Developed stocks had a strong first quarter. A setback seems overdue, and there is no shortage of potential triggers, but we continue to think that the primary trend points upwards, and would use such reversals to add to positions. We stay tactically underweight cash and investment grade credit, and advise using rallies in government bonds to reduce strategic weightings there.
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The Global business cycle: clouds continue to lift
The most widely-watched cyclical indicators continue to suggest that global order books and business confidence are stabilising (Figure 1), helping to underpin the outlook for corporate profitability and boosting investor risk appetite. Moreover, the consensus assumption that we are in the midst of a ‘great deleveraging’, and that growth cannot be sustained until massive amounts of debt have been repaid, is beginning to be questioned – as we’ve long thought it should be. Indeed, credit growth is resuming in the US, largely because the aggregate consumer balance sheet is not as fragile as that received wisdom would suggest – a point that should be familiar to our readers (see, for example, “Is there life after debt?” Compass, October 2011).
Figure 1: The business cycle stabilises: selected manufacturing surveys
Considered alongside valuations suggesting that developed equity markets remain inexpensive both historically and relative to other asset classes – even after their rally – this leaves us continuing to argue for a modestly ‘risk-on’ position in balanced portfolios.
Our recommended tactical and strategic asset allocation is presented more fully, as usual, in the table on page 9.
As often, of course, the regional pictures diverge. Europe remains the weakest link economically, and eurozone politicians almost seem determined to snatch defeat from the jaws of victory in their latest handling of the peripheral debt crisis.
Eurozone: the troika tripped
Eurozone politicians and policymakers are demonstrating clearly in 2013 why we’ve long advised that the euro’s existential crisis is not over. In March’s Compass we noted the uncertainty added by the Italian election result; this month, the Cyprus bail-in is the unsettling development.
n making depositors in Cyprus share in the costs of rebuilding the local bank system, the troika of European finance ministers, the ECB and the IMF seem to be playing the role of school bully, picking on the smallest kid in the playground. The troika may have forgotten that the other, not-so-small kids watching in trepidation may decide to do something to protect themselves.
If Spanish bank depositors take fright, much of the good work done in stabilising the euro markets since last summer could be undone.
Ongoing growth in private sector demand is likely to more than offset the impact of sequestered public sector spending, and keep the US economy moving firmly forwards.
We think the policy mistake should not be seen as a harbinger of the official line to be taken should further refinancing suddenly be needed elsewhere soon (further ahead, as
part of the wider reform of banking supervision, the EU’s resolution and recovery direction could leave depositors exposed – but the directive is unlikely to become effective until 2015, and we think it very unlikely that other eurozone bank depositors would be asked lightly to share in the restructurings currently underway). The latest version of the Cyprus bail-in leaves smaller, insured depositors protected – after much understandable protest, the government in Cyprus has felt able to ask wealthier depositors to shoulder the burden. We think contagion will remain manageable.
The (modest) revival in market volatility that the Cyprus bail-in has inspired – like that caused by the Italian election result – is certainly a reminder that the long journey to a credible, lasting resolution of the single currency’s angst will not be a smooth one. But this does not mean that investors need stay on the edge of their seats: the big picture, as we see it, has not altered. Provided the ECB in particular stands ready to act as a financial backstop, such bouts of volatility need not have a lasting impact on portfolios.
Figure 2: Italian and Spanish spreads are up, but well below last summer’s levels
Meanwhile, after a weak winter, our economists now expect full-year eurozone GDP in 2013 to register another small fall. Given the margins for error, the economy is probably best described as flatlining, with a marked resurgence in the German economy (Figure 1 again) being offset by continued weakness elsewhere – notably in France and Italy. This is hardly good news, but investment markets are driven largely by expectations, and those have long been pretty low to begin with. And positive surprises elsewhere – notably, in the US, as outlined below – offer some compensation at the global level.
As we see it, regional equity selection in 2013 is not so much a case of (Continental) Europe or the US – rather, we expect both big regions to perform relatively strongly. The ongoing short-term risk stemming from the disappointing pace of eurozone integration should not obscure the fact that as a relatively volatile market, eurozone stocks can actually outperform the wider developed markets if global risk appetite is improving – particularly if that improvement is driven by signs of healthier world trade, which can benefit the eurozone’s many successful exporters and multinationals. Continental equities, like many others, remain inexpensive, even after their rally.
The stronger trade-weighted euro needn’t get in the way – in the past, it has often coincided with eurozone stocks outperforming, partly because the currency and stocks can be driven by the same underlying driver – in this case, rising risk appetite.
In Continental Europe as elsewhere, we strongly prefer corporate to government securities, and stocks to most bonds. But eurozone bonds – like the bloc’s equity markets – have a good chance of outperforming their developed world benchmarks. The weaker local economy does matter to bond investors. More prosaically, because Italian and Spanish bonds trade as risky assets, their inclusion in the indices means that those indices will perform better in a ‘risk on’ climate than (say) US and UK benchmarks.
UK: chaste, but not yet
The UK government is sticking grimly to its battered ‘plan A’. The latest budget makes no concession to those arguing for a big fiscal stimulus to boost growth. Instead, the main focus remains on deficit reduction, albeit with a further slippage in the schedule: the debt/GDP ratio is now projected to peak in 2016/17, a year later and almost 6% of GDP higher than was forecast in December (and 3 years later, and 15% of GDP higher, than originally suggested in 2010).
This need not condemn the UK to recession, or even stagnation. The headwind from fiscal tightening is fading as the biggest tax increases move further into the past. Moreover, the private sector’s saving ratio has risen pre-emptively, providing a buffer to support spending as incomes are squeezed, and the monetary climate is much friendlier to growth (a more competitive pound is helping further in this respect). We noted last month that both these factors have helped the UK weather a tough fiscal climate in the past. The latest employment and retail sales data suggest that the economy is not quite as fragile as the GDP numbers make it appear.
Figure 3: UK CPI inflation and gilt yields
We still think the UK stock market is likely to lag the US and Continental Europe in a risk-on climate, but sterling’s recent weakness will boost the substantial international earnings of companies quoted on the UK exchange, and it is a closer call than it was. And even after their rally, we still expect UK stocks to outperform local government bonds, or gilts, tactically and strategically, and by more than enough to compensate for risk.
Indeed, we think that gilts will underperform not just local equities, but other high-quality government bonds – not because of credit concerns, but because they are simply very expensive. The UK remains relatively inflation-prone: on a rolling twelve-month basis the CPI has risen faster than the Bank of England’s 2% target continually since late 2005, and we expect this prolonged period of underachievement to become a round decade in 2015. The 10-year gilt is currently yielding 1.9%.
The monetary policy review announced with the budget is unlikely to result in a much looser climate than would otherwise be the case. Nonetheless, it will not reassure a currency market that thinks the UK has ‘gone soft’ on inflation – understandably, given that track record. Sterling is already pretty competitive, but we think the dollar will remain stronger for a while yet (and see the currency essay on page 10 below).
US: customer no. 1 continues to spend
The American consumer – still a key engine of global economic growth – has continued to spend apace: retail sales in February rose solidly, undaunted by higher taxes (and the resulting lower personal income) and petrol prices. The private sector continues to create jobs and those who are employed are earning more money.
Meanwhile, the housing market continues to recover, and consumer balance sheets to begin with are in better shape than many feared (as noted above). To keep things in context, however, the fall in unemployment is not yet as soundly based as it could be.
Another important economic driver is increased capital spending by businesses. Capital investment tends to lead to more durable economic growth. US companies have the cash flow and balance sheets to add more substantially to capital spending, but have so far lacked confidence. Acquisitions represent a barometer of that confidence – the willingness of corporate chieftains and their boards of directors to take risk. And in this respect, the pace of recent US merger and acquisition activity is a good sign. Small and mid-capitalisation companies have been the primary beneficiaries of this acquisitiveness, funded predominantly by the sizeable cash on the acquiring companies’ balance sheets.
Ongoing growth in private sector demand is likely to more than offset the impact of sequestered public sector spending, and keep the US economy moving firmly forwards.
Our economists estimate that growth in the first quarter of 2013 has been tracking in the 2-3% range on an annualised basis, about a percentage point faster than they’d initially thought. This is hardly a boom, but it does much to offset the downside risks to European growth, and ensure that global growth continues to exceed stall speed.
The US equity market is still by far the largest and most influential, and it would be unusual for global markets to rally without it. US stocks have already risen some way, of course: the S&P500 has more than doubled since its low point in March 2009. A question many clients have been asking is whether having come so far this fast, US stocks are now overvalued. An examination in Figure 4 and Figure 5 of several valuation metrics on the S&P 500 now as compared to when it was last at this level in 2007 suggests the answer is no. Whether on a price-to-earnings, enterprise value-to-sales, or free cash flow yield basis, valuations remain attractive.
Indeed, the US remains one of our preferred equity markets. The favourable valuations, and the resilient economic story sketched above, both help. But so too does the general malaise of low expectations, which has been particularly evident for the US because of the fiscal concerns so visibly overshadowing the economy for much of the last year or two – concerns which in our view are overstated. Like the dollar, US stocks can outperform in risk-on climates as well as in more defensively-oriented ones.
US Treasuries continue to look expensive. It is difficult to call the decisive sell-off, not least because the Federal Reserve’s ongoing Quantitative Easing programme continues to offer support to the wider US bond markets. Nonetheless, while we are tactically most wary of investment grade credit – which looks particularly over-priced – a belief that US nominal GDP growth is likely to trend in the 4-5% range in coming years leaves us strategically wary of US government bonds, and is a big reason for us allocating only a small portion of our strategic investment portfolio to government bonds generally.
Figure 4: S&P 500 valuations at similar index levels: today vs. 2007, trailing data throughout
Figure 5: S&P 500 looks cash rich and undervalued relative to history
Japan: long-term conviction missing
The biggest developed economy not mentioned so far is of course Japan, whose stock market has been rallying strongly in local currency terms. We doubt that Japan’s structural malaise has been dispelled by the new monetary regime – and falling yen – that has excited traders, even though business confidence has hit post-crisis highs: we stay neutral, preferring the US and Continental Europe. Japanese corporations are getting a short term boost for their exports, driven largely by that weaker currency. But a sustainable, cyclical upswing remains questionable as policymakers remain in a policy gridlock – one of fiscal pump-priming with limitations arising from structural demographic, labour supply and political issues. For now, most of the good news is already being priced in.
Emerging economies: solid growth, patchy markets
Much global growth is driven by the emerging world, particularly Asia, and for good reasons. Most of the world’s population is in the emerging bloc, but it accounts for only a fraction of its economy (and an even smaller portion of its securities markets). In an increasingly liberalised, integrated world there are fewer and fewer barriers to capital and technology flows, and over time this will help to narrow that inequality in incomes. This doesn’t mean that living standards in the developed world need fall, but it does mean that economies there will grow more slowly relative to the emerging bloc.
This assumption is baked into our long-term strategic asset allocation. However, it does not apply in the short term – particularly when, as now, emerging market growth has been very visible for a while, and expectations in the developed world have become overly pessimistic. Moreover, some individual emerging countries have faced short-term economic disappointments – most visibly in the cases of Brazil and India, and more subtly elsewhere. China is an exception to this economic disappointment – we remain convinced that growth there is stabilising in the 7-8% range – though its government-heavy markets continue to languish (it remains nonetheless one of our favourite emerging investments).
Emerging equity markets have now underperformed developed markets since early 2009, and in local currency terms have lagged by 11% in 2013 to date. We continue tactically to prefer developed markets. Within the emerging bloc, however, Asia remains our preferred region. It has the most diversified markets, and so is not reliant on any single industry or commodity; its macroeconomic policies are the most credible; it has the soundest financial position; and its politics are perhaps the most predictable.
China is, as noted, one of our structurally-preferred emerging economies. From the concluding months of 2012, economic revival seems to have extended into 2013 with good momentum from trade data – exports have surged with high levels of imports. The Purchasing Managers Index (PMI) continues to hover at the 50 level (Figure 6). The latest reading from the HSBC Manufacturing PMI has come in at 51.7 for March 2013, a two-month high. Both surveys confound the bears who continue to herald a hard-landing. In the meantime, the People’s Bank of China (PBOS) continues to keep a vigilant watch on the over-heated real estate market and inflation – the lingering side effect of the massive 2009 fiscal stimuli.
However, the current level of inflation (Figure 7) does not warrant any monetary policy tightening, and if needed, the PBOC is more inclined to execute direct and administrative measures instead. This is in line with the central leadership’s intent on bringing about growth stabilisation and sustainability for China based on structural reforms – likely to be introduced and announced in 2013.
India has, as noted, disappointed of late. Its demographics are favourable and its economic growth potential may be even better than China’s, but it faces a stagflation that has largely been induced by government’s populist policies. Despite the recent resumption of reform, and lowered interest rates, the hands of policymakers remain tied by high inflation and burgeoning fiscal deficits. Barring a radical policy change away from populism, India may not accelerate back to the historical 6.5% growth rate on a sustainable basis. Barclays’ forecast for India’s GDP growth is 5.6% for 2013 and 7% for 2014. Thus, the momentum on reform must continue in earnest to resolve issues, such as infrastructures, at least in the short term.
Asia’s exporting tigers faced a challenging year in 2012, and their woes have yet to recede as Japan looks more competitive and the latest round of export data points to challenging times. However, their diversification will help: these countries are likely to get a lift from an improving US and global economy.
Figure 6: National Bureau of Statistics – Purchasing
Managers Index (2008–2013)
Barclays’ key macroeconomic projections
Figure 8: Real GDP and Consumer Prices (% y-o-y)