By Gary Kirk
The swift and aggressive action from the Fed, since the onset of the credit crisis, always led us to believe that the US would be the first to emerge from the problems with their markets intact (even if their balance sheet remained impaired). The recent political events in Europe and last week’s data continue to reinforce that view.
Last week Bernanke delivered a candid talk on why long-term interest rates were low and the conditions that would be required to enable an exit from its current extraordinary policy actions. At the other extreme we are faced with an impasse in Italy where, at the time of writing, there is a real possibility of a future Government not being willing to sign up to the conditionality required to receive the benefits of extraordinary central bank policies (i.e. OMTs). Closer to home we have the UK Treasury and BoE who must now be wishing they had been more assertive earlier on when the crisis arose. In that regard, Thursday’s MPC announcement should be quite interesting. The consensus is for no change but we would not be surprised to see a return to one-off QE (indefinite QE is too much to hope for at this stage), as well as some interesting minutes when they are released.
Data-wise, Europe continues to lag with a less than impressive set of Manufacturing PMIs, with only Germany posting above 50 (50.3) and the eurozone delivering a sluggish 47.9; this was in contrast to the US which surpassed expectations with a strong Manufacturing ISM of 54.2. As we have reported in the past, PMI/ISMs are very well correlated with equity market levels and in our opinion provide a good indicator of where markets should be. With the recent rally in global stock indices, the US now looks fairly priced whereas Europe continues to look significantly overpriced. It appears to us that the markets appear to have been expecting, or hoping, that the data would catch up; in this respect the wait is still on. Coupled with the Italian political situation, this recent PMI data leaves stock markets in Europe looking more vulnerable.
As a result, the euro is looking increasingly vulnerable, especially against the dollar. In our opinion the recent strength of the euro is not merited and the fastest way to push it back would be via a rate cut. However, we appreciate that this is not the consensus and hence it remains an outside probability to be enacted this week.
The US economy is clearly best positioned for a sustainable recovery (if the spending cuts can be controlled), but as far as fixed income markets are concerned this means that interest rate duration could begin to hurt investors sooner than previously anticipated. In his address on long-term rates Bernanke said they could easily move from the 2% rate we have today to 4-5% by as early as 2017. For those without a calculator handy that would be a negative total return of between 16-23% over the period (excl. any coupon income). For US investors, continued corporate spread tightening should soften the blow thereby offering better returns for their credit holdings. Unfortunately we remain a long way from this point in either the UK or the eurozone and hence additional intervention is desperately needed; keeping both short and long rates at low levels must be one of the key objectives to help keep credit spreads as tight as possible until the real shoots of recovery are established.
So while we may favour the US currency and US stock markets, as far as fixed income assets are concerned the best returns will still come from this side of the Atlantic. However, they will continue to be vulnerable to surprises as we are witnessing in Italy at the moment.
Gary Kirk is partner and portfolio manager at TwentyFour Asset Management
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