The timing of when the US Federal Reserve will raise interest rates will depend on the strength of the US recovery.
Data has been mixed, with a poor first quarter giving way to a strong second-quarter bounce as inventories were rebuilt.
The rhetoric from the Fed has been cautious. Chairman Janet Yellen said in July that “labour market indicators suggest there remains significant under-utilisation of labour resources”. However, the Fed noted that unemployment and inflation were moving towards its targets.
Meanwhile, the International Monetary Fund (IMF) has reduced its 2014 global growth forecast, released in April, from 3.7 per cent to 3.4 per cent. It said the global recovery was still not very strong, citing particular weakness in Latin America.
This was offset by the economic upturn in the US and UK, which the IMF stated was strong enough to start planning for monetary policy “normalisation”, but that it was too soon for it to be implemented.
This chimes with the view of some that, in the US and UK, wage growth is not strong, productivity is low and interest rates need to stay at historically low levels for longer to allow the recoveries to gain a surer footing.
Others are more positive about the strength of the recovery in the US, and even more so in the UK. The UK is enjoying the fastest growth of all developed markets. The announcement in July that its inflation rate (consumer prices inflation) rose from 1.5 per cent to 1.9 per cent fuelled expectations the Bank of England would instigate its first rise in interest rates since 2007, ending the ‘emergency’ base rate level of 0.5 per cent.
This would be likely to support sterling’s strength, to the irritation of the export sector. However, if the rises are “gradual and limited”, as guided by BoE governor Mark Carney, the recovery may turn out to be resilient.
Other positive factors are that corporate balance sheets are in much better shape, with high cash levels, and the household debt-to-income ratio is at a decade-low level.
This expectation of continued domestic growth is a major reason why the UK equity market has broadly retained the gains made in 2013, though with marked divergences between different parts of the market.
In contrast, other parts of the world are not as buoyant and any tightening in the US could have an impact on their economies.
The eurozone, for example, is at a different stage in its economic cycle, with inflation at its lowest for four years. Sentiment was recently dented by concerns of systemic risk to the financial sector as the Espírito Santo family group, Portugal’s last surviving banking dynasty, collapsed following apparent accounting irregularities at its Luxembourg-based parent company. The single currency area remains fragile and its structural problems have yet to be resolved.
The market will find out the results of the European Central Bank’s asset quality review in October. There are approximately 130 banks under review, of which some 50 per cent are unquoted.
The market could be positively surprised by the stress test results of some of the quoted banks, whose shares have been under pressure. However, poor results could have a negative effect.
John Chatfeild-Roberts is chief investment officer at Jupiter Asset Management
