Heave! Heave!

Market froth may stir memories of 2005, but underlying tensions make 2014 a very different beast. Behind the market bravado, improving growth and falling sovereign yields, are central banks – still heaving and trying to sustain recoveries that are a bit loose at the seams. Governments and regulators should be trying to fix their economies and banks too, with plenty left on reform to-do lists. However, the European outlook looks a little murkier following a truculent display of voter displeasure and the IMF is getting increasingly frustrated with progress. This is no time to stall – the recovery isn’t secure, sustainable or strong and the battle for capital is hotting up.

Come here often?

EY’s latest attractiveness survey shows Europe getting back in the game in 2013. Global business leaders ranked Western Europe as the most attractive global destination for foreign direct investment last year, just ahead of China. As a result, FDI into the region rose by 25% to hit an all-time high, with Europe (excluding Russia) ranking second for total inflows, behind ‘Developing Asia’

Businesses were encouraged into Europe last year by increasing economic, regulatory and political stability. This stood in stark contrast to the travails of emerging markets. However, looking less bad than the alternative is not a sustainable investment advantage. Europe will need to work hard to build on its gains by continuing to show labour market and regulatory reform in order to draw FDI from outside of the region. Investor’s confidence and capital flows can quickly reverse – as last year’s taper tantrum amply demonstrates.

EU tremors

A reforming agenda looks tougher to maintain following last week’s EU elections. The voters certainly bloodied the noses of many of the incumbent parties signed up to the fiscal compact – although it’s misleading to apply a simple region-wide anti-EU or anti-austerity narrative . Voter concerns range across EU bureaucracy, immigration, austerity and faith in mainstream politics. Just to show how varied those concerns are, two of the biggest blows against incumbents landed in Greece and France, where there has arguably been the most and the least economic reform. Nor is the protest universal. In Germany and Italy there were only minor gains for what might be termed ‘populist groups’, who don’t share a common platform and are still a minority within the EU Parliament.

Thus, the results aren’t necessarily a strong catalyst for change within the EU Parliament; although it may be tougher to operate with greater division. The biggest impetus will come at a national level from EU leaders, anxious to win back voters through changes in domestic policy and their relationship with the EU. Certainly their rhetoric suggests change. What this means for the pace of economic reform and EU cohesion remains to be seen. There is always a lag between economic recovery and a rise in household incomes, but this drawn out austere recovery is severely testing the patience of voters. There has to be a question mark over whether politicians can hold their nerve.

Taper tantrum to rate rage?

Meanwhile, emerging markets are staging a market comeback. The MSCI Emerging Markets Index has recovered  to barely half a percentage point below its pre-taper announcement level. The dramatic gains of the last three months, when US rate expectations have also eased, aren’t coincidental. There is still a strong correlation between confidence in emerging markets and the Fed’s trajectory. So what’s the likelihood of what Lombard Street Research terms ‘rate rage’? The Fed’s continual assertions that  interest rate rises will be small and slow may help to limit volatility; however, emerging markets still look vulnerable to outflows. Currency devaluation should be a natural balance; however, this silver lining requires significant improvements in export demand – something that hasn’t happened so far due to the slow US recovery and slower Chinese growth.

The uncertain timing and currency impact of rate rises is a corporate forecasting headache. EY research showed last year’s turbulence in emerging markets, combined with the strong pound, triggered 19 currency related UK profit warnings in Q1 2014 – the highest since 2009.  Steadier currency markets have allowed companies to aclimatise and currency-related profit warnings have dropped off during Q2. This may be the calm before the next storm, but multinationals have by no means surrendered hope in emerging markets. Companies are still investing across the cycle – albeit with revised, more realistic expectations– which ultimately means more competition for capital in years to come.

Taking it easy

There’s no immediate alarm on rate rises, since the main central banks know that their economies are by no means ready for tightening – central banks are still doing the heavy lifting. So, the Fed is still dovish, the BoE more conflicted – but still cooing and the ECB is well on the road to loosening. Easing is as much of a no-brainer as it ever has been in the Eurozone and Mario Draghi continues to drop hints on rate cuts and lending incentives, although it looks like QE is still off the menu. If he had any doubts, April’s figures showing M3 money supply growing at less than 1% – the lowest since September 2010 – will soothe them.

As for the first UK and US rate rise, many analysts now seem to be plumping for Q1 15 – you could also stick a pin in the calendar. It’s just so difficult to judge by their own nebulous production and labour market metrics and to time the tightening across the economy. A recent JPMorgan report argued that asset bubbles emerge long before inflation has a chance to rise. In other words, “financial overheating” happens quicker than “economic overheating”. Sounds familiar.

Although, we are seeing a few signs of IPO indigestion, with recent underwater issues and a few hasty profit warnings making investors choosier. Compelling new issues are still getting away. There’s still enough liquidity sloshing about to keep the IPO market moving, but at lower valuations – low enough to give a few companies cold feet. This is good news for trade buyers who are finally getting a look in after being priced out for so long.

In the meantime, the flat calm of the bond market in particular isn’t helping investment banks. According to Goldman Sachs, this is a bigger challenge than recent increases in regulatory and capital requirements.


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