Over the past week two significant milestones were reached. The first was, of course, sterling's climb (or was it just as much the dollar's fall?) to $2 / £1 its highest relative level since 1981. Sterling's strength and the dollar's weakness has much to do with the perceived direction of short-term interest rates in both countries. A strong set of March inflation data here in the UK, boosted in no small measure by food, furniture and transport (including petrol) costs, drove CPI inflation to an annualised rate of 3.1% (V's 2.8% in February) and thus forced Mervyn King, the governor of the Bank of England, into an open letter of explanation. Underlying inflation (which excludes energy, food, alcoholic beverages and tobacco prices) also climbed year on year to 1.9% (V's 1.7% in February).
It is by no means certain, even after such strong data, that inflation will remain as robust as it appears now over the next few months. Utility prices are likely to exert a particularly negative influence, we do not expect the oil price to remain at prevailing levels for long and furniture prices are not expected to prove as resilient as they were over early spring. That said, a further rate hike in May looks a virtual certainty. By contrast, US inflationary pressure appears, at last, to be ebbing and activity levels (as discussed below) are sagging markedly. US base rates appear to have peaked and a process of, possibly aggressive, monetary easing is anticipated by the financial markets.
The second milestone was the FTSE 100's breaching the 6,500 level on its way to hitting multi-year highs, in keeping with the buoyancy already apparent across other global developed equity markets. The surprise to us is that equities continue to perform as well as they are while the macro economic clouds darken. This environment looks suspiciously like the exact opposite of conditions which prevailed in the latter part of 2002.
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Back in late 2002 / early 2003 we (and others) were writing about the possibility of a severe deflationary spiral emerging which, unless drastic macro economic measures were taken, could result in a downward slide into depression conditions similar to those experienced in the 1930s. At that time global central bankers, following the Fed's lead, were cutting base rates aggressively in order to pre-empt such a spiral evolving and equity markets were reacting negatively to the possibility that central bankers were grappling with conditions which were out of their control. At the same time, macro economic data was beginning to give the impression that a corner had been turned. Whilst it took the US invasion of Iraq to act as the catalyst for equities to begin their recovery what struck us then, as now, was the lag effect between the clear appearance of improving fundamentals and the lighting of the "blue touch paper" under the equity market.
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Now we see the almost exact opposite at work. Equity markets have enjoyed a prolonged revival and multi-year (and in some cases all time) highs have been achieved and built upon. At the same time the macro economic picture, to some extent in the UK but to a much greater degree in the US, has deteriorated markedly.
Whilst we acknowledge the highly supportive nature of ongoing merger and acquisition activity and the possibility that Asia, and to a lesser extent Europe, might be able to decouple from a US slowdown we are not entirely convinced that either is sufficiently guaranteed as to ensure that equity markets can completely extricate themselves from deteriorating fundamentals. The purpose of this note is to look at the extent to which those fundamentals have deteriorated as a means of assessing by just how much share prices have been looking in the opposite direction. We cannot believe that the dollar's ongoing weakness and its adverse impact on the translation of dollar revenues and profits back into sterling (or euros) can be completely offset by further improvements in profit margins. UK and European companies with significant dollar exposure must be potentially vulnerable to that currency's slide on the foreign exchanges.
How severe has the US economic slowdown become?
Annualised US economic output is expected to have grown by just 1.7% over Q1 2007, a marked deterioration from the levels recorded twelve months ago and indeed the 4%+ growth that many were anticipating at the beginning of the year. The collapse in the US sub-prime mortgage sector has proved a significant contributory factor. Our earlier view, that this collapse might have more widespread implications than the market initially thought, appears to be being born out by recent data releases.
Notably, the National Association of House Builders index gives a reading of just 33 in April, down from 36 in March and at its lowest levels for the year in clear recessionary territory. The number of foreclosures increased over Q1 from 83,154 in Q1 2006 to 168,829 reflecting an aggressive tightening in mortgage lending standards across the board. Anecdotal evidence from every housebuilding company across the US indicates that that spring activity has been flat on its back indicating a weak environment for many months to come.
Further evidence that the weakness in residential property is spreading is provided by weekly jobless data which, although in part weather-related, spiked to a two month high in mid-April and the March retail sales data which showed -3.2% annualised over Q1, against +5% in Q4 2006 and +7.9% over Q1 2006. Retail sales have now slowed in each of the past five quarters, an event which hasn't happened in the past twenty years!
On balance, we suspect that annualised US Gross Domestic Product (GDP) growth may emerge below 1.7% given the weakness across so many indicators and that Q2 data, having started so flat, suggests prospects for a revival over the second quarter do not look particularly promising either.
Unlike the UK experience, US inflationary pressure does seem to be easing. March CPI data showed a month on month increase of just 0.1% (rounded up from just 0.061%) sufficient to take the annualised figure down from 2.7% to just 2.5%. This level is still above the Fed's comfort level but is at least heading in the right direction.
The Greenspan Fed tended to look through CPI data as it regarded the release as being too lagging an indicator. Note that core inflation tends to lag the US economic cycle so much that in five of the six recessions over the past fifty years it rose point on point on the way into each downturn only to collapse the following year. The reason for this is the significant weight accorded to rents (c40%) in the headline CPI and 20% in the core rate. Given the very slow pace at which housing components tend to impact on CPI it is little wonder that US central bankers opted to look instead at activity measures in the broader economy before taking decisions on base rates which impact only after a further nine months or so.
Are equities ignoring an economic slowdown?
Despite the sanguine equity market, bond market action appears to be telling a different story (again). The ten year US Treasury bond yield has hit levels nowhere near previous highs even after the latest surge in gold and commodity prices, rising equity markets, strong jobs data, a futures market still largely pricing out the chance of Fed base rate cuts this year and a falling dollar.
By contrast equities have hit new highs against rising inflation expectations (here in the UK and in Europe), rising bond yields, downgraded GDP growth forecasts, higher oil prices and earnings estimates under remorseless downward pressure. Hedge fund managers may cluster around bullish cart configurations, private equity may take advantage of the plentiful supply of cheap debt, equity investor braggadocio may have recovered to pre-2000 levels and yet the lesson from recent history is that in the medium term economic fundamentals tend to reassert themselves. Just as equities ignored a reviving economic backdrop in late 2002 only to recover strongly once activity became strongly apparent, might equities be ignoring the deteriorating US macro economic environment now, only to struggle when it becomes even more apparent in the future?
By Jeremy Batstone, Director of Private Client Research at Charles Stanley
