The world is looking to be a slightly more benign place compared to a few months ago. Despite a mild contraction in Europe, the global economy is expected to avoid recession, driven by growth in emerging Asia and the United States. In fact, financial market sentiment has improved significantly since the beginning of 2012.
Markets could still be dominated again by more bad news from the eurozone and disappointing economic data in China
This reflects the combination of a steady, albeit unspectacular recovery in the US and the massive European Central Bank intervention which helped to dispel fears related to the euro debt crisis. Meanwhile, fears of a hard landing in China have so far not materialised. This scenario has also prompted various analysts to revise upward their global growth forecasts.
Going forward, these three main themes will continue to shape the fortune of the world economy and the prospects for financial markets. However, political uncertainty relating to the elections in Greece and France, a prolonged period of elevated commodity prices, in particular oil, and serious signs of liquidity fatigue, would most likely cast serious doubts on the outlook.
Macroeconomic Outlook
Europe continues to pursue efforts aimed at stemming the sovereign crisis, thereby reducing the systemic threat for global growth. These include a second bailout package for Greece, a debt swap for Greece’s private creditors and a fiscal compact treaty aimed at reinforcing budgetary discipline and enhancing the power to monitor and enact sanctions at the European level. Furthermore, the monetary injections by the ECB, through the longer-term refinancing operations (LTROs), have been successful in easing financial market tensions. Despite these developments, challenges remain to further increase the size of the anti-contagion tools, ratify the fiscal compact, and convince markets that the budgetary adjustments in the periphery are being met despite backdrops of recession and high unemployment.
In view of this, the divergence in economic performance of the different member states will nonetheless remain a key issue, as the drag on domestic demand from fiscal consolidation will probably offset most of them pickup in German growth.
In the US, indicators continue to surprise on the upside and budgetary stimulus measures were renewed at the end of February. Meanwhile, stronger job growth in recent months indicates that the US economy is weathering headwinds from both home and abroad, bolstering consumer confidence. Deleveraging is becoming less of a headwind.
US businesses still flush with cash have responded to the brightening outlook for consumer spending by rolling out plans for new capital spending projects. Nonetheless, falling house prices, fiscal restraint, rising oil prices, and weak growth in Europe still present headwinds to the US economy. Although the probability of an additional round of quantitative easing is decreasing, this still remains an option given the still high unemployment and expectations that inflation will fall close to the central bank’s target.
On the other hand, emerging-market growth has continued to slow since the beginning of the year due to lagged effects of monetary tightening. Developing nations are expected to benefit from lower interest rates, lower risk premia, global liquidity and better prospects from developed markets. In fact, the bellwether economies such as South Korea, Taiwan and Singapore, have all seen a clear improvement in export trends since November.
An unusual feature of Asia’s quickening cyclical recovery is that China, the regional leader, is lagging rather than leading the improvement due to muted export performance in recent months. However, China’s growth is still expected to stay above the 7.5 per cent growth projected by the Chinese government this year. Should economic growth falter abruptly, with government debt currently only at 17 per cent of GDP, the Chinese authorities have room to take the appropriate supportive measures.
In the meantime, falling inflation and deflating real estate market gives more flexibility to monetary and fiscal easing. The weak external environment will reinforce the importance of rebalancing China’s economy away from investment and exports, and more towards private consumption.
Central European economies look less fragile than last year, thanks to a stronger growth outlook in Germany, the region’s main trading partner. However, the European sovereign debt crisis still poses significant risks to the region which therefore remains vulnerable to swings in global sentiment. Poland is expected to outperform the rest of the region in terms of growth this year, especially as it has only seen a very mild credit squeeze so far.
Like many other emerging markets, Latin American economies are running close to full capacity. Policy makers in this region are facing challenges in trying to control inflation and currency appreciation at a time when international capital is flowing freely and eroding the competitiveness. In this respect, growth performance will vary. After starting 2012 on a soft note, Brazil is expected to grow much faster in the second half of this year, while Mexico is expected to continue to benefit from its close links to the US.
Fixed Income and Credit Markets
Fading uncertainty, in combination with better economic data and improved risk appetite, has caused safe-haven sovereign yields both in Europe and in the US to rise noticeably of late. Since the global economic outlook continues to improve, fundamental headwinds for US treasuries and bunds could continue to emerge in the near term. In Europe, as the end of the recession comes into view, it should become increasingly unlikely that the ECB will lower its key rate once more.
On the other hand, rate hikes will not be on the agenda either in the foreseeable future, and this should keep yields at the short end of the curve low. Against this backdrop the yields of long-dated bunds should trend only moderately upward and the yield curve looks set to grow slightly steeper.
Meanwhile, in the US, the Federal Reserve Bank (Fed) in its last meeting confirmed it would continue with its current ultra-expansive monetary policy until the end of 2014 at least, keeping short term yields under pressure and causing the yield curve to steepen.
Going forward, the upward pressure on long-term yields is likely to persist as economic data improves and further measures to stimulate the economy will become less likely.
However, as soon as the Fed signals that further support to the economy is no longer needed, short-term yields will start to rise. Despite this upward pressure on yields, the yield structure of US treasuries is unlikely to get any steeper over a medium-term horizon.
The combination of the ECB’s intervention and the Fed’s commitment to maintain a highly accommodative monetary policy stance has meant that US and European credit, both in investment grade and high yield have performed similarly as spreads continued to tighten and yields to fall. This shows that liquidity continues to play a major role on both sides of the Atlantic. Going forward, excess liquidity within the financial system will act to dampen volatility, however, growth and improving fundamentals will be essential to drive spreads tighter from here on. In this interest rate scenario, lower duration exposures, with selective credit risk will be preferred.
Equities
Equity markets in the developed countries continued to see strong gains in the early part of this year as market participants paid less attention to the daily speculation and rumours about Greece. Ample liquidity, the risk-on mood, attractive valuations and higher earnings expectations should offer a more benign environment for equities in the coming months. In fact, equity valuations are still low relative to their ranges of the last decade and, outside of the US, most equity indices remain below year-age levels.
However markets could still be dominated again by more bad news from the eurozone and disappointing economic data in China. On a relative basis, attractive growth-adjusted valuation multiples and encouraging recent data on the economic trend are expected to push European equities higher. On the other hand, the better performance of the US market over the past couple of months has pushed multiples on the high side.
Although better-than-expected employment growth could put further pressure on still high profit margin and the end of Operation Twist may pose a near-term risk, current relative macro-economic strength remain supportive for US equities. In view of this, assets that benefit from stronger US-led global growth are expected to remain attractive.
Meanwhile, UK equities are expected to benefit from global growth but since they have not been the focus of negative investor attention the market has relatively less room to rebound. Asian equity markets are steadily recovering on the back of depressed valuations, easier liquidity conditions and supportive economic growth. Rates of inflation are falling in most of the emerging world and hence there are many signs of at least a temporary stabilisation.
However, if the price of oil keeps rising, although it may be a blessing for Russia and Brazil, there could be a renewed threat from inflation. This would make it more difficult for central banks in emerging markets to keep easing their monetary policy stance.
Foreign Exchange
The greenback has recently appreciated against most other developed currencies. Although, the dovish position of the Federal Reserve is unlikely to change much in the coming months, signs of sustained improvement in the economy are expected to raise market expectations of a recovery. On the other hand, the European Central Bank kept interest rates on hold in March, but highlighted that risks to growth still remain. In view of this, positive US growth and interest dynamics are expected to support dollar strength against the euro in the medium term.
Meanwhile, the British central bank is not expected to raise rates this year, despite the high inflation rate, which is mainly due to external factors which the Bank of England is unable to influence with its monetary policy. In view of this, market expectations of a rate hike seem to be exaggerated and there is a risk of such expectations being corrected which will put pressure on sterling in the short term. However in the medium term the British pound is expected to appreciate further against the euro as the eurozone debt crisis is likely to put pressure on the euro on a sustainable basis.
Commodities
Gold’s rally since last year was deflated by Federal Reserve chairman Ben Bernanke’s speech in late February, in which he failed to make a direct reference to further liquidity injection. Gold has since then been behaving in line with equities, but this positive correlation with risky assets is expected to be only temporary.
Although the yellow metal still faces near-term hurdles such as dollar strength and broad risk reduction, the broader macro backdrop remains supportive. Negative interest rate environment, longer-term inflationary concerns, lingering sovereign debt uncertainties and continued buying interest from the official sector are expected to continue to support the price of gold.
In spite of this, we do not expect to see the same momentum seen last year. Meanwhile, palladium has been underperforming platinum since the beginning of this year, owing to a more risky environment and supply disruptions in South Africa. However, the palladium market is much tighter than the platinum and growth from large producer countries is not expected any time soon. In this respect, given palladium’s recent underperformance, a performance catch-up relative to platinum is expected.
Meanwhile, base metals are faced with conflicting near-term demand signals. Despite improvements in the main developed economies, China’s shift in the composition of growth away from construction and investment and towards internal consumption, suggests a more cautious outlook for base metals and infrastructure materials in general.
Finally, in the energy market, the price of Brent oil has settled at around $125 a barrel. In addition to a generally brighter sentiment on financial markets, the possibility of supply outages amid the nuclear dispute with Iran is also lending support. As the dispute is unlikely to be resolved soon, the geopolitical risk premium should remain high for now, especially as other purchasing countries besides the EU are thinking about reducing their crude oil imports from Iran.
Poland is expected to outperform the rest of the region in terms of growth this year
The risks overshadow the actual supply situation, which is generally quite comfortable at the moment. Libya has returned to the market surprisingly quickly and Saudi Arabia has hardly trimmed its production, hence the market has an oversupply. Going forward, as long as the nuclear dispute does not escalate further, prices should therefore drop slightly by summer.
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