Europe – Deflation
We have spoken about it for some time, but the deflation story in Europe is now coming to a head. Wholesale prices fell for the fourth month running in December, and consumer prices finally tipped in to deflation with a -0.2% reading. This is the weakest reading since September 2009, and is down from +0.3% in November. Meanwhile the unemployment rate in November was unchanged at 11.5%. The backdrop was undoubtedly there for the ECB to take action (discussed below).
Meanwhile for the first time in a while, some data points have turned positive in Europe. The German economy bounced back somewhat from zero growth at midyear to finish 2014 with 1.5% growth. The government budget surplus was 0.4% of GDP for the final quarter, the second-highest since reunification, and in stark contrast to most other European countries. This gives you a sense of the friction in the Eurozone, where exchange rates obviously can’t adjust, and trade imbalances can persist. Elsewhere U.K. inflation collapsed to a 0.5% annual rate in December with the declining oil price. GDP also matched this figure, growing 0.5% quarter-on-quarter in Dec, with the struggling Eurozone taking a toll on growth.
Our outlook on the Eurozone remains cautious. We believe it is likely the Greek issue will be resolved without a Eurozone break up, but don’t see any imminent exit from the zone’s structural issues. On the other hand European equities trade at a steep discount to their U.S. counterparts, so even limited growth could spark a rally, and some data points are ticking up.
Australian Company News
– Orica has indicated it may return capital to shareholders following the $750m sale of its chemicals business, which is expected to be concluded before the end of March.
– Santos has indicated it may look at asset sales to shore up its balance sheet. Woodside warned of spending cuts and $400m of write-downs. Oil Search warned of a 200m write-down. In other commodities news, according to Bernstein, Vale is now the lowest cost producer of iron ore, over BHP and RIO. This is due to the oil price slump cutting shipping costs.
– Figures from Veda showed that demand for business credit in Australia slowed in December, the banks had been expecting business lending to accelerate.
– Transurban’s Queensland Motorways acquisition, as well as healthy traffic growth, boosted revenues by almost 37% in the Dec quarter to $761m.
International Company News
– U.S CEOs are the most bearish since the financial crisis according to research from Bespoke Investment Group. The percentage of companies cutting profit forecasts during this earnings season was greater than those raising by 8.6%, the widest margin in six years.
– Google Inc.’s dominance of the U.S. internet search market slipped last month in the biggest drop since 2009 while Yahoo! Inc. posted its largest share gain, as the companies grappled with the fallout of a search deal on Firefox browsers. Despite this Google’s revenue grew 15% in the fourth quarter but fell short of Wall Street’s target as foreign exchange and falling ad prices weighed on the company. While the number of consumer clicks on its ads increased 14% year-on-year, “cost per click” decreased 3%, as more consumers accessed its online services on mobile devices, where ad rates are typically lower.
– Visa announced an 11.5% increase in profit during the quarter, as a strengthening U.S. job market and cheaper gasoline prices encouraged people to spend. Beating both top and bottom line estimates, net income rose to $1.57bn from $1.41bn, a year earlier. Visa also announced a four-for-one stock split, cutting its weight in the Dow from 9% to 2.5%. This demonstrates why price-weighted indices such as the Dow and the Nikkei are nonsensical as a benchmark!
– Yahoo announced a tax-free $40bn spinoff of its entire stake in Alibaba Group Holding Ltd., seeking to maximize its return of cash to shareholders and minimize taxes on the sale.
Interest Rates
For the first time ever, the average 10-year bond yield of the U.S., Japan and Germany has fallen to less than 1%, which is even lower than during the Great Depression. This is a strong signal that bond markets don’t expect the global economy to generate much growth for a long time. Though to be fair the structure of financial markets has changed somewhat since the 1930s, so the “natural” interest rate is lower than it used to be.
Central Bank News
It has been a very busy period for central banks! The undoubted trend has been for further easing:
– Not long after a top legal adviser to the European Union indicated that a QE program would fall within the boundaries of the law, the ECB announced a program that was larger than expected. The program exceeded expectations by agreeing to buy €60 billion in government bonds per month, in addition to purchases of asset-backed securities and covered bonds, for a total balance sheet expansion of more than €1 trillion. This sent the EUR to its lowest value versus the dollar in more than a decade.
– Financial markets around the world were rocked as the 3-year-old cap on the Swiss franc against the euro, at CHF1.20, was suddenly removed. The move caught markets by surprise as the Swiss central bank had recently described the measure as a cornerstone of its policy. The bank also lowered its deposit rate to -0.75%. The exchange rate moved nearly 20% in one day. This is a very apposite example of how central bank actions can suppress volatility only for it to pop up again somewhere, or sometime, else.
– India’s central bank cut interest rates by 25 basis points to 7.75% in an announcement outside its normal schedule. This was in reaction to signs that inflation is easing.
– The Canadian central bank surprised economists and traders with an interest-rate cut that brings the overnight rate among commercial banks to 0.75%. The Bank of Canada said it acted to protect the economy from risk brought on by plunging oil prices.
– Edging away from the doves the Federal Reserve has indicated that it won’t increase interest rates before June but remains silent about what happens after that. Although the central bank’s policy committee is upbeat about the economy, it says it expects a deepening of inflation slowdown.
A number of other central banks also cut rates. This is in response to slowing growth, and slowing inflation (disinflation). This speaks of slow growth, but for bond and equity markets the bullish message is clear.
Discretionary Portfolio Changes
In the international growth portfolio we sold Mitsubishi UFJ Financial Group and bought Iron Mountain. We have reduced our weighting to Japanese financials given uncertainty over the government’s reform program, though still maintain a position in Sumitomo Mitsui Financial Group. We have added Iron Mountain due to its dominance of the document storage business and compelling valuation.
Summary
It is interesting times for the markets. On the one hand global growth outside the United States is slowing, and geopolitical issues remain at the fore in Greece, and to some degree Ukraine. However we have seen central banks taking action to combat the spectre of deflation, and we know from history that it does not pay to fight the central banks. How it ends up in the medium term is hard to say, but it does seem clear that the environment for higher volatility remains intact.
Please be in contact if you wish to discuss any of these themes further, or wish to make any changes to your portfolios.