Archive for September, 2014
The British Isles have been living through some historically significant weeks. The Scottish referendum resulted in the continued existence of Great Britain as a nation, but only by a narrow margin. To say therefore that politics has been interesting here lately would be an understatement. But market behaviour, on the other hand, has not been terribly volatile. The stock market has remained completely range-bound. Gilt yields did reach new lows for the year to date in August, but there were never any signs of panic. In both cases prices have been moving in the same direction as other major markets.
Where there was some more eye-catching behaviour was in the currency.
Given the focus on the pound throughout much of the political campaign this is satisfyingly appropriate (and of course its international trading symbol clearly reads: “GBP”). The sharpest move against sterling came after a weekend poll published by the Sunday Times on 7 September showed a narrow lead for the Yes campaign. Monday saw the pound fall by 0.9% on a trade-weighted basis, its biggest one-day tumble for well over a year.
We should not get too carried away here: the euro has fallen further against the dollar since mid-year and shown almost equally great volatility this month, in no small measure due to the operations of the ECB. Still, the pound has experienced a material shift over the past twelve months and this begs the question: what is its fair value?
Trading ranges are one obvious place to look for guidance. Against the dollar, sterling almost fell to parity in 1985, and peaked at over $2 in 2007. The average cable rate for the past thirty years is parked in the middle of this range at $1.64. For almost exactly one half of that three-decade period, the pound has traded within ten cents either side of the average rate, which is remarkable. At its current price of $1.63, therefore, it looks fairly valued.
The euro rate is harder to pin down on this basis. From the launch of the single currency in 1999 to mid-2007 the pound held a range of €1.40-€1.70, broadly speaking; then it weakened dramatically towards parity in 2008 and has occupied a range of between about €1.05 and €1.30 ever since. At €1.28 currently sterling therefore looks a bit toppy on a purely post-crisis view, but a bargain relative to its pre-2008 levels. (The latter also applies if one charts the pound against the old European benchmark of the Deutschmark. If the DEM still existed a pound would buy 2.5 of them, below its averages over both the past twenty and thirty years.)
Fixating on ranges, however, is the proper preserve of traders, technical analysts and all those trying to make short term sense of the foreign exchange market (there but for the grace of God … ) The long run – and textbook – point of reference is the currency’s purchasing power parity. The theory behind PPP is that the same goods and services should cost similar amounts in different countries, assuming perfect freedom of trade between them. In practice, PPP valuations are therefore calculated by reference to the relative costs of similar items of consumption and to inflation rate differentials over time. OECD PPP estimates for the equilibrium sterling exchange rates against the dollar and the euro are $1.38 and €1.11, so the pound is actually looking expensive on this measure at the moment.
More interestingly, perhaps, are the implications of PPP for long term trading ranges. Using the OECD estimates, sterling is about 13% overvalued against the dollar. When it hit the same kind of levels about nine years ago the actual exchange rate was nudging $1.80. In other words, the somewhat higher rate of inflation in the UK relative to the US over that period has shifted the PPP valuation of the pound by about fifteen cents. Another way of looking at this is that the high reached recently of $1.72 is equivalent to $1.87 a few years ago.
Over the last three decades the UK and US economies have exhibited identical average rates of CPI inflation (2.8%), which is consistent with the stability of the cable rate’s trading range over the period. Turn to Europe, however, and the picture is rather different: over the last ten years, the annual rate of CPI inflation in the UK has on average been higher than that in the eurozone by 0.8% (2.7% as against 1.9%). Going back much further is problematic as zone-wide data is not available prior to 1997 and back in the 1980s there was the matter of the separation between East and West Germany. But the twenty year average rates of CPI inflation in France and Germany are 1.5%, compared with 2.2% here in Britain.
This means that the 14.5% undervaluation of the euro against sterling on the OECD measure pits the current rate of €1.28 against a rate of almost €1.60 when the same level of undervaluation could be observed in the autumn of 2002. So while the trading range of the currency alone might suggest that the pound is priced at a rather weak level against the euro, PPP tells us that we need to shift our assumptions to take account of the material inflation differential between the UK and Europe over the last ten to twenty years and perhaps adjust ourselves to something along the lines of the post-2008 range as the new normal.
Between the long-run PPP and the short term trading view of the world are a handful of other significant forces on the exchange rate. The desirability of UK assets, the attractiveness of the country as a place to do business, the development of views on the likely future path of interest rates and (joining all these dots together) the outlook for economic growth are hugely important considerations. But the impact of PPP, and inflation, is observably apparent.
On that basis it is not quite reasonable to interpret the recent fall in the value of the pound as a conspicuous buying opportunity. And when looking at the currency diversification of a portfolio on a medium to long term investment horizon, it is worth bearing in mind the stubborn tendency of the UK economy to inflate more quickly than its major market peers over the last decade or so, especially in the case of Europe, and to consider the possibility that this might persist.
One of the key themes this blog identified on the eve of 2014 was earnings growth. Equity valuations in the major markets had reached territory that needed to see a higher denominator in the p/e ratio or risk looking overvalued.
Since then we have seen a quarterly contraction in the US, patchy outcomes for GDP across the Eurozone and tax-related volatility in the Japanese economy. There has thus been reason to suspect that this growth would disappoint. And that is before considering any confidence impact from events in Ukraine, the Middle East and elsewhere.
So the Q2 US earnings season which opened in early July was arguably more important than most. When it opened, consensus expectations as followed by Bloomberg were for a 4.5% increase on the prior year, barely higher than the 4.2% increase in nominal GDP over the same period.
In early August, however, just as the S&P 500 had fallen back towards 1900, things were looking rather better. By this time the first 200 companies had reported their results. The increase in EPS was averaging 12%. The analyst consensus began to catch up, and the final outcome for Q2 was then expected to reach 8.2%.
Now the season is essentially over with 499 companies having reported. Index earnings for the S&P rose by 10.3% over the prior year. In price terms the 500 is up by more than 18% over the last 12 months, but supported by that bottom line growth the exuberance does not appear irrational – especially if most of the momentum can be maintained, as is expected.
There was an interesting story out this morning on European earnings growth too. With the sovereign debt crisis and the double dip recession, the outcomes for reported EPS on the Stoxx 50 have been dire. But for the first time since April 2012, there are now more positive than negative earnings revisions coming from analysts covering European stocks. In the words of one such:
“There are signs that the pressure on European companies … is beginning to abate. We’re beginning to see small upgrades in earnings estimates overall for the first time in absolutely ages.”
There is a connection here to recent euro weakness, and a further connection to the open mouth operations of the ECB. There is also a lot of ground to make up: simply stripping out reported losses reduces the historic p/e on the Stoxx to 16.1x from over 23x. For the S&P 500 this makes almost no difference – 18x drifts lower to 17.8x.
These markets are not a steal any more – in isolation, certainly. (Relative to bond markets they still look very cheap, but that says just as much about poor value in rates.) It has been a long wait for many to see real, underlying growth actually return to growth assets. What it needs to do now is continue.
Markets barely had enough time to recover from Mario Draghi’s last “rock star” performance at the ECB before he shocked them with yesterday’s encore. Back in June he left his fans with the rhetorical question: “Are we finished? The answer is no.” Yesterday he proved it, lifting the lid on a plan for purchasing about €700bn worth of asset-backed securities while slicing another 10bp off policy rates. Only six of the fifty-seven economists and investment banks surveyed by Bloomberg expected the rate move, and the ABS programme, though trailed at the June ECB press conference, has also come surprisingly quickly.
Three months ago it looked as though Mr Draghi was playing to the crowd as much as anything. Two questions now emerge:
- Has anything substantial happened in Europe since June which has increased the need for emergency monetary measures?
- If not, how necessary are the ECB’s announcements as “open mouth operations”?
Look at the growth numbers reported in August and it is tempting to answer question (1) with a “yes”. Across the eurozone as a whole, GDP for Q2 was flat, down from an already-muted 0.2% rise in Q1. Stagnation in France was no surprise but it was a mild shock to see Italy back in recession. At the same time, headline inflation has continued to fall back with the annual CPI increase to August down at 0.3%. There has also been heightened concern in recent weeks over events in eastern Ukraine, with some commentators attributing weakness in European business investment to fears over escalating sanctions against Russia.
At the same time, however, it’s not that simple. The PMI composite indicator of economic output for the eurozone remains well into positive territory, despite the usual variation between countries, and the economic sentiment indicator (of consumer and business confidence) remains well off its 2012 lows – and indeed well above the levels associated with the three quarters of positive growth witnessed from Q2 2013. The ECB along with the consensus expects GDP to grow again this quarter, albeit at the accustomed muted rate. Even on the inflationary front much of the decline is down to cheaper energy prices: the “core” CPI rate for August, which as it excludes volatile items such as food and energy is supposed to be a more accurate reflection of the economy’s underlying price dynamics, actually rose for the second time since May to 0.9%. On balance, then, it does not seem reasonable to believe that there has been a material deterioration in the fundamental prospects for the eurozone over the last three months.
This does nothing to detract from the importance of question (2). At yesterday’s press conference (the full text of which can be read here), Mr Draghi had the following important, and in this blog’s view unarguable statement to make in the tangential final section of his answer to a question about fiscal policy:
[I]n many parts of the euro area, there are several reasons why growth is not coming back, but one of them is actually that there is lack of confidence. There is lack of confidence in the future, lack of confidence in the prospects, in economic prospects, of these countries.
It is an indisputable fact that much of the world’s confidence in recent years has relied for better or for worse on the perceived actions of central banks. The ECB understands this. And the reaction to this week’s news, together with one key longer-term trend, seems to indicate that they are getting the confidence-building part of their operation right.
First the reaction yesterday: Stoxx 50 up by 1.8% on the day, credit spreads tighter, euro back under 1.30 for the first time in over a year – in its biggest daily percentage fall against the dollar since the height of the debt crisis in November 2011 – and as for the bond market, well, that brings us on to the longer-term trend side of things.
Talking of the height of the debt crisis, back in November ’11 it cost the Italian government 7.9% to raise three-year money. A few months later, after the ECB announced its potential use of an emergency long-dated bond-buying programme, Italy was borrowing for ten years at 5.8%. Finally, just on Thursday last week, Italy raised ten year money at 2.4% and five year at 1.1%, record lows in both cases. And it isn’t just Italy. At the time of writing, two year bond yields are actually negative now in Germany, Denmark, Finland, Belgium, the Netherlands, France, Austria, Slovakia and (wait for it …) Ireland. It puts even the two-year Japanese government bond to shame, and makes the yield on our own 4% 2016 gilt look positively generous at 0.8%. All this is just excellent news, of course, if you’re an indebted sovereign looking to refinance your borrowing at the cheapest rates available in the world.
It doesn’t do to be complacent about Europe, or indeed the world economy in general. But it is encouraging that the ECB has been rising to the market’s demands for action in its own managed, but clearly credible way. European confidence in particular does indeed need all the help it can get. Rock star: play on …