Strange as it may feel, we are entering year five after the infamous whirlpool year of 2008 that culminated in the Lehmann collapse in Sept. We examine both the supports and the drags on the global economic recovery, or, in sailing parlance the tailwinds and headwinds. Plotting a middle course position through these conflicting forces, the outlook, thanks to Uncle Sam, is brightening for 2013 and 2014 globally as tailwinds pick up and some of the scariest storms are behind – but it’s all relative to the extraordinary weather from which we are emerging, one characterised by real fears about Euro survival, the US fiscal cliff and a bubble burst in China.
The so-called output gap including the overhang of joblessness, poor credit and low confidence continues to dampen economic growth but the risks of another major shock have diminished, only by embarking on a massive fiscal experiment that is without precedent since the Industrial Revolution. This is Quantitative Easing (Q/E) on a herculean scale. At the end of 2012 the Governments of the US, Europe, the UK and Japan accounted for three quarters of all borrowing whilst central banks account for 60% of all lending. The expansion of the balance sheets of the ECB, FED, BOE and BOJ is without measure anywhere in economic history and, as outlined, in our Oct report it’s pretty much fiscal expansion now or bust.
Interestingly, inflation protection has finally begun to emerge in much research and analysis as we head into 2013 with the first round of US fiscal cliff just behind us and seasonal profit taking affecting most asset classes. So what’s this year and next likely to look like, insofar that it is possible to guess?
First the Headwinds
Europe remains moribund. The big question is how much social pressure can countries like Spain absorb from internal devaluation, without unravelling and exiting the Euro. Spanish youth joblessness is 50% and overall unemployment is 25%, yet still Spain remains 30% less competitive than Germany, Europe’s backstop economy where Debt / GDP is 80%. Spanish loans continue to worsen and its property market falls, meanwhile French growth has stalled widening the gap between it and Germany.
Italy’s Debt to GDP has rarely been higher since Garibaldi unified the country in 1860 and with Monti departing, Europe’s third largest economy faces into difficult austerity programmes. Greece’s economic decline matches that of many ex-Soviet states but even after haircuts it’s Debt / GDP is 170%. Portugal continues to contract but with no clear strategic plan to pull itself out of the mire while Ireland, reliant largely on its export economy is set to peak at Debt / GDP of 122% but has household debt of a similar scale and cannot rely upon a domestic economic recovery until there is restructuring of the national debt and relief on households where it looks like 10% will be bad debts.
The decisions to empower the ECB as a single banking regulator for big banks of systemic importance, the establishment of a central fund to separate banking and sovereign debt coinciding with the appointment and quick actions of Draghi has helped calm nerves but, notwithstanding these developments there is a hard road ahead for countries like Spain and France where productivity gains or wage declines of 30% are required to match German competitiveness.
All told Europe, at best, will experience no overall growth this year and its declining imports will impact non-OECD countries. On the opposite side of the Atlantic the USA, narrowly avoiding the fiscal cliff in a last minute deal between Obama and the Republican dominated Congress, has merely delayed the inevitable tax increases and entitlement adjustments required to reduce the US deficit by $4 trillion over the next decade through higher taxes and lower spending. Japan continues to be swamped by a huge national debt sustained only by the willingness of Japanese workers to sustain it with savings and is unlikely to see economic growth in a year when Iran is expected to have enough enrich uranium to build a nuclear weapon, increasing the risk of an Israeli-US-Iranian conflict.
The Strengthening Tailwinds
Interest rates remain remarkably low which helps Governments carrying high debt and are likely to remain so for some time while mute inflationary forces will allow central banks to continue QE operations.
But thank heaven for Uncle Sam. The biggest, strongest and most balanced economy in the world is recovering and set to remain the global powerhouse for decades to come as its institutions tackle its debt, bolstered by a remarkable transformation in its domestic oil and gas industries reviving the US as the manufacturing giant.
The US housing market is beginning its recovery, consumer spending is showing signs of returning after several years of deleveraging and repairing balance sheets and the world’s largest economy seems to be adding 200,000 jobs per month while its corporations sit on vast reserves of cash filtering out in dividends and acquisitions. Overall the USA is poised to grow 2.5% to 3% this year, good news for exporters to the USA.
Fears of a bubble burst in China are abating as it enters its tenth year of reform under this Chinese Government with growth forecast at a rude 8% and which will help drive the rest of Asia where interest rates have fallen to support the economic lag created by Europe’s rolling crisis.
What Moves to Consider?
Given this background European equities are 30% cheaper in comparison to the USA which, priced at 12 times forecasted earnings is still reasonably priced. As ever in this part of a recovery cycle from a deep recession, an over-indulgence in pessimism leads many growth investors to remain too cautious despite the clear value in equities. The trend has been towards high dividend-paying PLCs, making undervalued and unloved cyclical growth stocks the likely next winner for those taking fresh long only positions in equities.
In Non-OECD markets prices have come down, reducing multiples since before Lehmann’s and reflecting the general manufacturing slowdown. We continue to rely on Asia excluding Japan and allowing fund managers to take a view on China’s allocation rather than second guessing from a distance.
Despite recent profit taking we continue to recommend a presence in portfolios for precious metals, gold and silver as a hedge against declining fiat currencies from too much QE and to counteract inflation.
At best we are in a sustained period of ultra- low interest rates which means lousy returns on cash deposits but good news for highly indebted nations grappling with deficit reductions. In these conditions returns on Fixed Income Securities, (conventional Government debt) will be flat and expectations for returns on equities reduced but still capable of outperforming cash by 4% to 6%.
Today we’d strongly favour European equities which are trading at a deep discount to the US and capable of giving higher returns over the next five years but any portfolio without a heavy allocation to the US would be most unwise given the huge advantages the US has in R&D, Education, Institutions and the world reserve currency. Asia Pacific still remains a favourite but at lower multiples and expectations.
Inflation – the next big cycle?
Keynesians, comfortable with massive expansionary policies at a time of deep recession have confidence in central banks to reverse QE as growth returns without triggering high inflationary forces. So far the theory is working, buts that’s only because of huge output gaps depressing inflation. We expect historically low bond yields to continue but, ultimately, the fixed income bond market will sour as interest rates follow inflation, albeit delayed by central bank nervousness over strangling recoveries. That’s why we continue to emphasise global inflation-linked Government bonds protected with a Euro hedge for defensive investors.
So what to do?
- Growth investors comfortable with long only equities and commodities could now consider moving fully back into unprotected funds, with a strong emphasis on Europe High Yield and USA and Asia ex Japan growth funds. Global Natural Resources, combined investment across precious metal, oil, gas and coal miners is also recommended.
- For those with shorter horizons and lower risk we suggest taking the second step back into carefully selected growth funds and some absolute return funds. These target returns typically 3% to 5% above Euribor using highly diversified range of investments including derivatives and can make money in falling markets.
We are advising those who took defensive steps in 2011 to now begin the second tranche back to growth funds. Last year the first of these was taken by many shifting 1/3rd out of defensive funds. We are now recommending that half the remainder follows suit.
- Highly defensive investors should stick to global inflation linked bonds protected with a Euro hedge as an alternative to cash deposits.
Finally on property we remain unconvinced that the floor has yet been found in the Irish market and favour distressed property in fast recovering economies like the USA. We are currently investing heavily for clients in Metro Detroit at rental yields of 15% and scope for capital uplift as the remarkable Midwest recovery continues with the US manufacturing rebound. There is no leverage required and minimum investment is €1m.
For more information on suggested switches within fund ranges or to better performing asset managers, whether for personal funds, lottery wins, inheritances, charities or retirement schemes, contact Eddie at 045 409364 or email firstname.lastname@example.org
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