The threat of stagflation diminishes, oil prices fall back under $100 a barrel and the future looks brighter – providing the Monetary Policy Committee takes action on interest rates.
While it appears that the spectre of inflation has largely abated, the British economy still has several problems, not least the ability of the Monetary Policy Committee (MPC) to cut interest rates.
“The most important underlying story remains the property bubble and the underlying credit crunch,” says Peter Lucas, the global investment strategist at Ashburton. “Inflation concerns were at times fairly spurious; now we’re pretty much back to the original story. Deflation is a bigger risk than inflation. Commodity prices have complicated things – it led to the illusion of inflation.”
“It’s been the most interesting two or three months we’ve had for years,” says Clive Beagles, manager of the JOHCM UK Equity Income fund. “If you go back to June, oil was at $140 a barrel and bond markets were assuming interest rates would go up 50 basis points. They now assume they’re going down 90 points. The stagflation nightmare scenario has become a lot less likely. Inflation is rapidly becoming yesterday’s story.”
Peter Bickley, the director of economics at Tilney Private Wealth Management, agrees. “The story of the last quarter was the ditching of the inflation issue.” He notes that the economy was constrained until then by the effects of high energy prices and concerns over inflation.
“We seem to have arrived rather more quickly than I expected at the tipping point. The oil bubble has burst, and headline CPI [consumer price index] will fall by the year end. This takes the lid off for the MPC so interest rates can come down. Bond yields have already come down, and you’ve got things slotting into place for the economy to turn better. But banks are still recapitalising in the interim; it will be a difficult period for companies. The stockmarket is quite volatile while it makes up its mind which concern to worry about most.”
There has also been more concrete evidence in terms of a slowdown in consumer confidence and spending, says Mark Lovett, the manager of the Allianz RCM UK Equity fund. “There’s some suggestion there’s been another lurch down in July and August. That’s in keeping with the breadth of negative tone. This slowing momentum in terms of the economy will focus the MPC on interest rates.” His main concern is whether the higher cost of living will translate into wage inflation. “In the UK, the economy didn’t really have a significant downturn in 2002-2003. It was more a corporate recession than a consumer recession. This time it’s the opposite.”
Lucas says there is still a big risk of a downturn which could turn quite nasty. “Currency markets have moved a lot. I’m sensing that if the MPC overlook this one by getting overly hawkish they run the risk of imploding the economy. The pressures on the economy are building all the time. Things will have to get worse before they get better.”
Bickley points out that the equity bull market did not end with an explosion in valuations but with a big contraction. “It’s not unreasonable to assume that the market has discounted a lot of this. My hunch would be we’ve already seen the low. It’s not an environment where they can go zooming up over 6,000 in a hurry, but the cycle will turn, although it may take quite a long time.”
Chris White, the manager of the Threadneedle UK Growth and Income fund, says the big change in interest rate expectations was triggered by the Bank of England’s July Inflation Report, published in August.
“We’ve been very bearish on the economy but it was clear interest rates would start to fall in the first quarter of 2009,” says White. During 2007 and early 2008, White’s portfolio was in very defensive parts of the market. “There is a change now. There’s a much flatter structure in terms of our top-down position. Oil, mining and financials are very volatile. We’re not taking the size of bets that we were.” The other change, adds White, is on currency. “The weakness of sterling is of benefit to overseas, and particularly dollar earners.”
“The obvious leadership has come away from commodities,” says Beagles. “People have to consider other bits of the market – 90% of active money was invested in exactly the same way; long commodities and short financials.” He has been following the Chicago Purchasing Managers index, which has been going up for six months.
“There are increasing signs that the US economy is sorting itself out. I’m looking west not east.” Stocks he likes include industrials such as Tomkins, Melrose, BBA and GKN. He also points out that investing in American-orientated stocks has allowed a free run on the dollar. “The UK economy is going to be a depressed place for a period. If you look at the more UK-centric sectors, we’re not betting the house on those. Within financials we still find better value in insurance. We’ve also started to rebuild our property weighting. The pure financial metrics of what drives property are in place.”
White says he has started to see much better performance from some of the more interest rate-sensitive parts of the market, such as retailers, property, and building and construction. “Volumes were a bit light in August – we’ll have to see a bit of confirmation of that trend in September. But the outlook for those sectors is a bit more optimistic.
“Generally, I believe we will get close to the deflationary abyss and ultimately the European Central Bank and MPC will step back and prevent the economy from completely imploding,” says Lucas.
For Lovett, there are two key factors to consider. “There’s been a rapid deterioration in consumer spending and a blocking up of the credit system. Lower interest rates need a freeing of the credit system. There are also structural problems. The government and the consumer are fairly indebted. A degree of consumer re-leveraging needs to take place.”
No-one yet knows what the fallout will be from the collapse of Lehman Brothers. But as Bickley says, “If you buy the concept that it does get better, you should focus on the end game and be positioned for that. Risk assets will come back and when they do, it will happen quite quickly.”