Interest rate cuts continue to support the global expansion



Conflict between the bond markets, equity markets, whose side are you on?

  • Low yields in bond markets reflect sluggish trade and manufacturing data, which has suffered from the US-China trade spat
  • low yields also reflect loosening monetary policy from the major central banks
  • the European Central Bank(ECB) announced another assert purchase program to buy fixed income securities
  • the market has discounted a scarcity premium in the bond market, and particularly as countries such Germany run a fiscal surplus.
  • The result is that bond yields fall due to the lower supply of available bonds on the market
  • It is this combination of poor manufacturing and trade-related data and distortion in fixed income market that has lowered bond yields
  • Equities on the other hand continue to be supported by global growth
  • Monetary easing will also provide lift to the global economy. The Smith and Williamson World Interest rate Indicator (WII), which is constructed to track shifts in interest rates by some of the world’s largest central banks, concurs with this view
  • We believe the improvement of company earnings will continue to provide fundamental backing to the current equity rally

Consumer has been the strong spot in the global economy, can that continue?

  • In short, we believe it can because consumer purchasing power remains robust
  • Despite ongoing uncertainty from Brexit and a potential general election before Christmas, the UK unemployment rate fell to its lowest rate for 50 years, and hourly earnings rose by more than 4% from a year ago, the first time that has happened since June 2008
  • In Germany the unemployment rate has trended down to its lowest level since reunification in 1990. This combination of employment and wage gains lifts labour income and spending.

Is the consumer arguably more important than the manufacturing sector?

  • For the major developed economies, personal consumption accounts for somewhere between 60-70% of the economy.
  • The manufacturing sector is a much smaller part of the economy and continues to shrink in its importance in driving growth.
  • To take an example, US manufacturing employment currently accounts for around 8% of total private sector employment. Back in 1953, this ratio was 32%.
  • Essentially, as part of globalisation, companies have outsourced manufacturing to cheaper destinations like China. Due to China’s greater reliance on manufacturing in its economy it has been affected by the slowdown in factory production.

The labour market and wage rises have been buoyant. Do you see any threat to that?

  • Some of the lead indicators we follow continue to suggest labour markets are likely to remain buoyant.
  • First, in the UK, there are currently 812,000 UK job vacancies, suggesting plenty of hiring opportunities are being generated by the economy.
  • Second, US hiring intentions, as shown by the Manpower survey, which measures 11,500+ U.S. employers, hit a 13-year high in the third quarter of 2019
  • And third, crucially, labour is cheap. The share of US labour compensation to Gross Domestic Product (GDP) at 53.5% is close to its record low of 52% in 2011 and below the long-term average of 55%. Given that it is not that costly to hire, firms are likely to continue to expand their workforce.
  • Given the low share of manufacturing in labour markets, we see the trade spat being more acutely felt in China and to some extent Germany, where it also more exposed to factory output.

Where does the housing market fit in? Is it likely to be a source of strength?

  • We see evidence that falling rates, led by the Federal Reserve, are filtering through to final demand.
  • lower rates in the US has led to a notable pick-up in mortgage purchase applications, which are typically a lead indicator for housing market activity
  • increased construction will have ripple effects that bolsters private demand: think of refurbishments and greater demand for the latest electronic gadgets as buyers move into new homes.

You’ve mentioned rising consumer purchasing power – can you discuss in more details?

  • Putting together all the available financial resources available to consumers from wealth gains, take-home pay (wages after tax is deducted) and consumer credit, we have calculated a measure of real consumer purchasing power. From our estimates, US real consumer purchasing power is running at an annual rate of 4.5%, higher than current personal consumption growth of 2.6%.
  • Not only does this metric suggest that consumers have the financial wherewithal to maintain their rate of expenditure, but it also points to upside in consumer growth, provided shoppers remain confident enough to spend, rather than save.

Where do you see the biggest risks to the consumer?

  • Bigger risk to the consumer is confidence
  • Should there be a sharp correction in equity prices from an existential crisis, such as a war in the Middle East that drives up energy prices, this could encourage consumers to tighten their purse-strings and save, rather than spend.
  • Consumers could also be hit by a decline in business confidence that reduces hiring.
  • This could come from a political event, such as the election of a progressive left presidential candidate in the US, like Elizabeth Warren, or Jeremy Corbyn taking over in number 10.

Interest rates are shifting, and with it, bond yields. Does this create risks? (Eurozone/Japan – banking sector).

  • Yes, as some countries move into negative interest rates, it creates problems for the financial system. This is already apparent in the Eurozone and Japan.
  • The risk for investors is that negative rates can hinder economic performance
  • European banks are struggling to raise their profitability when lending at long-term rates offers a lower return than short-term rates. Given that banks seem unable or unwilling to pass on negative interest costs to retail depositors, this has squeezed net interest margins and has weighed down on the overall financial sector.
  • Other Eurozone financials are likely to struggle in a low yield environment
  • Insurance companies and pension providers are finding it difficult to match assets and liabilities in a profitable way, as purchasing a negative yielding bond locks in a guaranteed loss against a future maturing liability.

What does this mean for asset class selection?

  • Our strategy team are less favourable towards financials for this key reason, negative interest rates are negative for banks
  • Key hindrances for the banking sector going forward. Banks will find it difficult to charge the cost of negatives rates to the depositors, they ill just take their money out of the bank
  • Key problem banks have at the moment, that why the net interest income has come down to hardly anything at all



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This episode was recorded on  01/10/2019

This S&W The Pulse podcast is of a general nature and is not a substitute for professional advice. No responsibility can be accepted for the consequences of any action taken or refrained from as a result of what is said. The views expressed are not necessarily those of the presenter or of Smith & Williamson or any of its affiliates. No reproduction of this podcast may be made in whole or in part for professional or recreational purposes. No action should be taken based on this podcast and we accept no liability if we change your views on any of the subjects mentioned.

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The Pulse from Smith & Williamson

Investment Show: Interest rate cuts continue to support the global expansion

Episode 2

Broadcast on at 09:00, 1st October 2019

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