International Equity Commentary: May 2014

International Equities Gain on Hopes of Further Monetary Stimulus

International equity prices continued on an uptrend in May as expectations about further monetary stimulus in Europe and Japan outweighed concerns about the European recovery losing pace and the emerging market slowdown. Economic data from Europe showed the region expanding at a lower than expected rate, as major economies such as France, The Netherlands, and Italy continued to face challenges. Inflation in the common currency area remained well below the target, highlighting the weak labor market that is restricting consumer demand. In response, the European Central Bank (ECB) has lowered its benchmark rate further and will now charge commercials banks for keeping reserves with the central bank. The ECB has promised further monetary measures if the recovery continues to be weak and deflation risks persist.

In contrast, Japanese economic growth for the first quarter of this year exceeded expectations and has led to renewed optimism about a sustained revival. Growth at 6.7% annualized, when compared to the previous quarter, was one of the fastest in several years. The rebound was driven by an unexpected rise in capital spending, and increased consumption ahead of the tax hike that took effect in April. Among the emerging markets, China expanded at a better than expected 7.4% during the first quarter while growth inched up marginally in India. Global manufacturing activity data for the month of May remained largely positive, helped by gains in the U.S. and China. Euro-zone factory activity was relatively subdued, but the services sector unexpectedly gained strength during May. After the weak first quarter, Chinese exports picked up strength in May while the relatively weak export data from Korea was partly due to the fewer working days during the month.

Near-Term Outlook

Recent growth trends from Europe have shown the significance of structural reforms in reviving economic competitiveness. Countries such as Germany which had implemented labor market and other reforms earlier continue to drive growth in the region. In contrast, the pace of the recovery has dropped in France and other countries that have been slower in accepting reforms and adapting to the changing external environment. Spain has seen positive economic trends recently, but still needs to find ways to reduce unemployment and revive domestic consumption. Despite the divergent growth trends, expectations of aggressive policy measures by the ECB have driven down sovereign yields across Europe, narrowing the spread between the healthier and weaker economies. Unless the decision to force banks to pay interest on reserves kept with the central bank leads to a meaningful increase in lending, the ECB is likely to expand its monetary measures later this year. Outside the Euro-zone, the U.K. had adopted tight fiscal measures after the global recession and is now one of the fastest growing among the developed countries.

Stronger than expected growth during the first quarter has triggered optimism that the Japanese economy will be able to weather the consumer spending drop, induced by higher taxes. While manufacturing activity contracted marginally in May, it was still an improvement from the previous month and is seen as a signal of businesses regaining their confidence. However, the surge in first quarter growth was partly on account of unusually large gains in capital spending. This is unlikely to be sustained, unless consumer spending rebounds strongly and drive business confidence higher. To encourage businesses to sustain higher capital spending, the Japanese government faces pressure to implement labor and tax reforms without further delay.

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