Worldwide: Investment Management Outlook - December 2011

Last Updated: 1 December 2011
Article by Smith & Williamson


Waiting for Godot – or a euro crisis resolution

After experiencing a strong rally in October, equities have subsequently registered a sharp decline. The catalyst behind the reemergence of the 'risk off ' trade once again resides with mounting eurozone concerns. Over the last four weeks the announcement of a potential referendum in Greece, the rise in peripheral bond yields to unsustainable levels, the removal of the administrations of Italy, Greece and Spain and the imposition of technocrat led governments with a remit to impose stringent austerity programmes have raised legitimate questions over the viability of the euro. There is a growing sense that unless Germany sanctions aggressive quantitative easing by the ECB – the end game is fast approaching.

Amidst all of this turmoil UK gilts and Index Linked bonds have attained safe haven status registering strong returns in November. This is partly attributable to the commencement of bond purchases by the Bank of England but is also due to declines in both growth and inflation expectations. The recent Autumn Statement has acknowledged that it almost impossible for the structural budget deficit to be eliminated by the end of this parliament. However, as long as the government adheres to the existing spending cuts their credibility will not be dangerously tarnished. The market should forgive a couple of years of slippage. What is manifestly clear is that as 2012 unfolds attention will increasingly focus on arresting the shortfall in demand. This will require coordinated and sustained policy responses from the MPC and the treasury.

As we close out 2011 the outlook remains challenging. The combination of much lower trend growth (the New Normal) combined with the substantial risks attached to the turmoil in the eurozone has increased the chances that growth expectations will continue to ratchet lower. Corporate earnings appear to have peaked and are vulnerable to the impact of negative operating leverage. In addition we need to acknowledge that the significant volatility we have experienced over the last few months has increased the equity risk premium. Undoubtedly a signal that the ECB is embarking on unconstrained QE would trigger a significant 'risk on' rally. Unfortunately, this increasingly resembles hope rather than expectation. The systemic risks posed by the unravelling of the euro justify the maintenance of a cautious stance.


The economy is gaining traction

The US economy has been gaining traction. A rebound in both broad money supply growth and commercial and industrial loans are encouraging as they confirm that the aggressive quantitative easing undertaken by the Federal Reserve has eventually started to get the monetary cogs moving. Q4 2011 GDP growth is expected to improve upon the 2% growth achieved in Q3. However, with unemployment remaining stubbornly high at around 9% and the housing market mired with both negative equity and excess inventory it is clear that the US economy is still facing significant structural headwinds. The recent failure of the congressional super-committee to agree to unilateral budget cuts has resurrected market concerns that the dysfunctional political leadership in the US could result in subsequent ratings downgrades and erode the nascent recovery in confidence. It now looks as though the US earnings cycle has peaked with earnings revisions turning negative. This implies that after several years of supportive corporate news flow the next few months could prove to be difficult as corporations recalibrate expectations.


An Autumn reality check

Over the last few weeks there has been a substantial reorientation of concerns regarding the outlook for the UK economy. Initial fears over the impact of persistently high inflation have been supplanted by anxiety over the quantum of the deterioration in demand. The waning in economic momentum can be attributed to a blend of factors such as the uncertainty engendered by the turmoil in the eurozone as well as domestic influences such as a deteriorating labour market (unemployment has increased to 8.3%) and negative real incomes. Consensus 2012 growth estimates have fallen to 1% from 2%. Indeed, the OECD has recently forecast UK growth of just 0.5% in 2012 and warned of the heightened risk of a contraction in GDP over the next few quarters.

The Office for Budget Responsibility has recently reduced both the short term and trend growth forecasts for the UK indicating slippage in the plan to eliminate the structural deficit by 2015- 16. However, as long as the chancellor does not do anything rash in response to these new forecasts the markets are likely to remain relatively sympathetic. Recent announcements of credit easing as well as increased infrastructure expenditure combined with the commencement of a second instalment of Quantitative Easing support the view that on a relative basis at least the UK is trying to do the right things to confront the economic headwinds.

Market volatility remains extreme and is likely to persist for some time. This is taking its toll on the Equity Risk Premium and valuations. Consequently, we think the best equity investment strategy is to remain focused on compounding reinvested dividend income and the identification of the handful of stocks that have competitive advantage, robust business models and global franchises (The New Nifty Fifty).


Will Germany blink and permit QE?

The rally post the October 26th crisis summit petered out within a few days as markets responded to a sequence of adverse developments in the eurozone. The suggestion from Greece that they would put the terms of the summit to a referendum came as a seismic shock. It explicitly raised the prospect of a country exiting the eurozone and broke the mantra that the club of 17 members was sacrosanct. This created a chain reaction that resulted in the bond yields of Spain and Italy and most importantly France moving much higher, together with the removal of the incumbent administrations of Greece, Italy and Spain. The new administrations have a clear remit to deliver stringent austerity programmes and reforms. Unfortunately, this appears to consign these economies to a debt deflation spiral and a recession in 2012. The failure to deliver the enlarged EFSF bail-out fund as promised at the October summit together with innate scepticism over the solvency of the peripheral countries has seen the bond market push yields in the peripheral markets to unsustainable levels. Having exhausted most other options the only realistic support structure that can be put in place is a commitment from the ECB to be the buyer of last resort unleashing massive Quantitative Easing (QE). The problem is that Germany is very reluctant to sanction such as move on the basis of moral hazard, the risk that this effectively enmeshes Germany into fiscal transfers to peripheral economies and also exposes Germany to the risk of higher inflation. We are clearly moving towards a critical pivot point.



While Chinese growth is starting to slow and has been impacted by the combination of the weakness in developed economies and the delayed impact of tighter domestic policy, the economy still looks capable of delivering between 8.0-8.5% growth in 2012. By Chinese standards this constitutes a soft landing. The government is endeavouring to reorientate the economy away from export to consumption led growth. If the economy was to show signs of decelerating too fast then fiscal stimulus will be deployed – unlike 2009 it will focus on tax cuts (boosting demand) rather than infrastructure projects.

CPI inflation has started to decline providing scope for monetary easing next year. Indeed, the authorities have already started to cut interest rates at a regional level.


The Japanese economy has started to recover from the impact of the earthquake and tsunami. The supply chain disruptions were not as great as first feared and consensus forecasts expect the rebuilding process to deliver 2.8% growth in 2012. The yen has rallied significantly partly in response to capital repatriation but also due to its safe haven status. The pressure this is exerting on the economy and corporate margins has prompted the finance minister together with the BOJ to consider measures to curtail the recent strength of the currency.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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