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Multi-manager View

Equity markets began the year in a buoyant mood, with renewed enthusiasm based loosely on the news that Federal Reserve chairman Ben Bernanke still does not have full faith in the economic recovery and that QE3 is still therefore a real possibility. Yet much of this optimism faded towards the end of March, suggesting that the markets will allow the outlook for policy and financial conditions to dictate market direction instead of Fed rhetoric.

It is our view that creation of excess liquidity by the Fed has allowed the commercial banks to extend occasionally large sums of money to the non-bank financial system which then goes off to play in the risk asset markets while the real sectors still seem relatively credit constrained outside big blue-chip corporations. There is an impression that the Fed’s liquidity is only finding its way into speculation and not into the real sector, something that is likely to constrain economic growth in the medium term.

The early euphoria of the Long-Term Refinancing Operation for the fringe sovereign debt markets also appear to be wearing off. Five-year Italian government bond yields have moved from 3.68 per cent to 4.29 per cent (as at the end of March) in recent weeks while Spanish debt has performed even worse, with the five-year yield up from 3.42 per cent to 4.09 per cent.

Euro area bank lending has also turned negative. It would appear that the ECB’s €1trn LTRO has not been able to halt or even reverse the contraction of European banks’ loan assets, suggesting that economic growth and profit forecasts for the euro area remain susceptible to further downside risks.

The withdrawal of bank credit slows the velocity of money in the system which in turn reduces the impact of the multiplier effect of money flow throughout the economy and, once underway, usually takes five to six years to reverse.

The combination of the eurozone debt crisis and the UK’s own austerity measures has caused the UK to tip back into a technical recession. Indeed, the UK’s close links with Europe puts it at a distinct disadvantage, with 45 per cent of its exports still going to the eurozone

However, there are a number of reasons to remain optimistic about the outlook for the UK’s external sector. The UK export industry has taken some action to protect against a slowdown in Europe and is taking greater advantage of stronger growth in the rest of the world.

Direct exports to non-EU countries have increased by an impressive 73 per cent over the past three years – the breakdown of goods exports by destination shows that the fastest growth has been to Australasia and parts of South-east Asia. Additionally, the trend in the UK’s market share of goods exports has improved, albeit shifting from a falling trend to a flat one.

James Sullivan is co-manager of the CF Miton special situations and CF Miton strategic funds at Miton Asset Management

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