the market. Equities still seem the most appropriate asset class at this point in the cycle of early stage recovery given that monetary policy is still supportive of growth in most regions. Here, we still like the US, Japan, and the UK. Monetary policy remains hugely supportive in the latter two countries, even if it is less so in the U.S. We remain cautious on Europe and Emerging Markets.
We have left our sector ratings unchanged, though we are leaning towards an upgrade to Materials as valuations in large mining stocks now look particularly attractive following recent sharp declines. In currencies, we maintain our preference for the US dollar.
The information contained in this article is provided by Baring Asset Management (“Barings”), a subadviser engaged by Aston Asset Management, LP (“Aston”). Barings is not an affiliate of Aston and their views do not necessarily reflect those of Aston.
This material is not intended to be a forecast of future events, does not constitute investment advice, and is not intended as a recommendation to buy or sell any security. Investors should consult their investment professional regarding their individual investment program. Since the date of this report, economic factors, market conditions and Barings' views of the prospects of any particular investment may have changed. Investors should consider the investment objectives, risks and associated costs carefully before investing. Forward-looking information is subject to certain risk, trends, and uncertainties that could cause actual results to differ materially from those predicted. Past performance is no guarantee of future results.