Thursday, August 4, 2011

A time for cool heads

It has been a difficult few days in equity markets. We had anticipated a weak patch for economic growth and equity markets, particularly in the US. That is why we moved to de-risk the portfolios over recent months. However, recent weaker-than-expected activity data and the political machinations of raising the US debt ceiling have taken a larger-than-expected toll.

It’s important at times like this to keep your head and stay true to investment philosophy and process. Here’s how we are thinking about things right here right now.

The major disappointment for us in the recent data has been the downward revisions to previous US GDP growth estimates. Those revisions have shaved around 1 percentage point off annual GDP growth. We are unlikely to gain that 1 percent back: I can’t raise my growth forecasts for the rest of the year. That means we have to take the lower growth on the chin and cut our year-end US GDP forecast from 2.5% to 1.5%. At this point I have left 2012 at 2.5%.

The good news is the weaker growth explains one conundrum of recent US data – weak jobs growth. July payrolls data is out this weekend. The consensus view is for jobs growth of 75,000 (according to Bloomberg), but after the recent trot of news, you’d have to think the risk is to the downside.

As we have discussed before, we concur with the view that there are transitory elements to the recent weakness in US activity data. But there is more to it than just the supply chain disruptions following the Japan earthquake, weather disruptions and high commodity prices: broad-based softness in jobs growth is the clearest indicator of that. Perhaps a better way to describe the current situation is that the US is going through another soft patch, much like it did last year, but this time it has been exacerbated by a number of transitory factors.

What is also different to last year is the synchronicity element: we are seeing weaker growth in Europe at the same time. Even in Germany, the powerhouse of Europe and the primary reason for the ECB’s tightening strategy, industrial production is slowing. That may still have something to do with the tail-end of the inventory cycle but it’s more likely that German corporates are reassessing the Europe/global growth environment. Expect the ECB to abandon its tightening strategy and perhaps to embark on some quantitative easing of its own.

While the risk of a sustained slowdown and even a return to recession in the US and Europe has increased, that is not (yet) our central scenario. But it does raise the chances of QE3. The debt ceiling debate in the US has confirmed to the market that fiscal policy no longer a tool to support aggregate demand. We have, to date, been somewhat lukewarm on the prospects of a further round of quantitative easing, but if the Fed were to take the view that recent economic weakness is becoming entrenched, we have no doubt they will implement a further QE program. The good news is that non-financial corporate America is in good heart. Strong business investment is a necessary precursor to stronger future growth.

Counterbalancing the weak trans-Atlantic story, Japan is recovering well and we are increasingly confident of a well-engineered soft landing in China. That assumes that China authorities make better use of the exchange rate in the fight against inflation. We continue to believe inflation is close to peaking in China. Furthermore, there is still robust economic growth across the other key emerging economies. Emerging markets will continue to be the key source of global demand in the years ahead. That argument becomes somewhat redundant in the short-term if the US and Europe fall back into recession.

It is not just growth that is worrying markets at the moment. There is still a major systemic risk overhang from the debt crisis in Europe. Greece, Portugal and Ireland cannot access debt markets. Spain, Italy and Belgium can, but with rising risk premiums. The July 21 agreement bought more time for Greece and finally started to deal with the issue of solvency, although not to the extent that markets have parked concerns about disorderly default.

Italy should prove to be more resilient than the smaller countries. It has a well managed budget, they have a high debt maturity (7.1 years) and the banks are solid. But a 10-year bond yield above 6% is not sustainable. Italy’s weakness is its poor growth performance. We also think Spain’s fundamentals are sound. Its main weakness is a negative net investment position (-87% of GDP).

The July agreement gave a broader role to the European Financial Stability Facility (EFSF) by allowing direct intervention in government bond markets and the ability to lend to governments needing to recapitalise their banking systems. But the limited size of the EFSF cannot prevent the spread of contagion to Italy. Should crisis hit Italy, we are back to watching the politicians demonstrate their commitment to the Euro-area.

In summary, recent market activity has predominantly been a re-rating of near-term US GDP growth, exacerbated by a concurrent slowdown in Europe. The debt ceiling debate-debacle hasn’t helped but America is not the key debt risk (yet). That still remains predominantly a Europe story. On the positive side Japan is recovering and there continues to be strong growth in the key emerging economies.

The most important point of all, however, is that equity markets are cheap. But as we know, what is cheap can become cheaper. We continue to be focussed on the medium-term and remain happy with our current portfolio positions which is neutral on a growth/income split. Obviously we are thinking hard about the future, as we have the whole way through, and will alert you to any changes in thinking or positions.