Slow world economy growth to linger
The world economy is heading towards a longer period of weak growth than initially thought, as the two economies which have been among the strongest performers during the recovery from the latest recession, Germany and China, have slowed significantly.
Most economic indicators across the globe, especially manufacturing data, international trade and business surveys, have been weaker than expected. This was mainly driven by a significant decline in economic data in China, further weakness in the United States, and the still-ongoing sovereign debt crisis in the euro area. As a result, economists have been revising down their global economic growth forecasts for this year and the next.
The International Monetary Fund in July also downgraded its global growth forecast to 3.5 per cent for this year and 3.9 per cent in 2013, marginally lower than its April 2012 forecast.
Given the renewed global economic weakness, Central Banks were back under the spotlight, especially since most countries’ fiscal policies could not be used to deliver stimulus to the economy. Investor sentiment has recently been buoyed by a number of actions by policymakers around the world, especially in Europe and the US. These include the European Central Bank’s announcement of its Outright Monetary Transactions programme, the expansion by the Bank of England of its bond-buying programme and the launch of a further round of asset purchases by the Federal Reserve together with the indication that it expects to hold the policy rate at its lower band until at least mid-2015.
This market confidence continued to be boosted by the stimulus package announced by the Bank of Japan. These events have continued to fuel global equity markets and pushed volatility close to its post-crisis low.
Now that Central Bank policy has been clarified in the world’s most important economies, markets are expected to renew their focus on economic developments.
The macro news flow is still consistent with a soft patch in a global low-growth cycle, with a shallow recession in the eurozone. Going forward, global growth is expected to be helped by recent monetary policy easing and contained inflation, but mounting tensions in Europe, the forthcoming elections and fiscal cliff negotiations in the US, the growth test and the leadership change in China remain key risks for global growth.
In the eurozone, the risk of the euro falling apart has decreased. Europe is expected to remain in a recession during the second half of this year, with the core countries also experiencing a mild negative growth due to tight budgetary policies and still-high institutional and economic uncertainties. Growth expectations in Germany have diminished significantly due to weaker growth in Asia and the sovereign debt crisis which are drags on net exports, overshadowing the effect of extremely expansionary monetary policy and Germany’s price competitiveness. However, if emerging market growth accelerates again later in the year, the dent in economic activity should be short-lived.
In the periphery, although the sovereign crisis is not yet resolved, uncertainty looks set to abate, as risks are being mitigated to a certain extent.
However, continued required austerity, reforms and high unemployment are expected to persist as a drag on growth. The ECB is, in principle, prepared to buy unlimited amounts of short-term sovereign bonds, without seniority, from the crisis countries provided they officially ask for support. The positive verdict from the German Federal Constitutional Court which paved the way for the European Stability Mechanism should help both Spain and Italy to be able to access funding at reasonable rates.
These measures are expected to relieve liquidity pressures and should help business confidence, but leave governments needing to put their fiscal houses in order and restore economic growth. This has lessened the urgency for the Spanish authorities to seek assistance. As far as Italy is concerned, a request for financial support is not on the agenda but the question might be raised before the general elections in April. The future of Greece is still undecided, as the tranche of the second bailout loan, originally due in June, has not been allocated yet and it is likely that the necessary reforms and targets have not been met.
However, most analysts still expect an agreement to be reached with the troika by the end of the month.
On a positive note, fiscal consolidation programmes in countries like Ireland and Portugal are on track.
In the US, the most promising sign this year has been the growth of capital expenditure and the turnaround in the housing market. Apart from the announcement of the third round of asset purchases to support economic growth on unlimited scale and time and the extension of the low interest rate environment, “Operation Twist” is still in progress and is believed to be adding mild stimulus.
Despite this, the Fed lowered its growth forecasts slightly for this year but increased projections for next year.
With the US presidential election now entering the final stretch, there will be increased focus on fiscal policy, the expiry of the extensive tax relief measures at the end of this year and the looming debt ceiling debate. Although a compromise is expected to be reached, uncertainty is likely to keep business investment and hiring sluggish in the coming months.
China’s economy continues to generate disappointing economic news as monetary policy has not been sufficient to provide further stimulus to economic activity.
Authorities are faced with a policy dilemma that a fresh cut in the reserve requirement ratio to help economic growth will re-ignite the real estate bubble.
However, lower inflation is creating more room for policy easing and hence further economic stimulus measures are likely, such as cuts in reserve requirements and interest rates in addition to more infrastructure spending. Domestic demand remains resilient, supported by a combination of past interest rate cuts, relatively-sound credit growth and moderate fiscal stimulus.
Away from China, despite resilient domestic demand, the general trend across the emerging world has also been one of a weaker growth due to the consequence of deteriorating inter-national trade. Countries most affected by this growth deterioration are the most open and trade-dependent economies such as Singapore and Malaysia, while the impact on other industrialised exporters, like Taiwan and Korea, is likely to be less severe. However, across the region governments have significant scope to use fiscal and monetary policies in response to a sharp growth downturn and are ready to mount their contingency planning quickly in the event of a downside external shock.
China remains centre-stage for Latin America as its growth will help determine the outlook for commodity prices. While LatAm has also slowed in the light of a weakening global environment, firm domestic demand has helped growth hold up better in several economies than might have been expected.
Fixed income and credit markets
In the eurozone, the announced peripheral government bond-buying by the ECB has fuelled risk appetite, causing the yields of safe havens to rise. Going forward, the crisis premium in the German Bunds is expected to be priced out gradually. However the uncertainty about the design and effectiveness of any potential support programmes for Italy and Spain and the ECB’s low interest rate policy (with a poss-ible further rate cut during the fourth quarter of this year) is expected to keep short-term yields low. On the other hand, policy decisions are expected to improve growth expectations, causing the yield curve to gradually steepen.
In the periphery, the yields of Italian and Spanish bonds, with a maturity of up to three years, may continue to decline. However the environment remains challenging for government bonds with longer maturities, causing long-term yields to continue to rise.
In the US, improving data and policy support have reduced downside risks to growth, causing long-term yields to rise and hence the yield curve to steepen marginally.
The Fed’s recent new interest rate guidance and the fact that it will not buy US Treasuries in its new round of quantitative easing should keep US Treasury yields contained in the near term. During the coming year, however, the Fed’s aggressive monetary policy and the better growth in the US should cause the yields of US Treasuries to rise somewhat more rapidly again.
Meanwhile, credit markets have continued to be driven tighter since the beginning of the year, supported by high levels of cash on the sidelines and supportive fund flows. Following the recent policy measures, credit spreads may continue to tighten for the near term, but the upcoming US election and fiscal cliff negotiations remain risk factors for credit markets.
In the US, record low yields and spreads getting closer to fair value make the valuation argument more challenging for US credit. On the other hand, companies with improving balance sheets in the eurozone provide pockets of opportunity. In this scenario of low returns, investors could be tempted to extend duration risk as an alternative way of generating returns. However it might be better to take conservative positions avoiding the long-end as the risk-reward balance is not compelling. In the investment grade arena, despite their low return, defensive bonds provide a cushion against market volatility.
Meanwhile, in the high-yield sector, yields are compelling but, given the lower default rate and better macroeconomic environment, selective US high yield is preferred over European.
Risk assets have been quite resilient in recent months considering no major improvement in the macro backdrop, continued earnings downgrades and scepticism over the effectiveness of the Central Bank’s interventions. Despite this rally, valu-ations are still below their historical levels and global multi-asset funds are still not excessively exposed to risky assets. The macro backdrop of further policy stimulus, low/zero policy interest rates, declining risks of a eurozone break-up, improved investor sentiment and better macro stabilisation data will provide a more favourable medium-term risk environment. However, key events and the earnings picture remain risks to risky assets.
Eurozone equities have continued to outperform US equities over the last month, despite the continued fundamental outperformance of the US, reflecting to a large extent the normalisation of financial conditions on the back of ECB policy. Going forward, European equities are expected to continue to benefit from the implementation of the OMT programme, more Central Bank action, any development of the eurozone towards a union of debt mutualisation and still-cheap valuations.
However, deteriorating leading indicators and the debt crisis in the peripheral countries continue to pose risks to the outlook.
Despite this outperformance, US equities continue to look more expensive than those in the eurozone as they have already responded aggressively to the monetary policy accommodation and data improvement. However, although slowing global growth dampened consensus estimates, expectations remain optimistic and further liquidity by the Fed, robust consumer spending and low interest environment are expected to continue to support US equities.
Meanwhile, emerging markets continued to underperform developed markets due to weak economic data and reluctant policy-makers in China, which caused analysts to downgrade earnings, for the 15th month in August. This has left emerging market equities to trade at a heavy discount to their historical average. In the short term, disappointing economic data and uncertainties due to the leadership change in China may continue to cause emerging market equities to underperform.
However, the expectations of higher growth prospects than in the developed world, diminishing uncertainty in the eurozone, Central Bank easing and stimulus programmes bode well for emerging markets in the long term.
Commodities were among the best gainers of risky assets following the announcements of further quantitative easing. However, the macro economy is much less supportive and each successive wave of QE by the Fed is having less impact.
Gold has recently reached a six-month high, above $1,770 per troy ounce. The main reasons for gold breaking out of its months-long sideways trend were the prospect of further easing by Central Banks, lowering the opportunity cost of holding the metal and fuelling inflation fears, dollar weakness and heavy buying interest from investors. Going forward, in addition to these supportive factors, gold is also expected to continue to benefit from ongoing high buying interest from Central Banks, negative real interest rates, revival of very disappointing demand from India and uncertainty emanating from political tensions, providing an overall positive market sentiment for the metal despite the possibility of near-term profit taking.
Meanwhile, severe mine supply disruptions in South Africa have lifted the price of platinum. Nevertheless, the market is still expected to remain in a heavy surplus this year and the next, but may remain supported by supply disruptions.
Also in the precious metals arena, palladium continued to under-perform the rest of the complex as the metal has been negatively affected by the recent economic slowdown since it is the most geared to industrial production growth. As the market is in deficit, palladium should benefit from any further mine disruption in South Africa and higher risk appetite, but a more positive economic growth outlook is needed for the metal to start outperforming the rest of the complex. Despite a still weak economic backdrop, especially in China, Central Bank actions managed to lift base metals, with aluminium and copper breaking decisively higher and some markets making double-digit gains.
In the very short term, base metals are likely to be volatile, driven largely by fluctuating sentiment as prices are currently running ahead of fundamentals since economic data from the respective region remains soft. The upside for base metals is limited until evidence of improvement in key regional economic data, alongside clearer signs of tightening in underlying market fundamentals appears particularly sustained reductions in Chinese stock overhangs. Copper and tin are still expected to remain in deficit this year, but are likely to diverge in 2013 as growth in copper output accelerates. By contrast, nickel has now joined aluminium in structural surplus, although distressed prices and other producer problems will limit actual physical surpluses next year.
Falling North Sea oil supply, fears of the nuclear dispute escalating between Israel and Iran, and hopes of further monetary policy measures have pushed up the price of Brent oil. However, the market remains fairly balanced. The Organisation of the Petroleum Exporting Countries, the oil cartel, is still supplying the market with more oil than the International Energy Agency estimates, offsetting any supply disruptions. Any rising geopolitical tensions could lend a positive bias to prices, but any substantial breakout on the upside is likely to be treated with caution given the US is still considering a Strategic Petroleum Reserve release.
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