Investment Outlook
Investment Outlook - July 2011
Global growth has been decelerating in recent weeks, whilst we have also witnessed a torrent of poor macro-economic news. More positively, European sovereign debt concerns are expected to be contained, but have provided a most disquieting backdrop. Despite these factors, global equities have been resilient and most high yield bonds have performed well in fixed interest markets. Markets have traded within relatively narrow ranges, with prevailing forces alternatively propping up and challenging asset prices.
The doubt about the Greek rescue package and the question of whether there will be a selective default or a credit event in the near term has been distressing markets. Uncertainty, principally caused by slow decision making by the Europeans, has led to increased market concern about the financial stability of other euro countries, as evidenced by widening in government bond spreads in larger economies, such as Italy and Spain.
Taking Italy by way of example, spreads have widened by an unprecedented amount since the start of the sovereign debt crisis. There are also obvious headwinds from macro-indicators in Italy, such as the poor manufacturing (PMI) statistics in June and a larger-than-expected fall in industrial production in May. With major structural problems, we expect particularly weak GDP growth in 2011 and 2012 in Italy. Across Europe, it will be critical to watch whether sovereign stress leads to further banking stress. Any material increase in bank funding costs would be particularly serious at this point in time.
Despite the worries in the Eurozone, interest rates are still very supportive for stock markets. Nominal GDP growth in the US and in Germany, two of the world’s key economies, is greater than bond yields. Interest rate policies in the UK, US and Europe remain very supportive to markets with low rates tending to drive investors towards riskier assets in search of higher returns. Whilst we have seen some short-term weakness in the rate of growth in the US, this is expected to be short-lived, with GDP growth projected to accelerate in the second half of the year. US politics meanwhile is dominated by the need to raise the federal debt limit before August in order to avoid default, while Republicans are calling for it to be cut.
Quantitative easing has provided a key boost for asset prices, which was the clearly stated objective at the birth of the ‘QE’ policies. As we reach the closing stages of the current policy phase, markets will be challenged as to whether self-sufficient economic growth has been established. If not, then we must assume that fresh policies will be required. This is not a policy that is coming to an instantaneous stop; for example, the Federal Reserve will still be reinvesting the principal of maturing bonds and interest back into the market, thus ensuring a degree of support remains in place. Nevertheless, this dynamic lays bare the vulnerability in developed economies that lingering structural imbalances might cause deflation, which they are eager to avoid.
One must set against this the fact that headline and core inflation concerns persist in many markets. Signs of weaker economic growth and a fall in commodity prices have mitigated inflation fears, as demonstrated by positive bond market pricing in markets. Nonetheless, headline inflation rates remain stubbornly high in some western markets, including the UK. While rates in emerging markets have been worryingly elevated in recent months, they may have reached or passed their peak. The most recent improvement has come on the back of declining food price pressure in emerging economies, which should help emerging market equities over the next few months.
In the UK, inflation is currently outpacing average earnings growth by about 2.5%. This gap may widen further if inflation rises, driven by the deterioration in the UK’s terms of trade. Domestic consumers are being squeezed under this pressure, with real household spending having fallen by 0.6% in the first quarter of the year and having also fallen in the last quarter of last year, which means that consumer spending is returning to recession. The increases in UK food prices (rising at an annual rate of about 5.5%), coupled with a rise of some 20% in gas prices and 10% in electricity prices, is likely to absorb a high proportion of any increase in take-home pay this year, with real pay already at its lowest since 2005. This is clearly a testing environment for the domestic consumer.
Public sector cuts, which are already causing some strike action, are being largely offset by the private sector of the economy, but there is a danger that this will begin to fade. The overall result looks likely to be a further significant drop in real incomes, coupled with limited scope for households to borrow more which, in turn, is particularly worrying for the domestic consumer related sectors of the market.
We feel that there is strong need to focus on assets that have the quality and value to endure these difficult times. Fears of a collapse in global profits seem misplaced given solid revenue growth and continued cost control and we would expect double-digit global earnings per share increases for 2011 and again in 2012. The level of investor pessimism seems to provide many attractive pricing opportunities, however, in searching for good quality conservatively valued assets, it is important to be in a position to tolerate downside risks to capital in the belief that these should prove temporary. In tricky times, the prices of good and bad investments tend to fall together, but circumstances can change quickly. It is important not to lose sight of positive factors that can be overshadowed when markets are blinded by uncertainty.
Our belief in the ongoing global earnings recovery, and the generally positive long-term prospects for the world economy, points to a cautious but upbeat strategy. The dynamic growth of economies in the developing world will inevitably cause volatility, whilst accentuating many of the imbalances that exist in markets. Defensive sectors seem relatively expensive, with weaker earnings momentum and we maintain a thematic cyclical tilt to our sector strategy.
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