Investment Committee is a new online series following on from its success in the magazine. We choose five heads of research, CIOs or senior directors from influential firms to form a panel of experts who give an insight into their firm's asset allocation meetings. Over a period of 10 weeks, each member writes two pieces.
Stock and bond markets have learned over the last few years to treat good news as bad news and vice versa, says TAM’s Christian Holland.
Good news on the economy implies an end to quantitative easing (QE) and, ultimately, rising interest rates that erode the real future value of returns in equities. Conversely, a bad print on US non-farm payrolls or lower than expected inflation serves to keep interest rate expectations pinned back.
In this regard, the negative UK CPI rate in April was sobering. However, it is clear both the Bank of England (BoE) and the chancellor, George Osborne, are happy to look though this period of ‘low-flation’, brought about mostly as a result in the fall in oil, and start preparing the ground for rate rises, probably in early 2016.
If this assumption is broadly correct, and if other economic indicators such as unemployment and wage growth improve in the second half of 2015, we can expect this to result in higher bond yields as the year progresses.
Meanwhile, with the base rate still pinned at 0.5%, the gilt yield curve will likely continue to steepen, as it has done over the last six months – a so-called ‘bear steepening’.
In a market obsessed with the short term, one can be forgiven for expecting this scenario to be a hostile environment for equities.
However, there have been more than a dozen periods since 1980 that technically counted as bear steepenings during which the FTSE All Share did marginally better than in other periods. It was not much, about +0.1% per month, but in a world of low returns, it is a more meaningful return than when interest rates were 5.5% back in 2007.
This is an important difference from previous periods of rising gilt yields because it sets the agenda for a honeymoon period. In this, the opportunity for equities, supported by the reality of an improving economy, outweighs the impact that implied higher rates has on future earnings.
Furthermore, in absolute terms, nobody expects the BoE to raise rates to pre-2008 levels. Markets are expecting no more than two quarter point hikes by the end of 2016, which would bring the base rate up to 1%, still below the end-2016 forecast inflation rate of 1.6% and well below the bank’s target inflation rate of 2%.
As such, we would also expect that the government and BoE will be keen to justify rate hikes as a ‘lifting of emergency measures’, and more of a return to normality rather than a concerted effort to curtail rampant inflation which, we believe, will be absent.
In such an environment, good news on the economy could change to being genuinely good news for stocks because, whatever the merits of an improving economy, company earnings will still have to deliver growth in order to support the more elevated valuations to which we have become familiar (particularly in defensive stocks).
If investors deem the UK to be sufficiently reflationary and buoyant – something indicative of a steepening yield curve – then they may deem the risk of a move into more equities, and even cyclicals, well worth the risk.
TAM Asset Management's fund picks: Investec UK Alpha and Standard Life Global Property
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