Economic & Financial Market Background
Even following sizeable reductions to economic growth forecasts in recent months, September witnessed another significant lowering of estimates for 2012, particularly in the developed economies. The proximate cause was a further significant deterioration in the economic and financial situation in the eurozone with many commentators now believing that a mild recession is underway. Even the core European countries are now being dragged down by the problems of the periphery via financial sector transmission. French banks were the latest to be caught in the firing line with the share price of BNP Paribas (BNP), France's largest and one of the world's biggest banks, at one stage down nearly 60% from the beginning of July and only marginally above its low during the financial crash. Such ignomy for a bank ranked just two months ago by Global Finance as the World's 15th "safest" bank (HSBC (HSBA) was 16th and Barclays (BARC) 49th).
The intensifying crisis in the eurozone continued to spill over into tighter financial conditions elsewhere and contributed to further downgrades to growth in the U.S. and U.K. Even the emerging economies have been drawn into the financial quagmire with massive capital outflows resulting in sharp falls in financial asset prices and currencies in many countries. Even so, once again it was the developed world that suffered more substantial cuts to forecasts than the emerging economies although downward revisions for the latter are now accelerating. The following table shows current GDP forecasts for the main economies for this year and next and compares them with those from the July GIS/AA document of just three months ago (in brackets).
While the "R" word is increasingly being used, the table shows that the global economy is still a long way from falling into a recession. Even though the current estimate of a 3.5% pace of growth for 2012 is below the level of the past few years it is still a fairly decent rate relative to past standards. An awful lot rests upon China, and other emerging economies, however, which are forecast to grow at a 5.5% pace compared to just in excess of 1.0% for the developed world. In particular, continued expansion in China is of prime importance as it is projected to account for nearly 30% of global growth next year.
Although the U.S. faces a difficult economic outlook, it should not be forgotten that activity has held up far better than many commentators predicted given the financial onslaught and initial collapse in confidence. Latest ISM survey data was more encouraging, capex is still climbing while consumers are benefiting from gasoline prices that are now falling rapidly. Housing may still be moribund but auto purchases have picked up smartly suggesting there may well be some further upgrades to Q3 GDP figures.
Most investors have tended to focus on the "dark side", however, particularly the escalating eurozone crisis morphing into another credit crunch and the consequent damage to the economic outlook. These conditions encouraged further de-risking of portfolios with the purchase of high quality bonds (even investment grade bonds produced small losses) and further heavy selling of equities. Nearly all equity markets performed very poorly (MSCI World -6.5%) amidst very high volatility, with the gyrations principally reflecting the growing systemic risk emanating from the European banks which has crystallised as the epicentre of market concerns.
Earlier commodity resilience gave way to a savage sell-off across the commodity spectrum (copper -25%, corn -22% and silver -28%) and even gold, the supposed last bastion of safety, plunged alongside equities during the worst of the collapse in bank shares in Europe. As noted, this retreat from risk assets spread to the emerging markets with record outflows from equity and debt funds, the latter for so long considered a much "safer" investment.
Alongside the sale of assets came a brutal unwinding of the emerging markets carry trade. Prior currency strength turned into a rout (Brazilian real -12%), as the dollar recaptured its safe haven status, and in this environment short term capital flows always trump any talk of structural growth plays. The euro fell some 7% against the dollar and, with the Swiss franc hitching itself to the euro wagon (at EUR/CHF 1.20), the dollar outperformed it by 15% over the month.
Apart from cash, the safe havens of choice were U.S., German and U.K. bonds resulting in a huge fall in yields that took, for example, U.S. 10 year yields down to a low of 1.67%, a fall of over 50bp from the start of the month. In sterling terms, U.S. 10 years+ returned nearly 14% in September and a staggering 27% over Q3!
Our Latest Asset Allocation Views
Equities
In recent months GDP growth forecasts in most advanced countries have suffered savage cuts as a combination of a serious escalation in the eurozone sovereign debt crisis and substantial falls in business and consumer confidence has resulted in severe financial turmoil threatening a vicious downward spiral. Even after a near 20% or so fall in equity markets risks remain elevated and further high levels of volatility are still probable. Even so, given the speed of market swings, the prospect of further monetary and fiscal support and cheap valuations this would suggest a neutral position be maintained for now, although long term investors should be considering adding at depressed levels. No early final resolution to eurozone debt issues is foreseen, however, and it remains a major concern. The medium term outlook for the advanced economies and corporate earnings is now far more opaque as governments and banks are being forced to accelerate deleveraging at a time of far greater economic and financial uncertainty. This has resulted in the prospect of a lower economic growth trajectory for some time to come. A good long term option, with cash offering a zero nominal return and government bonds a negative real return, is to invest in defensive, high quality companies with strong cash flows, high yields, growing dividends and with exposure to growth markets.
Bonds
With main market government bond yields at such low levels, it makes little sense to increase weightings unless a U.S. recession and/or a eurozone financial collapse is expected. In recent weeks U.S., U.K. and German yields have fallen to generational lows and on fundamentals the massive bond rally appears overdone, especially with the scale of government debt and deficits. Given current growth uncertainties, prospective stimulus via bond purchases and no sign of respite in the eurozone debt crisis, however, yields could stay at lower levels for some time to come. Investment grade corporates offer better value but upside is limited while emerging market debt should be reconsidered following heavy recent falls and currency weakness.
Property
After such a strong yield impact-led recovery in capital values the pace of advance in the U.K. property market has slowed to a crawl. The weight of money chasing high quality properties generated a near boom and prime yields seem very fully priced. With banks now becoming keener to supply the market with portfolios of properties from their involuntarily built stockpiles and lower levels of investor interest at current prime yield levels, this should inhibit further capital value gains and, indeed, they could decline over the second half of the year. Selectivity is important and Central London remains favoured. With yields in excess of 4% above ten-year gilts for even some prime properties the sector should outperform cash and possibly government bonds from current levels.
Commodities
Predicting commodity returns is difficult enough given the very broad spread, high volatility and problems associated with rolling over futures contracts on returns. It has become even harder as a result of the uncertainty created by EU sovereign debt issues, growing risks of a U.S. recession, a Chinese slowdown and a mass exodus by traders. Commodities such as crude oil and industrial metals have fallen very sharply during the recent sell-off but as long as the Chinese economy avoids a hard landing and the U.S. economy experiences nothing worse than a weak recovery, the pace of world economic growth should be sufficient to ensure that the prices of supply constrained industrial materials, such as oil and copper, will recover from the huge unwinding of speculative positions during next year. Gold reached a new closing peak of $1,898/oz before its recent reversal but remains favoured by many investors worried that a far worse fate awaits the global economy. Scarce supply and strong demand will keep prices elevated until sentiment turns and real interest rates rise. Despite drought conditions in the U.S. resulting in disappointing crop yields inventories were recently revised higher contributing to a major fall in prices. Fundamentals should eventually reassert themselves and grain prices look set to trend higher.
Currencies
Currencies remain as volatile and as difficult to predict as ever and near term trends will depend on the authorities' response to current financial turmoil. The yen is unlikely to strengthen too much further against the dollar given counteracting flows from the central bank while the Swiss franc has temporarily been pegged to the euro. In recent weeks the euro has lost all its interest rate differential support and, with the eurozone crisis intensifying, sterling and particularly the dollar are outperforming despite the prospect of QE2 and QE3, respectively. After its recent substantial fall, however, the euro is likely to be driven by market sentiment towards resolution of the eurozone financial crisis i.e. it will be volatile. Asian/merging markets currencies were downgraded both tactically and strategically several months ago, but remain undervalued despite short term capital flight.
