11 Sep 2014

Macro Strategy Update

2013 Outlook: Another Positive Year

As we begin 2013, we see the economic cycle turning up. The global economic slowdown is being arrested and the odds of the global economy regaining growth momentum are rising. Markets are also signaling a similar scenario as cyclical stocks continue to outperform. Despite fears of US political bickering dragging down the economy, the resurgence of the US private sector and a recovering China act as a counterbalance, enabling the global economy to muddle along without slipping into a recession. This is positive for risk assets.

Global PMI data suggests manufacturing has turned

Data for December and November show that the global manufacturing sector has stabilised, with the latest JP Morgan Global Manufacturing PMI rising to 50.2 from 49.61. According to the report, output gains were solid in countries like the US and China. With the two largest economies posting strong improvement, the odds are in favour of the end of the 2012 global economic slowdown.

US to sustain growth

We have been positive on the US economy for a while and continue to be positive in 2013. Domestic factors are favouring the US economy this year with housing remaining a key driver. The recovery in new housing starts (Figure 1) and home prices can trigger a virtuous cycle in domestic spending. Sales in durable goods has risen in line with new homeownership, which is confirmed by a rise in consumer spending. Even as the government begins to pare down its role in the economy (with a smaller budget deficit), the US economy is likely to weather it well, surprising critics with its resilence.

Figure 1: Good recovery in US housing starts

Chinese cycle has turned

We now have three consecutive months of industrial output increase in China (Figure 2). Momentum is building and it is likely that the downtrend, established since June 2011, has reversed. The same can be said of retail sales in China.

Figure 2: Recovery in Chinese output

It is very likely that the domestic economy is growing, rather than the external sector, since export growth remains anemic. With fixed asset investment growth stabilising, the Chinese economic turnaround is currently driven by domestic factors as the new leadership continues to steer growth towards the domestic economy. The odds are certainly rising that Chinese growth is back on track.

Europe's drag on global growth easing

Not surprisingly, Europe continues to be a drag on global growth. But there are signs that the impact is growing smaller by the day. The deep recessions in peripheral Europe has brought about some improvement in competitiveness. Since the European crisis started, unit labour cost has fallen in countries like Greece, Ireland, Portugal and Spain (Figure 3), according to the OECD. Domestic economic adjustment, in the absence of currency adjustment, is a key ingredient for economic recovery. Thus it would not surprise us that the drag from Europe on global growth will fade this year.

Figure 3: Fall in labour cost

Another potential development is how Brussels is dealing with the sovereign debt crisis. In 2013, we may find the EU being more lenient when it comes to adopting austerity measures. Deficit targets for Spain and even France have been eased2. This is not surprising since there is a growing body of evidence that beyond a certain point, austerity worsens the debt situation. The IMF, once a champion of using austerity to solve over-indebtness problems, has tacitly reversed its position3. In a technical paper published by their chief economist, it found that economists underestimated the impact of reducing fiscal budget during times of debt crisis, thereby worsening the recession. Greece is a good example, still reeling from recession after entering into an EU/IMF program in May 2010. Less austerity, more growth measures in Europe will arrest the recession, providing a "boost" to the global economy.

Loose monetary policy set to continue

It is against this backdrop that policy makers manage monetary policy. The Fed is rather clear that it is now targeting unemployment, even at the expense of higher short term inflation. The ECB continues to support the entire eurozone until the politicians come up with more permanent measures to strengthen the union. The PBoC (China) remains cautious, fearing an overheated property market although it is encouraging bank lending to aid the growing economy. A key policy change may come from the Bank of Japan, where the newly elected Japanese prime minister has called for more aggressive inflationary targets and quantitative easing, similar to the Fed's program. Hence, unless economic growth surprises strongly to the upside, the ultra accomodative policy by central banks should continue for 2013, a bullish support for risk assets.

Market signals bode well for the global economy

Thus far, markets continue to signal growth in the economy. Cyclical equities are outperforming (Figure 4), as are financial stocks (Figure 5). Having correctly anticipated the stabilisation in global growth, the continued rise in cyclical and financial stocks is likely to indicate further improvement in the global economy.

Image courtesy of Stockcharts.com

Figure 4: Cyclical stocks outperforms

Image courtesy of Stockcharts.com

Figure 5: Financial stocks outperforms

This positiveness is also confirmed by the lacklustre relative performance by defensive sectors like the consumer staples (Figure 6).

Image courtesy of Stockcharts.com

Figure 6: Defensive sector underperforms

In the fixed income space, we see signals that suggest bond managers are buying risk. Emerging market (Figure 7) and high yield (Figure 8) debt remain in favour versus Treasuries, thanks to the Fed's ultra low interest rate policy.

Image courtesy of Stockcharts.com

Figure 7: Emerging market bonds outperforms Treasuries

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Figure 8: High yield bonds outperforms Treasuries

Equities remain our preferred asset class

Given our favourable outlook for the economy and markets, we choose growth over safety. Hence we find equities, high yield and emerging market bonds more attractive than risk free bonds. Better economic performance by the major countries will boost revenues and bottomlines, driving share prices higher based on better earnings, and lowering credit risk for bonds.

Chinese and Japanese equities have potential to surprise

These two markets have lagged the global equity market recovery since 2009. There are good reasons to believe that 2013 will be a good year for them. As mentioned earlier, the Chinese economic cycle has turned, giving investors a fundamental reason to buy Chinese equities as earnings improve. Compared to equities in other markets (Figure 9) which have risen significantly over the past four years, just playing catch up would generate handsome returns.

The potential outperformance by Japan is largely a play on the currency and monetary policy. The new government is determined to lead the country out of deflation, by following the US example. Higher inflationary targets have been suggested although not yet adopted by the soon-to-retire BoJ governor. Currency markets have already moved, with the yen losing ground (averaging double digit losses in six months) not only to the US dollar, but also to the Euro, Singapore dollar and the Polish zloty. The rise in competitiveness due to a significantly weaker currency would be a boost to Japanese exporters, raising revenues, profits and stock prices. Japan may have disappointed investors numerous times in the past but if the yen weakness persist, perservering investors may be richly rewarded.

Image courtesy of Stockcharts.com

Figure 9: Chinese and Japanese markets underperformed global equities

Falling agriculture prices favour Asia

From a regional perspective, Asian equities look poised to outperform with agriculture prices falling and China's reversal of fortunes. Agriculture prices have given up half the gains during the mid-2012 surge in prices (Figure 10). This would relieve some pressure from Asia's food-heavy CPI numbers and allow monetary policy to be more accomodating towards growth. Relative to US equities, Asia appears to have turned the corner after languishing since mid-2011 (Figure 11). As investors embrace the idea of growth rather than recession, high beta equities like Asian equities can outperform.

Image courtesy of Stockcharts.com

Figure 10: Agriculture prices giving up sharp gains

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Figure 11: Asian equity performance

Politics will remain a key risk for markets

As with 2012, keeping an eye on politics, especially in Europe, is important for managing risk when it comes to investing. As Germany, the largest economy in the eurozone, heads for election in the September/October period, it is likely that national interest overtakes European interest when Angela Merkel campaigns for re-election. We could potentially see divisions and disagreement on how to further integrate Europe. This would raise tensions in financial markets and provide investors an excuse to reduce positions. In our view, the second half of 2013 is likely to be more challenging for investors.

Conclusion

Annual outlooks have lost much of its value in recent years as policy makers intervene more actively. Understanding how policy makers react would give investors an advantage in today's volatile markets. Based on the data and the signals given by markets, the positive momentum in risk assets can continue in 2013, especially in the first half. Stay invested for 2013.

Portfolio Positions

We have recently recommended taking some profit from Asia equities. Please contact your adviser if you have any questions.



References
1. Global manufacturing holds steady at end of 2012. 2 Jan 2013. Institute of Supply Management
2. EU to give Spain, France more time to cut deficit. 22 Dec 2012 Reuters
3. An amazing mea culpa from the IMF's chief economist on austerity. 3 Jan 2013

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