Macro outlook - 16 September 2009

“The global recession has ended,” says Ronald Doeswijk, “and an economic recovery has started, somewhat earlier than was expected.” Evidence of the rebound includes a pick-up in world trade and the robust momentum in the manufacturing sector, albeit encouraged by temporary measures such as the “cash for clunkers” car-buying stimulus initiative in the US. The economic rebound is particularly pronounced in Asia, but Europe is showing a surprising resilience as well.

It looks like there’s more to come. Doeswijk forecasts that the next few quarters will see strong economic growth, based on further spending by governments and an up-tick in the inventory cycle as manufacturers increase production to replace depleted stocks.

Yet he also cautions that consumer-credit data suggests that paying down debt still has some way to go. “It thus remains doubtful whether consumers and companies can provide a strong impetus to growth once governments withdraw some of their stimulus,” he concludes.

That means that the global economy isn’t out of the woods yet. Unemployment will continue to rise, while the withdrawal of government stimulus will act as a drag on growth. But at least deflation is no longer a significant threat. At this stage, central banks—sensibly—prefer to err on the side of caution. They do not want to hurt the recovery by raising interest rates too soon. As a result, no rate hikes are expected in the main markets at least until well into 2010.

Stimulus is critical in US economic revival
In this picture of budding growth, the US is one economy where the recession is not yet officially over. In fact, its economy contracted by 1.0% in the second quarter. And yet signals are emerging that this economy is also returning to a growth path. In August, the ISM Manufacturing index revealed that economic activity in the manufacturing sector—as well as the wider economy—had expanded, following 18 consecutive months of contraction.

The US housing market is also getting back onto its feet. Housing starts, building permits and new home sales were all up in July. And existing home sales even surpassed the annualized five million level for the first time in ten months. The US government’s measures to support housing are clearly having an effect.

Given such developments, the US economy is now widely expected to bounce robustly back into growth in the third-quarter. “For a sustained recovery, however, the US consumer has to start spending again,” warns Doeswijk. But he observes that consumption growth is likely to stay sluggish, as consumers remain reluctant to spend. For one thing, US unemployment is already high at 9.4% and it is likely to rise to 10%. At the same time, consumers continue to reduce their borrowing.

European economy is unexpectedly resilient
Perhaps the most surprising macroeconomic development has been the strength of the eurozone economy. France and Germany both emerged from recession in the second quarter, while the economy in the eurozone as a whole contracted by just 0.1%. One indication of continuing improvement was that the PMI composite index of Europe’s manufacturing and service industries rose—unexpectedly—to 50.4 in August, up from 47.0 in July. This was the first reading above 50 (the dividing line between growth and contraction) for 15 months.

Why was this robustness so unexpected? As Doeswijk explains, “We are witnessing a synchronous recovery. This is a surprise, as Europe usually lags North America.” Europe’s speedy recovery is particularly striking, given the modest level of government stimulus in the region.

Government stimulus in focus in Asia
In Japan, meanwhile, a new DPJ government is taking power after a landslide victory in August’s elections. The incoming administration intends to invigorate consumption by improving welfare provision. “But it remains to be seen if real stimulus will materialize,” says Doeswijk, “given the precarious state of the country’s public finances.”

One positive for the DPJ is that the Japanese economy is out of recession, having grown by an annualized 2.3% in the second quarter. Further growth will be hampered by falling business investment and rising unemployment (5.7% in July). And with deflation running at a substantial 2.2% in July, the consumer is unlikely to be spending much.

In China, the government’s stimulus package is clearly working. The PMI for manufacturers has been on a modestly upward trend above the 50 threshold since March. All told, China is on track for growth of 8% this year. Even so, worries persist that domestic demand cannot compensate for the decline in exports, which fell by 23% year-on-year in July.

European equities now in favor
What implications does this outlook have for securities markets? In equity markets, Doeswijk believes that a sideways consolidation phase is more likely than a continued rise. “Although the next few quarters will see strong economic growth, based on further spending by governments and the up-tick in the inventory cycle, it remains doubtful whether consumers and companies can provide a strong impetus for further growth once governments reduce their stimulus, because of their own debt repayment issues,” he argues.

A further negative signal comes from the heavy selling by senior corporate executives of the stocks of their own companies in the rallies of March/April and July/August. That suggests they have no confidence in further share-price appreciation. Lastly, valuation is no longer so attractive and is not acting as a turbo for the market.

Within equities, Doeswijk now believes that Europe offers the best investment prospects of all the regions. As well as highlighting Europe’s unexpectedly robust macro picture, he identifies the attractive valuation of the region’s equity markets, as well as their superior momentum, as other key positives.

US and emerging markets equities no longer preferred
That means that North American and emerging markets equities—previously the Economic & Financial Markets Analysis team’s preferred asset classes—are no longer favored. Doeswijk says he expects North American equities to lag those from other regions. He points to the US economy’s emergence from the crisis being very much dependent on large government stimulus as a negative that is likely to hold back equities there.

And although Doeswijk remains positive on emerging markets equities in the medium- and long term, he no longer expects outperformance in the short term. “Valuation is no longer attractive, momentum is declining somewhat and there is increasing skepticism about the continuation of stimulative policies in China due to conflicting signals from policymakers,” he says.

Bonds: investment grade still preferred
Doeswijk remains neutral on government bonds. “We expect government bonds to trade sideways,” he says. In general, it is unlikely that central banks will start to lift short-term interest rates, which would hurt bonds, before the second half of next year. But this is offset by the concerns that are mounting about longer-term inflationary pressures.

Corporate bonds continue to have better prospects. Within this category, Doeswijk prefers investment-grade bonds (credits) to their high yield counterparts. This is because the good performance by high yield has reduced the extra yield that investors receive for holding these bonds. Doeswijk says that the yields on these bonds are now back to levels that he feels are normal in the current macroeconomic conditions.

“With economies now growing again, we feel that questions about the sustainability of the revival may intensify. In such an environment, credits are more attractive than high yield,” he explains.

Finally, Doeswijk thinks that real estate is somewhat less attractive than the other asset classes. In particular, he is concerned about valuation. Indeed, investors are paying 20 times expected earnings over the next 12 months for the global MSCI Real Estate index. That compares with 15 times for stocks.