World
Markets riding a wave of liquidity
Global equity markets have made a positive start to the New Year driven by improving investor sentiment, a steady flow of encouraging economic data from the US and a wave of liquidity in the form of the ECB's LTRO manoeuvre. The volatility that plagued equity markets in 2011 looks to have eased somewhat and markets appear to have already absorbed a lot of the negative news flow.
The US economy showed stronger growth in Q4 and there is a hope among investors and policy makers in the Western world that the economy can act as a locomotive for global growth as many developed nations contemplate climbing the long, uphill road to recovery. The IMF has lowered its global growth forecast for 2012 to 3.3%, from 4% in September, with Europe to enter a 'mild recession' shrinking by 0.5%. Indeed, the IMF has identified a potential global financing need of $1trn in the next few years, with managing director, Christine Lagarde, calling for nations the world over to play their part by increasing contributions to $500bn in new lending resources. Larger developing economies such as China, Russia and Brazil have all intimated they may make modest contributions, an ironic twist on the globalisation status quo (emerging markets bailing out developed markets?).
We continue to believe the best equity strategy is one that focuses on companies offering attractive dividends, robust business models and global franchises (the New Nifty Fifty).
US
Economy gaining traction
Encouraging economic data from the US continues to provide a welcome distraction from the uncertainty in Europe. However, there are still some doubts about the sustainability of stronger growth, even if housing, employment and industrial output data surprised on the upside over the past month and the US looks likely to grow more strongly than Europe in 2012. US manufacturing appears to be rebounding and showed its biggest gain in 12 months in December. Since early 2010 the US manufacturing sector had added more jobs than the rest of the G7 nations put together. Solid productivity growth and slow wage rises have increased competitiveness. Unit labour costs have fallen 11% compared with increases in Japan, Germany and China. Housing remains the Achilles' heel of the US recovery, along with the reluctance of corporates to hire more aggressively. GDP growth accelerated 2.8% in the fourth quarter, up from 1.8% in Q3.
Although a large jump in business inventories (+$56.0bn in the three months to December) can take a lot of the credit for the robust Q4 GDP figure, there was some (modest) evidence of slightly faster employment growth. However, unemployment, at 8.3%, remains high compared with past cycles, some three years into a recovery. Corporates are at least much better prepared for any further shocks from the financial sector, than in 2008/09.
UK
Outlook remains difficult
UK inflation slowed in December for the third month in a row to 4.2% YoY, and looks in line with the Bank of England's forecasts to drop back down towards its target rate of 2% by the end of the year. The falling inflation data clearly provides scope for the MPC to commit to further quantitative easing after February's Inflation Report.
Economic data continues to show the UK's recovery is more 'L' shaped than 'V' shaped as we have seen in the US. GDP growth contracted in the fourth quarter by 0.2%, meaning the UK economy grew by a mere 0.8% in 2011. Although a small number of temporary factors, including public sector strikes in November, were a drag on growth, these were likely to have contributed little to the overall contraction.
The +0.4% increase in Government spending was more than offset by the 1.2% contraction in overall industrial production. Unemployment has risen to a 17-year high of 2.6 million. More concerning is that the rise in private sector employment is no longer counterbalancing increased unemployment in the public sector. The outlook for the UK economy remains difficult.
Europe
Greece on the brink
Investors appear to have shrugged off the credit rating downgrades of nine eurozone nations in January, including reducing France and Austria's coveted AAA status. We have seen a number of successful bond auctions in some of Europe's peripheral nations such as Italy and Spain, which have helped lower yields to more sustainable levels. Clearly some of the money raised through the ECB's offer of unlimited three-year loans (quantitative easing by any other name) has found its way into sovereign debt, with banks hoping to profit from the higher yields on Italian and Spanish bonds. However, the market is increasingly pricing in a Portuguese default with 10-year bond yields rapidly rising above 16% from below 12% in mid-January. With borrowing costs at unsustainable levels and an economy forecast to contract in 2012, Portugal is facing a huge debt restructuring process or a certain default.
In Greece, it appears the political bickering and brinkmanship that was a feature of 2011 looks set to continue as negotiations between officials and private holders of Greek debt broke down over the size of losses needed to be taken. Private bondholders, mainly hedge funds who purchased Greek debt late on in the crisis, had originally agreed a 50% 'haircut' with Greek officials. However, the IMF calculates this figure must now be increased to nearer 70% if Greece is to reduce its debt to GDP ratio to 120% by 2020. The IMF has also proposed that the ECB should itself participate in losses or debt swaps if Greece is to stand any chance of reducing its debt, a proposal that has been staunchly rejected by the ECB, not least because the ECB is now the largest holder of Greek Government bonds. Talks are likely to go down to the eleventh hour as we edge closer to the 20 March deadline when Greece is due to redeem €14.5bn of debt.
Asia
China continues to slow
We have seen further evidence of how the global economic slowdown is reshaping China's economy. GDP growth came in at 8.9% for the fourth quarter, and 9.2% overall for 2011 (compared to +9.4% in 2010). By OECD standards, growth of 9%+ is still impressive but it is only when we look deeper at the underlying components of growth that the reasons for China's slowdown become clearer. The overall trade surplus has fallen to $155bn in the past year – its lowest level since 2005. As demand from the developed world slows, exports have continued to fall. The emphasis is now on China's consumers and business investment to take up the slack. Inflation is clearly falling. CPI fell to 4.1% in December for the fifth consecutive month, this continues to provide scope for monetary easing and will support consumer spending.
This could prove to be an interesting year for Chinese equities. Not only do valuations look attractive on an historic basis, but recent commitment by the China Securities Regulatory Commission to greater financial market liberalisation, is likely to make Chinese markets more accessible and transparent, while reducing the corruption that has long been a hurdle for private companies seeking a stock market listing. Moreover, with Chinese household bank deposits (which are roughly the same size as the combined GDP of Brazil, India and Russia) earning a negative real return sat on the sidelines, we could see money move into Chinese markets, especially if the economy continues to enjoy a 'soft landing'.
Japan – outlook not so rosy
Slowing export demand and a strong Yen continue to exert pressure on the Japanese economy and corporate margins. The trade deficit widened to ¥567bn for the third consecutive month in December leaving Japan with its first calendar year trade deficit since 1980. Much of this deterioration can be attributed to increasing imports of expensive fossil fuels, as Japan has struggled to get its nuclear power back to full capacity following last year's earthquake and tsunami. The BOJ recently downgraded its growth forecasts for the fiscal year sharply and now expects GDP to contract by 0.4% in the year ending March and growth to come in around 2.0% next fiscal year.
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