Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, Nigel Cuming, CIO of Canaccord Genuity discusses the outlook for Europe.
It would appear that last month’s forecast that interest rates were unlikely to rise this year remains very much intact following the release of the latest Bank of England report which was described by most commentators as surprisingly “dovish”. Whilst Governor Mark Carney stated that the economy and the banking system are now “more than halfway towards a return to normality”, any interest rate rise will be “limited and gradual”.
One of the conundrums that Governor Carney is having to deal with is that although the unemployment rate is falling sharply, (it is presently 6.4% and will possibly be below 6% by year end) earnings growth remains very weak and actually fell by 0.2% year on year in Q2, the first negative figure since 2009 when we were in the depths of a global financial crisis. Even allowing for the fact that this figure was distorted by the early payment of bonuses last year to take advantage of tax changes, the weakness of this figure does not seem to make sense and requires further examination. A variety of explanations have been given and there is probably more than a grain of truth in all of them.
There are distortions at both ends of the pay spectrum. In the higher paid sectors such as finance, wages have been falling whilst at the lower end, many of the new jobs are at or around the minimum wage where there is little or no pricing power. There is also some evidence that immigration is acting as a deflationary force on wage growth and it also appears that in an era of low or no returns on savings, older workers are being forced either to work longer or return to the workplace after a period of retirement. Whatever the cause of the present subdued level of wage growth, it is likely to persist for some time and the Bank of England now believes we can cope with a lower unemployment rate for longer without a pick-up in inflation which came in at a mere 1.6% for July.
The Uk is now forecast to grow at 3.5% this year and this compares very favourably with Europe where recent economic data has been very disappointing with Italy falling back into recession. Growth is non-existent and with deflationary forces gaining momentum, one wonders what it will take to prompt the ECB to take further supportive action by embarking on quantitative easing. Given that the Ukrainian situation is clearly a large negative for the economy, there is a very real danger that things could get much worse. Therefore any inclination that we had previously to increase European exposure at the expense of our US holdings on a relative valuation basis has been replaced by a decision to reduce it.
However, we must not get too bearish at the uneven pace of the global economic recovery. Risk assets have shown remarkable resilience this year in the face of a deteriorating geopolitical backdrop and there is nothing to suggest that the rally is about to end because this recovery is at present not sufficiently robust to lead to higher inflation which would then force central banks to normalise policy.
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