4th July 2017

Rathbones: Just a little misunderstanding

A sell-off in bond markets bled into equities last week.

The European Central Bank (ECB) and the Bank of England (BoE) gave investors less clarity about their intentions for interest rates over the next year than they expect. ECB president Mario Draghi has also been alluding to reducing the amount of bonds his central bank will buy for its quantitative easing programme sometime in the future.

To be fair to BoE Governor Mark Carney, he was summing up previous views and his remarks were hardly inflammatory. People got carried away and then market momentum took care of the rest. We believe the BoE won’t start hiking its benchmark interest rate before the third quarter of 2018. As for the ECB, it could start to taper its bond purchases (although none of its four conditions have yet been met), but it is unlikely to touch interest rates till 2019.

The market was less convinced, however. Sterling leapt higher against the dollar, ending the week above $1.30. Ten-year Western sovereign bonds yields jumped about 20 basis points last week. Longer-dated yields rose even more, “tightening” the yield curve. That helped boost banks and other financial companies because they borrow short-term and lend long: deposit rates and central bank interest rates (crudely, the cost of goods sold for banks) are still at bargain basement prices, but borrowing rates for longer terms – like mortgages – have stepped higher. Another boon for US banks was a clean sweep of the Federal Reserve’s stress tests. American lenders passed the regulator’s simulation of a devastating financial shock without breaching capital requirements. This means they are free to pay out this year’s earnings to shareholders – in some cases more than 100% of their income.

Other parts of the share market were less buoyed by the shift in yields, with technology and other growth companies selling off. Increasing hints that US and UK consumers are finding life tough don’t help. American consumer spending is growing, but stubbornly slowly. Easing US inflation is making more of an impact on people’s wallets than higher wages. Meanwhile, consumer confidence is still lacklustre, with the University of Michigan’s measure falling to its lowest level since November.

The GfK Consumer Confidence survey showed a particularly sharp downbeat mood in the UK. As did the Asda Price Tracker: it showed weekly income after bills for the poorest was almost 30% lower than a year ago and negative (i.e. income didn’t cover bills). Only the highest-income households’ spending money is keeping pace with inflation, according to the measure. Our

research shows real income after tax has dropped for three consecutive quarters, the first time this has happened since 1977.

Meanwhile, the UK’s savings rate has hit a second all-time low in as many months: just 1.7%.

Source: FE Analytics, data sterling total return to 30 June

Perception is reality

All eyes are on the leading indicators, particularly those taking the pulse of the high street.

The UK manufacturing PMI, released this week, dipped to 54.3, far below the expected 56.5. The forward-looking measure of manufacturing output and confidence has been erratic, though, so it’s not a reason to panic. We will be watching the services PMI closely which are out this week.

More important for the market mood will be the US ISM and PMI, which are out this week. A strong ISM performance just before the country shuts down for Independence Day should inject some welcome spirit into the world’s largest economy. America has had puzzlingly contradictory data recently. Employment stats remain exceptional and small businesses are brimming with confidence. Consumers are more circumspect, however, and the Citigroup Economic Surprise Index shows data have been dramatically undershooting expectations. But then you get a stratospheric release: the Chicago Business Barometer came in at 65.7 in June, up more than six points from May and one of its highest readings of the millennium.

As for the UK mood, much of it is being driven by politics. Concessions is the name of the game right now. Following the Conservative’s election shock, Prime Minister Theresa May’s iron grip on decision-making has loosened. The aloof and stony front of Britain’s Brexit negotiations has already given way to talk of compromise and the reality that the government will need to bend on sovereignty if it wants to retain market access.

Cabinet is now murmuring about the fairness of the public sector pay freeze, which has been in place for seven years. Reversing this would put upward pressure on nationwide wage growth and inflation. It would also mean more blow-outs for the country’s budget, as there is no clear way of paying. Greater government borrowing would be the first port of call; and if history is anything to go by, National Insurance will be due a bump too.

But as we noted in our recent quarterly Investment Update, an easing of austerity may be necessary to avoid disappointing UK growth.

Bonds

UK 10-Year yield @ 1.26%

US 10-Year yield @ 2.30%

Germany 10-Year yield @ 0.47%

Italy 10-Year yield @ 2.16%

Spain 10-Year yield @ 1.53%

Please visit rathbones.com for our latest views.

Investments, Investment Commentary