Asset Allocation 3rd Quarter 2011
World equity markets have suffered a correction in the region of 20% since hitting cyclical highs in April.
There is also genuine concern about the sustainability of the US recovery, the ability of policymakers’
Meanwhile the global risk appetite index which is a broad measure of investor confidence hit an all time low in August which exceeded previous “deep panics” in August 1982, October 2002 (the dotcom and 9/11) as well as November 2008 (credit crisis) which implies markets are “heavily oversold.”
The sell-off is purely a reflection that the markets face stronger headwinds in the aftermath of the credit crisis than previously anticipated due to global debt levels, debt deleveraging and global economic rebalancing;
US stock market turmoil can be attributed to debt default concerns which never materialized, losing its AAA rating following a credit downgrade by S&P and increased pessimism over economic growth prospects after Q2 GDP growth came in slightly below expectations at 1.3% versus 0.4% for the previous quarter. This is simply a wake-up call that the US needs to implement a credible deficit reduction plan to restore market confidence in the country’s creditworthiness. Interestingly, softer economic data releases coincides with the withdrawal of the FED’s second round of quantitative easing at the end of June. Whilst many commentators are predicting doom and gloom claiming the authorities have exhausted all the available tools to tackle the crisis the reality is somewhat different. The Federal Reserve has already come out fighting saying it now expects to keep its zero interest policy well into 2013 and a third round of quantitative easing is also on the cards. Assuming these initiatives are successful in bringing a degree of calm to the markets and restoring consumer confidence, despite our expectations for below trend growth, there is no reason why stock markets should not recover from current levels in Q4. We have a positive outlook on US equities.
We expect the economic recovery in Europe to trail the developed and emerging markets due to the scale of the austerity measures which require governments, businesses and private individuals to reduce their debts to more sustainable long terms levels. The financial markets are applying pressure on debtor states, the so called PIIGS, questioning their resolve to drive austerity measures claiming low economic growth and fiscal slippage will hamper plans. We have already seen markets push bond yields on Spanish and Italian paper over the 6% threshold above which funding becomes unsustainable. The ECB had to purchase Spanish and Italian bonds to bring short term relief. Greece requires another bailout and S&P have downgraded their debt rating to CCC which places them a notch above default. Even France has come under fire with rumours they could be the next country to lose their AAA rating. Such is the scale of the problem that the European Financial Stability Facility needs to be increased significantly in size to accommodate potential bailout requirements. Increasing the borrowing capacity of the EFSF potentially impairs the credit rating of its main backers Germany and France raising their own debt-to-GDP ratios well above 100%. The Germans are already questioning the legality of having to fund bailouts and six prominent euro-sceptics have brought this matter to Germany’s highest court for a ruling. Some have suggested greater fiscal harmonization as a way out of the crisis and have mooted the idea of creating a common Eurobond but how should such a bond be rated given the disparity between German and Greek bonds when it comes to ratings? The pain of austerity will eventually force these debtor states to break away and form their own weaker Euro and with it the possibility to restore growth through currency devaluation. We have a positive outlook on good quality blue chip euro-zone equities over the longer term.
The ability to set interest rates, manage its currency and control fiscal policy allows the UK to manage their economy more efficiently than Europe. But the UK is also saddled with debt. Growth prospects remain weak with Q2 GDP coming in at +0.20% in line with official forecasts but below the 0.50% increase registered for Q1. The Bank of England have cut its growth forecasts for 2011 from 1.80% to 1.50% on concerns that rising oil prices, the tsunami in Japan and debt levels across the EU; risks which if they materialize can have a significant impact on the UK economy. In terms of stock market valuation equities are very attractively priced trading at just 9x forward price earnings whilst the dividend yield on the FTSE at 3.8% compares quite favourably with the ten year gilt which yields just 2.7%.
Japan’s machinery orders rose for a second consecutive month in Q2 as firms increased their corporate spending to restore production disrupted by the March 11 earthquake and tsunami. Production and export data coming out of Japan suggests the private sector has recovered faster than initially expected. But increases in oil prices, a very strong Yen and debt worries coupled with Moody’s downgrade of Japan’s sovereign debt rating threaten to derail any recovery. The Yen needs to depreciate perhaps quite significantly for the economy to enjoy a sustainable recovery and for the stock market to rally. We are not convinced a recovery is around the corner and maintain our negative outlook.
Asia and Global Emerging Markets
The Asian economic powerhouses of China and India continue to apply market-cooling measures which come mainly in the form of interest rate hikes to curb inflationary pressures from taking hold and creating an asset bubble which inevitably would end in a hard landing. Meanwhile the IMF has welcomed the appreciation of the Yuan as a tool to tame inflation and for global economic rebalancing purposes. Despite the faltering economies of the developed nations and internal measures to dampen growth the Asian and GEM’s continue to power ahead? According to a new wealth report by 2012 China and India alone will account for 40% of global growth. Given the long term growth potential of these markets we maintain a positive outlook.
Over the coming months we expect inflationary pressures to ease on the back of weaker global economic activity (particularly in the emerging markets such as China and India) which should drive down food and energy prices.