Global Investment Outlook
Aberdeen Asset Management
By Mike Turner
May 23, 2012
Growth remains key for markets
• Steady growth continues, although it remains fragile
• Equity valuations are not expensive
• Abundant liquidity is supportive of markets, although the next stage is unclear
Investors continue to focus on the global macroeconomic backdrop, which is still relatively positive despite slightly disappointing data recently. Data from the U.S. has mainly been resilient.
Both consumer confidence indices and the labor market have been consistently solid, and U.S. households are making progress with their debt-reduction cycle. Housing statistics have been more mixed and the fiscal situation is unlikely to be addressed until later in the year.
Economic growth in China, while slowing, is still higher than that in developed markets and indicative of a soft landing scenario. Furthermore, Chinese industrial production and retail sales both remain very healthy. Should the growth outlook deteriorate though, Chinese authorities have additional policy tools at their disposal in order to stimulate growth.
There are signs that some of the imbalances within the Eurozone are starting to ease as competitiveness is improving in some of the peripheral countries and this is beginning to be reflected in trade figures. However, it must be remembered that the long-term structural problems remain unresolved and much work on this front lies ahead for European policy makers. Recently, the Eurozone wide composite Purchasing Managers Index (PMI) has dipped below 50, signaling a very modest contraction, but remaining above late 2011 levels.
Overall, growth looks to be reasonably supported for the time being, albeit at a steadier and slower trajectory than previously. Looking further ahead, we feel that global consumption should be supported by falling headline inflation. Currently, the downward inflation pressure is being held back by high oil prices but, in the absence of any future price shock, we feel that this should ease this year.
The S&P500, our favored indicator of market risk, reached our 2012 target area of 1400-1440, only to fall back a little. We believe that the recent market pause is indicative of a period of modest consolidation to come. Growth momentum has shown signs of slowing recently and the twin stimuli of Operation Twist in the U.S. and the Bank of England’s asset purchase program in the UK are coming to an end. Furthermore, it is uncertain whether we will see a third long-term refinancing operation in Europe. These factors could lead to greater uncertainty within markets and make them vulnerable to bouts of volatility.
Economic and monetary policy outlook
A key question is whether or not the Federal Reserve will embark upon further unconventional monetary policy, dubbed QE3, and what form it might take. “Pure”, or unsterilized, quantitative easing would mean additional money is printed to buy Treasury securities. Alternatively the current Operation Twist, where existing short-dated Treasuries are sold to purchase longer-dated bonds, could be extended. It is expected that should QE3 occur it will be either in the second quarter of 2012 or after the November election, given that the Federal Reserve will likely want to avoid being viewed as acting politically. From the Federal Reserve’s point of view, the conditions are perhaps not quite right for QE3 to be justified. They would rather see a deterioration in data before acting. We believe that with accommodative monetary policy for the foreseeable future and inflation reasonably contained, fiscal policy will remain of utmost importance to investors. The ECB’s long-term refinancing operations (LTROs) have done a great deal to ease the funding crisis in Europe, but we are concerned that peripheral Eurozone banks have been encouraged to buy their own domestic debt markets. The net result is that cross-border capital flow in the sovereign debt markets may not be occurring to the extent required for a healthy, functioning
market. This could add to the uncertainty in the region as greater domestic bank ownership of domestic government debt increases the inter-reliance of national governments and banks. Clearly, political risks also still surround the ratification and implementation of the EU’s fiscal compact, with elections on the near-term horizon, which could fuel further volatility.
While elevated gasoline prices continue to be a risk to consumption, there is no evidence as of yet that they are constraining final demand; confidence data is buoyant and the U.S. consumer continues to delve in to their pocket. Intra-month yields rose as the Federal Reserve made no reference to additional quantitative easing measures in its statement following the March Federal Open Market Committee meeting. With the market anticipating some additional official bond buying there was considerable disappointment in the immediate aftermath of the meeting. Federal Reserve Chairman, Ben Bernanke, perhaps concerned about the speed of the sell-off and the risk of a resulting tightening in financial conditions, made a number of resolutely dovish comments, cente ring on a belief that the underlying dynamics of the labor market are softer than the recent decline in the unemployment rate would suggest.
The tentative signs of a housing market recovery, albeit from a very low level, continue to seep through and this, coupled with the Federal Reserve’s long-term accommodative stance, should provide further support.
In aggregate, Europe is likely to suffer a mild recession in 2012. The picture for specific countries is more mixed, with Germany likely to enjoy better growth while some peripheral nations may face a deeper recession. Both the German and French Purchasing Managers’ Surveys are in expansion territory. However,
growth in peripheral countries is much weaker as they struggle with a combination of tight credit, poor sentiment, private sector deleveraging and public sector austerity. While consumer confidence data also collapsed in late 2011, it has since stabilized and more recently has seen a very modest pick-up. Against this slightly better survey data, monetary and credit data has been
disappointing, so a key question for European growth is how much the ECB’s LTRO policy has averted a European credit crunch.
The key challenge for Europe this year remains one of economic adjustments within the Eurozone in order to resolve some of the structural imbalances that lie at the root of the long-term problem. While our base case for the euro is one of survival, there are obvious risks to this outcome. At present, the apparent lack of growth in Europe appears to be the Achilles Heel of the more optimistic market view of the world.
From the Federal Reserve’s point of view, the conditions are perhaps not quite right for QE3 to be justified The U.S. consumer continues to delve in to their pocket The apparent lack of growth in Europe appears to be the Achilles Heel of the more optimistic market view of the world.
Despite the UK being put on negative credit watch by rating agency Moody’s, markets have continued to rally and risk assets have generally been buoyed by the news coming from Europe. While interest rates remain unchanged at 0.5%, a key focus in months to come will be whether the Bank of England’s total Asset Purchase Facility (APF) of US $523 billion is increased.
Over the first quarter of 2012, headline CPI inflation has fallen from 4.8% to 3.4%, consistent with the MPC’s expectations, and reflects the base effects of last year’s VAT increase and high fuel inflation dropping out of the equation. There were a broad range of changes announced in the 2012 budget that, overall, were considered to be fiscally neutral.
Economic data has been mixed. The initial release of 2012 Q1 GDP (-0.2%) confirmed that the UK has returned to recession although this figure could well be revised upwards at a later date. 2011 GDP was also revised to 0.5%. The latest figures for both manufacturing and service’s PMIs also indicate a slowing in the pace of expansion.
Growth in Japan this year will largely be driven by reconstruction following the Tsunami. Recent industrial production was weaker than expected, contracting 1.2% and the March Jobless rate was 4.5%, also slightly below consensus. Japanese trade has been in deficit for five months, in large part because of surging demand for imported fossil fuels. However, it posted a trade surplus in February after a record high deficit the previous month, as external demand
was not as weak as expected, in part due to U.S. strength.
The government is planning on raising the consumption tax from 5% to 10% in two stages by April 2015, with a move to 8% by April 2013. In the short term, it is possible that this boosts consumption for 2012, with consumers bringing forward big-ticket purchases before the VAT hike occurs.
The Bank of Japan recently announced a new commitment to monetary easing aimed at achieving a goal of 1% inflation. It is hard to judge how significant this commitment will turn out to be. It only really matters if Bank of Japan policy makers start referencing it in policy statements as a reason for a particular policy action, otherwise the Bank may fail to convince on its credibility. Perhaps more significant could be the change in composition of the Bank of Japan policy board and whether policy does change on the back of this. The prospect of an end to corrosive disinflation, perhaps also helped by a stronger labor market, will provide positive support to consumption. Central bank easing, along with an increase in the trade deficit, should support further Japanese yen weakness and potential Nikkei strength.
Asia and emerging economies
The impact of softness in European demand will constrain an otherwise bright outlook in the Asian and Emerging world, but we also need to be vigilant about the risk of rising oil prices (which have recently been better behaved). In general we expect consumption to be boosted by the cyclical downturn in headline inflation which continues to support monetary policy easing. Nonetheless, a combination of a sustained rise in oil prices and tightening labor markets do pose medium-term risks to this more benign inflation and growth view, and new inflation drivers have begun to emerge - notably transportation.
Data so far this year from China is broadly consistent with moderating inflation and some stabilization of economic activity, with encouraging recent PMI data. New orders (both domestic and export) point to improving activity in the months ahead. We continue to expect the policy setting framework to focus on fostering growth rather than constraining inflation, therefore ongoing reserve requirement ratio easing and modest fiscal measures targeting small & medium enterprises are likely.
Although equity valuations have improved, we feel that they are at reasonable levels given that corporate earnings are likely to remain relatively robust. Having said that, it is likely that the momentum in earnings growth will ease off, which may well provide less of a support for equity markets in the months ahead.
The recent pause in capital values is not surprising given the strong market recovery experienced
since December of last year. It also reflects the fact that uncertainties over global growth have
resurfaced somewhat, caused by reignited concerns over Europe and fears of an extended
slowdown in China. We anticipate a period of market consolidation leading up to, and including,
the summer and would not be surprised to see more elevated levels of volatility. However, over the longer term we see risk assets continuing to be supported by valuations and abundant liquidity, although tail-risks to growth from global fiscal policy remain.
However, we are starting to witness greater dispersion of equity market returns. The U.S. and
Europe are not moving so closely together as they have done in the past, and returns within
Europe have also varied substantially. The UK’s muted equity market performance has been
driven down by the fortunes of mining companies. In contrast, Asian and emerging market
markets have performed well recently and we expect this relative trend to continue as they
benefit from a supportive monetary policy environment.
Equity markets incorporate considerable risk premia currently, with core government bond
yields now materially lower than corresponding equity market dividend yields. This reflects a
continued decline in the (PE) rating afforded to stocks, as capital price volatility since the turn
of the millennium has greatly affected investors’ propensity to take on risk. We do not think
that this elevated risk premia will immediately translate into strong returns as macroeconomic
uncertainty is all pervasive. However, once investors do become more convinced about sustained growth, and therefore the stability of growth, the impact on returns of elevated risk premia will kick in.
In the immediate future, valuations, steady (albeit not spectacular) growth, and abundant liquidity should continue to support risk assets and help avoid a major bear market. Meanwhile volatility within stocks has increased again and this is likely to continue while developments within Europe attract attention.
Bonds & currencies
In the U.S., while in the short term risk asset volatility and Bernanke’s dovishness may provide support for U.S. Treasuries, we feel that yields, particularly long-dated, are likely to rise over time. A combination of better economic outlook, the ending of Operation Twist in June (which has seen the Fed switching short-dated Treasuries into long-dated bonds) and the current
overvaluation of core sovereign bonds support this view.
The abundance of liquidity and the improvement in risk appetite brought about by the ECB’s two LTROs has caused a strong rebound in the absolute returns of risk assets. However, it remains a concern that the foundations of the rally, a provision of huge temporary liquidity by the ECB, may prove short lived. Fundamentally, the Eurozone continues to struggle with painful austerity, a lasting prospect for many economies and the slow pace of structural reform, the cumulative effect of which will not be seen in the near term.
The Eurozone countries have agreed to contribute a further US $190 billion to the IMF in the hope of encouraging larger pledges from national governments outside the Eurozone, thereby increasing the amount of international (IMF) support in addition to the support available from the European Financial Stability Facility and European Stability Mechanism. However, the main creditor nations remain skeptical about the Eurozone’s ability to stabilize the situation. Therefore we think the so called “firewall” could lack credibility, especially when the funding needs of Italy and Spain over the next three years are taken into consideration.
We continue to expect 2012 to be a year of volatility as the market continues to grapple with the fight between high levels of personal and government debt and highly accommodative monetary policy. However, corporate balance sheets remain solid and valuations are still attractive even after the strong performance in the first quarter of 2012.
Consensus forecasts predict a gradual easing of the oil price over the medium term. There are, of course, risks to this scenario – most notably geopolitical tensions in Iran. Should supply disruptions materialize, the ensuing oil price spike and global growth slowdown could lead to a decline in the price of other commodity prices. Generally speaking, we expect commodities to remain correlated to risk appetite, driven by supply and demand factors. In line with this, base metals and soft commodities (foodstuffs) are, in the main, likely to be weaker due to strong supply. Precious metals should also maintain their high correlation with risk aversion and trade on safe-haven demand.
Looking further ahead, we anticipate that the long-term commodity bull market will continue, interrupted only briefly by the global financial crisis, driven by growing demand from Asia and emerging markets.
Annually published benchmark performance indices confirm that the Eurozone sovereign debt crisis led to renewed declines in capital values in 2011 after a stable 2010. Of the ten Eurozone countries where independently reported data is available, only Germany, France and Austria recorded higher commercial property values last year. Low short-term interest rates and strong investor demand for perceived safe assets helped to hold-up capital values in the latter markets,
as has also been the case in the UK, U.S. and across advanced Asia Pacific economies. However, we estimate that pricing is very stretched in many of these so called safe-haven markets relative to fundamentals, and is most marked for office property which international capital has targeted very aggressively over the past 12 to 18 months.
Given current global market pricing, we believe that major advanced Asia Pacific property markets offer the best medium-term returns. Lower capital values in Europe should put the region in a more attractive position for investment as broad based under-pricing should eventually occur. If the Eurozone sovereign debt crisis were to worsen in 2012, the low in property prices should be even deeper, increasing opportunities for global investors. On the other hand, for the over-priced U.S. market, there may well be short-term upward momentum in capital values due to safe-haven demand, but this implies a greater degree of over-pricing and very moderate prospective returns over the medium term.
Risk and index Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries. Equity stocks of small-cap companies carry
greater risk, and more volatility than equity stocks of larger, more established companies. Fixed income securities are subject to certain risks including, but not limited to: interest rate, credit, prepayment, and extension. Indexes are unmanaged and have been provided for illustrative purposes only. You cannot invest directly in an index. The S&P 500 Index is an index of 500 selected
common stocks, most of which are listed on the New York Stock Exchange, that is a measure of the U.S. Stock market as a whole. The U.S. ISM Purchasing Managers Index– Manufacturing is an indicator of the economic health of the manufacturing sector. The index is based on five major indicators: new orders,inventory levels, production, supplier deliveries and the employment environment.
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