The global economy has been losing momentum for some time. The initial soft patch in growth and extended soft patches have now been replaced by outright fears of recession. A streak of weak economic data in the developed economies and rising inflation in emerging markets, together with a series of credit downgrades and the natural catastrophes that struck Japan and Australia sent shockwaves to investors.
In the meantime politics has so far failed to calm sentiment in the peripheral bond markets
Moreover, consumer and business sentiment were hit hard due to concerns that the European sovereign debt crisis in the periphery is spreading to the core countries of the euro area region and also to the other side of the Atlantic. In addition, the absence of concrete political reaction to the current deterioration in eurozone market conditions is increasing worries for investors.
In fact the International Monetary Fund has lately revised downwards global economic growth for this year and the next to four per cent, from June’s projection of 4.3 per cent and 4.5 per cent respectively. The agency also warned of severe repercussions if Europe fails to contain its debt crisis or if policy makers in the United States reach an impasse over a fiscal plan. Furthermore, the US Federal Reserve added to the gloom by warning of “significant downside risks to the economic outlook”.
Macroeconomic Outlook
Over the last four weeks economists have significantly cut their expectations for growth in 2012. The weakness is widespread. Growth forecasts in Italy and Spain have been halved over the last month, for Germany, the US and the United Kingdom these are down sharply and the outlook for emerging markets has also softened. The need to deleverage coupled with the ongoing global debt crisis, weak labour markets, poor sentiment, recent market turbulences and the lack of fiscal and monetary ammunition, are limiting growth in the developed region. This has caused governments to take temporary actions.
However, policymakers need to have a credible and clear framework for sustainable growth to materialise. Until policymakers come up with convincing responses, especially in Europe, the risk is that growth expectations will continue to decline. Although risks are still tilted to the downside, lower oil prices, declines in bond yields, easing supply chain disruptions from Japan, a halt in rate tightening across emerging markets and increased pressure for further easing in the West will provide some support to a fragile world economy.
On the other side of the Atlantic, emerging Asia, despite a slowdown in growth due to the impact of policy tightening and slower exports, is still expected to lead global growth due to better diversification, lower government debt, solid domestic demand, an infrastructure boom across a number of countries and greater inter-regional trade. Meanwhile, the commodity-producing region, Latin America, which regained strong momentum after the recession, is caught in a crossroad between strong Asian demand and risks of a global slowdown.
Investment Outlook
The flow of news about the sovereign debt crisis in the eurozone and the possibility of a Greek debt restructuring with contagion risks to other economic countries will likely continue to haunt the markets, at least in the near term. Furthermore many leading indicators have not shown signs of bottoming and several analysts are downgrading their forecasts for company earnings, increasing possibilities of a recession in the eurozone. Despite seeming to be expensive, the elevated risk of recession and hence the search for safe havens will continue to support government bonds and the price of gold. Notwithstanding the already high pessimism in the market, further market volatility is expected and any sustainable renewed appreciation of risky assets in the developed countries is likely to be curbed for now.
In spite of the economic interdependence and a correlation between markets, some economic decoupling exists with emerging markets, given the credibility of their monetary and fiscal policies, which make it easier to put stimulus plans in place, if needed. In this respect, the likelihood that a solution will be found, increased possibility of further policy stimulus and very cheap valuations may provide some pocket of opportunities in some asset classes as evidence in equity risk premia as compared to bonds and credit. This suggests that investors should still retain some selective exposure to risky assets such as high dividend stocks with strong fundamentals and absolute return funds.
Credit Markets
Central banks are fighting against the crises as the Federal Reserve has promised low interest rates until the middle of 2013 and the European Central Bank has stepped up its purchases of government bonds. In addition, the ongoing sovereign debt crisis, the mounting macro worries and the increased uncertainty about the economic and political outlook suggest that US Treasury and Bund yields will remain low and could also mark new lows should pressure on equity markets intensify further or economic activity remain disappointing.
As the flight to quality subsides and fears of a recession prove to be overdone, yields are then expected to start rise again, however this is likely to depend in part on the extent to which the eurozone sovereign debt crisis can be contained. The crisis has also caused the yield curve in Europe to steepen as the markets have started to price in a degree of rate cut. Should the ECB start to cut rates, the yield curve should flatten also from the long end. Meanwhile, the loss of the US AAA rating by Standard and Poor has hardly affected the Treasury market due to its safe haven status.
The US Fed’s decision to exchange short-dated securities on its balance sheet into longer-dated bonds has shifted the floor again. As prospects for growth in the US become cloudier against the backdrop of a tighter fiscal policy and the Fed’s promised low interest rates until mid-2013, yields in the US should also remain low in the foreseeable future.
In the meantime politics has so far failed to calm sentiment in the peripheral bond markets. The market remains concerned especially about Greece. The market’s scepticism on the prospects of the planned debt swap for private bond creditors reflect the high uncertainty on the payout of the outstanding tranche under the bailout package. The uncertainty has also spread to the large peripheral countries of Italy and Spain as risk premiums climbed to new highs. Despite this, the ECB’s expanded bond purchase programme has managed to stabilise such yields, in addition to further austerity measures by the countries.
However, although the payment of the next tranche under the rescue package for Greece and implementation of the debt swap would remove a great deal of uncertainty and support risk appetite in the short term, the sovereign debt crisis is not resolved yet and will continue to preoccupy the bond markets in the coming months as it looks increasingly necessary that bolder steps needs to be taken.
In fact the discussion about the issue of eurozone common bonds is becoming more and more significant. Worries that the rescue package might be too small to effectively fulfil all new tasks, and fears that a further increase in support funds could overtax even the financially strong euro-zone countries is expected to push spreads wider in the near term, especially for financials and high yield. Furthermore, liquidity concerns and a lack of market access to meet issuers’ funding needs are likely to sustain the underperformance of high-yield credit. In this respect, more defensive industrial sectors in high grade will remain preferred. However, in the longer term, any positive developments in the eurozone, the likely continuation of a favourable slow growth environment and hence better liquidity condition will eventually overwhelm fears of various risks and drive spreads tighter.
Equities
The combination of government debt woes and the deteriorating global growth outlook have spilled over to equity markets, mainly through the financial sector. Fears that Greece could default and the risks it would entail for the European banking sector are expected to continue to weigh on equity markets for the foreseeable future. Although short-term technical rebounds are possible, the markets are expected to continue to be highly volatile in the coming months due to higher risk aversion. Valuations have obviously become more attractive, both in absolute and relative terms, however profit estimates are expected to continue to be revised downwards.
India, Indonesia, Brazil and to a lesser extent China, remain domestically driven economies
In Europe, lower exports due to an expensive currency, high unemployment rate and slower growth momentum due to the eurozone sovereign concerns and related funding stress should continue to weigh on apparent very attractive valuations in european equities. Meanwhile, in the US and UK, despite the growing risks to economic growth, attractive valuations, healthy corporate sectors, extremely supportive monetary conditions and the possibility of more stimuli from the respective central banks are supportive for both countries’ markets.
In emerging markets cyclical indicators have also been trending down in reaction to monetary tightening, rising inflation, diminishing fiscal stimulus, and weaker external demand. Although valuations may become cheaper, EM equities are preferred due to an elevated growth outlook and resilience, a halt in monetary tightening, easing inflation pressures and going forward, excess liquidity emanating from the G3 can also be supportive factors.
However, recent months have highlighted the need to differentiate between economies driven by domestic demand, which look more resilient and the more open economies whose growth rates are more volatile. India, Indonesia, Brazil and to a lesser extent China, remain domestically driven economies. In contrast, Hong Kong and Singapore remain the two most open economies in the region, while Malaysia, Taiwan, Thailand and to a lesser extent South Korea also have significant direct export exposure to the growing risks in Europe and the US.
Forex
Mounting risks of an escalation in the eurozone debt crisis, and the ECB President’s warning that growth risks were to the downside and risks to inflation were downgraded to balanced, has pushed the euro under pressure. Going forward, as markets begin to price in a higher probability of an ECB easing cycle, the common currency could come under more pressure. On the other hand, the greenback seems to have de-coupled from risk aversion this year, with its safe-haven status damaged by the lack of a credible fiscal policy. Although an increasing probability of a new round of quantitative easing will weigh on the American dollar, fundamentals still favour a stronger currency.
A mix of poor domestic economic performance and increasing risks in key export markets should serve to undermine confidence in the pound. The pound has benefitted over the last few months from quasi safe haven status as investors bought UK gilts as an alternative to European sovereign debt. However this process seems to have run out of steam and the downgrade to economic growth prospects in key export markets (US and EU) could prove to be a burden upon any hopes of an export led recovery. Furthermore, increased possibility of further asset purchases will put further pressure on sterling.
Commodities
Commodities had been surprisingly robust in the current market environment until mid September. Volatility in commodities is expected to increase due to heightened uncertainty about the macro environment. If further quantitative easing in the US is introduced it will push commodities back onto an upward trend on the back of higher demand expectations. However, this is likely to be temporary if the market does not see the added demand as sustainable.
The long-term view on gold is still positive, as the metal is expected to benefit from safe haven demand, low interest rates, further central bank purchases especially from Asia and a possible increase in liquidity in the developed countries. However, given the increased volatility due to lack of clear improvement in the situation in US and Europe and the recent sharp rally, gold prices looked vulnerable to a significant pullback that might take it back towards its longer term upward trend.
Silver should also be supported by a higher gold price. Palladium and platinum tend to suffer most from the economic slowdown although platinum less so given its positive correlation with gold and worries about South African supply, while in palladium the likely end of Russian stockpile releases, although largely priced in is expected to support prices.
Base metals had been remarkably resilient given the recent financial market turbulence and economic worries since prices have been shielded by strong demand growth in emerging nations, which now account for two thirds of of global demand for some metals. Although the outlook for such metals is not as bright, demand in emerging nations, supply constraints and most monetary conditions will support base metals prices into next year. Copper’s pull back was expected given that it was trading at a much higher price than other metals above costs of production but is expected to peak again by the mid-2012 due to likely faster production growth. Other metals will broadly track copper and should the wider environment deteriorate more than expected, aluminium is expected to be the best defensive play.
The oil price has been largely immune to the turbulence on the financial markets for some time. Spare production capacities in the OPEC countries have fallen sharply in the past few months and industrial inventories in the OECD countries are currently below their five year average, while demand in emerging markets remains robust.
Meanwhile, although a partial return to output from Libya is expected, security conditions, infrastructure damage and title on the oil may still represent stumbling blocks. Furthermore geopolitical uncertainty in the Middle East has not subsided. However, a possible increase in both OPEC and non-OPEC production is expected to limit upward price pressure in the first half of next year.
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