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OPINION

Nervously complacent

Nervously complacent
July 2, 2014
Nervously complacent

For evidence of that complacency, look no further than the Bank of England’s biannual Financial Stability Report, the latest edition of which was published last week. The press naturally focused on the Bank’s novel but tentative measures to dampen the housing market, including a 15 per cent cap on high loan-to-value mortgages as a proportion of total home loans. Yet more arresting in many ways was the Bank’s account of the becalmed financial environment.

A 10 per cent fall in UK stock prices is now less likely than at any time since 2006, if you believe the market expectations implied by options pricing. More generally, expectations of three-month volatility in equities, interest rates and currencies have, over the past six months, been even lower than in the balmy pre-crisis world of 2003-06.

Given this backdrop, it comes as no surprise that the hunt for yield has intensified, particularly in credit markets. Spain can now borrow more cheaply than ever before - and as cheaply as Britain. Investors have also piled into US corporate debt, particularly the lower-grade stuff. And for all the talk of a housing bubble, spreads on UK mortgage-backed securities, having ballooned three standard deviations above the 10-year average in 2008-09, are now tighter than in 2006.

Greater turbulence is expected two to three years hence, particularly in UK interest rates. That clearly reflects the perceived disruption of rising rates. For now, however, investors seem happy to postpone worries until next year.

So what of the nervousness? Curiously, stock investors seem to be taking risk off the table, even as they strike a relaxed pose. The FTSE 100 is more or less flat year-to-date, while the FTSE 250 is down 1.8 per cent. The divergence over three months is even wider, with the large-cap index outperforming its mid-cap peer by 5.5 percentage points. At the same time, the benchmark 10-year gilt yield, having spiked above 3 per cent in December, has fallen back to 2.6 per cent.

So it seems investors have been buying bonds, not stocks - and if they have bought stocks, they've favoured liquid, globally diversified ones. This is exactly the opposite of what was supposed to happen. At the start of the year, the UK recovery was the talk of the City. Consensus was bullish on stocks, particularly those exposed to the roaring UK economy, and bearish on bonds.

The poor performance of equities can partly be explained by the nearing threat of rising interest rates - though that hardly explains the rally in bonds. A second factor has been heavy issuance. Finally, Simon Ward, chief economist at fund manager Henderson, points out that growth in industrial output peaked in November. The unanticipated slowdown has kept analysts busy downgrading their profit forecasts (see table) - just as they have in previous years.

Mr Ward reckons production is now due to pick up, and the stock market with it. Obe Ejikeme, equity and quant strategist at Bank of America Merrill Lynch, takes the opposite view. "Construction data is starting to soften a bit. Add to that Carney's latest comments and there's not much upside to the domestic-growth story. We're not in the early part of the business cycle any more," he says, recommending classic defensive stocks such as British Amercian Tobacco (BAT), Shell (RDSA) and GlaxoSmithKline (GSK).

Personally, I’m not convinced this is the time for a big macro-driven call on the market, as 2007 turned out to be. But the passing of the summer solstice may be a useful excuse for private investors to weed their portfolios. If volatility does pick up - as it surely will sooner or later - they can at least enjoy the comfort of conviction.

2014 consensus EPS growth

FTSE 100FTSE 250
Dec 1311.410.5
Jan 1411.09.7
Feb 149.38.6
Mar 1410.36.1
Apr 148.37.6
May 147.06.3
Jun 146.25.0
Source: IBES, Datastream, Bank of America Merrill Lynch