Investment Outlook - October 2013

INVESTMENT REVIEW

Tiptoeing Away From a Taper

Both bonds and equities had a good month in September, helped by the Federal Reserve's announcement that it would not after all immediately begin tapering its asset purchase programme, as many investors had expected.

US

The surprising decision by the Federal Reserve to maintain the size and pace of its asset purchase programme at its September meeting remains a positive for both equity and bond markets in the longer term. The Fed's reasoning for the delay appears to be twofold. First, the extent of the surge in longer-term interest rates since tapering was first aired back in May has clearly taken policymakers by surprise. Any further increase in interest rates could derail the recovery in the housing market, which was already showing some signs of running out of steam. Secondly, the central bank will no doubt have had one eye on the imminent and potentially damaging showdown in Congress over the Government's debt ceiling, which can only be increased with legislators' approval. The prospect that parts of the Government would have to be shut down for the first time since the Clinton era, coupled with the risk that the debt ceiling could be breached as early as 17 October, has weighed more heavily on US markets since the tapering decision was announced. Political brinkmanship in an increasingly partisan Senate could well cause further market uncertainty in the near term.

After hitting new highs in mid-September, the US equity market is now looking for new direction and leadership. As we enter the final quarter of the year, a number of hurdles will need to be negotiated if US markets are to drive on further. The decision by Larry Summers to withdraw from the race to succeed Ben Bernanke as chairman of the Fed is likely to mean that President Obama announces a less controversial successor, one who is unlikely to deviate too far from Mr Bernanke's doveish policy prescriptions. In the medium term, however, US equity market valuations are beginning to look expensive relative to developed market peers. With monetary policy remaining supportive and economic growth continuing to trend upwards, some cyclical areas of the market whose valuations don't look too stretched, such as financial and material stocks, should still do well. In the fixed income market, bond yields rose sharply ahead of the Fed's announcement but have since traced some of that ground, with ten-year yields declining to around 2.65% at month end, after touching 3.0% earlier in the month.

UK

While investors remain unconvinced by Bank of England governor Mark Carney's efforts to downplay the recent rise in market interest rates, the economic backdrop in the UK continues to improve. Notable increases in manufacturing, construction and services PMIs suggest that a more balanced economic recovery is taking place. The most recent meeting of the Monetary Policy Committee showed little appetite for increasing the Bank of England's quantitative easing programme. Mr Carney's recent comments, implying that he sees no case for further QE at this stage, have prompted sterling to rise sharply against the dollar and euro. The committee did draw attention to the risks posed by recent developments in the housing market. The Government's decision to bring forward its Help to Buy scheme by three months to capitalise on the recent momentum in mortgage approvals has prompted talk of a new housing bubble. That looks premature at a time when lending by non-State-owned lenders remains subdued and demand is only recovering from historically low levels. The lack of growth in real wages in the UK remains a concern that will restrain consumer demand. While real wages rose by around 2.5% per annum in the decade leading up to 2008, they have fallen by 1.1% a year since then.

Sterling's recent strength is having an impact on earnings expectations. Earnings growth forecasts for this year, while comfortably above areas of the eurozone, have fallen into negative territory. The telecoms sector has been a standout performer year to date, but other more defensive sectors have begun to underperform. The makeup of the UK market means it could lag other developed markets if the economic outlook...