By Mike Dolan
LONDON, March 15 Bank of England chief Mervyn
King suggested this week the "black cloud" over the economy may
be lifting, but with assets buoyant and the pound feeble, what
investors think of Britain's growth prospects is less clear.
King surprised markets by saying on Thursday he saw
"momentum" behind a UK recovery that will emerge this year, and
that sterling was fairly valued after a recent tumble.
The pound's broad exchange rate index, which has
plunged up to 7 percent in 2013, promptly perked up a bit.
Sterling remains about 25 percent lower on a trade-weighted
basis than before the crisis that started in 2007, however,
while soaring British stock prices appear in step with King's
But which more accurately reflects investors' views of the
British economy after a long period during which financial
sector retrenchment, household deleveraging and fiscal austerity
have meant little or no growth?
Pessimists feel the rhetorical shift by King, who talked
last year of a "black cloud of uncertainty" over the economy,
may simply be aimed at shoring up sterling to prevent
"stagflation", where a free-falling pound aggravates import
inflation even as growth flatlines.
Others say the gloom is probably overdone.
Standard Life Investments director Jonathan Gibbs said he is
sceptical stagflation has taken hold, and that even if such a
toxic combination persisted, it would not mean a repeat of the
dire 1970s economic and investment environment the term evokes.
"We would argue that the medium-term return environment is
continuing to improve," said Gibbs. UK markets' exposure to
global reflation and recovery rather than the sluggish domestic
economy is helping drive equity and real estate performance, he
added, while investors are also seeking inflation protection.
The slow beginnings of a worldwide shift in asset
allocations from expensive low-yielding bonds to equities is
also a support for the stock market, which hit five-year
highs this week, Gibbs said.
Citi economist Robert Buckland said the rally in UK and U.S.
equities is driven mainly by valuations, with the state of the
domestic economy almost beside the point, and reflects a similar
rebound of earnings per share (EPS) back above 2007 levels.
Cyclically-adjusted price/earnings estimates for British
stocks are still about 15 percent below 40-year averages despite
"If economic growth, or lack of it, was all that mattered,
then we would expect the GEMs (Global Emerging Markets) and Asia
ex-Japan equity markets to be hitting all-time highs, which is
not the case," Buckland wrote.
But for overseas investors, who according to the Office for
National Statistics own more than 40 percent of Britain's stock
market, the key issue may be the performance of sterling.
A dollar-based fund invested in the FTSE 100, which has
gained 10 percent in 2013, would have seen its gains reduced to
just 3 percent once the falling pound is taken into account.
With 10-year gilts offering annual yields of less than 2
percent, a sustained exchange rate move like the one we've seen
this year is also a potential wipeout for bond investors.
And as few expect any let-up in government's fiscal squeeze
in next week's annual budget, the pound will ultimately take its
cue from whether the central bank moves again to support the
economy by printing more money to buy bonds.
That's why yields on gilts, a third of which are already
owned by the Bank of England, remain so low despite rising
inflation expectations, the loss of Britain's triple-A credit
rating and a general retreat from core government debt.
Sub-2-percent 10-year yields stand in stark contrast to
10-year inflation expectations as high as 3.3 percent, as read
from the inflation-protected bond market.
Bank of England minutes next week will reveal whether King
still favours more bond-buying and if he's winning the debate
among fellow monetary policymakers. Beyond that, new governor
Mark Carney is widely expected to be given a more dovish mandate
when he takes over from King in July.
So if strength in gilts is at least partly a monetary
illusion conjured up by current and expected quantitative
easing, is the FTSE's surge - to all-time highs on total returns
indices - also a QE distortion?
Buckland at Citi said there was little to back that up.
"If QE has been important in driving share prices up, it
seems to be more through its fundamental support of EPS than its
ability to inflate valuations," he said. "Some of this support
might come from the ability of QE to weaken the currency and so
boost stock market EPS."
The pounds' fall, then, is a double-edged sword, as the
'currency wars' debate and Japan's reflation push attests.
While some investors see a healing global economy and
employment data that is more upbeat than backward-looking growth
figures as supporting King's line, others feel the pound will
continue to feel the heat for a variety of reasons.
Scott Thiel, Head of European and Global Bonds at the
world's biggest asset manager BlackRock, told Reuters earlier
this month the pound had further to fall, reflecting political
uncertainty as much as the economic picture.
He cited questions about the stability of the governing
coalition, rifts within the ruling Conservative Party and a
promised referendum on European Union membership.
"Introducing the idea of British vote on European Union
membership is a negative for how investors view the UK. A 'No'
vote would be negative because of the amount of connectivity
between the UK and EU is so unbelievably high," Thiel said.
"If you're starting a company ... you need a multi-year
"If there is the possibility that in five to six years
you're going to have to go through this Y2K-type problem, it
will impede your 'animal spirits', as it were - your decision to
hire, or open a new plant."