Macro outlook - 19 October 2009

“The macroeconomic environment continues to pick up,” says Léon Cornelissen, “but expectations are generally not being beaten.” As evidence, he points to slower-than-forecast improvements in German producer confidence, a Tankan business-confidence reading in Japan that was in line with expectations and some disappointing US labor-market developments. “All in all, however, the general picture is that the global recovery is gaining strength,” he adds.

But that’s not to say that it will be clean sailing from here on. Unemployment, for example, will continue to rise and some government stimulus will be withdrawn. But the central banks, which are in a very cautious mode, will continue to provide ample liquidity. They do not want to hurt the recovery by raising interest rates too soon. As a result, Cornelissen expects no rate hikes in the main markets until the second half of 2010.

Recent US data has generally disappointed
The US was typical in seeing macro indicators generally failing to meet expectations. After eight consecutive months of gains, the ISM Manufacturing index dropped in September, when domestic vehicle sales slumped from 10.2 million to 6.8 million, after the cash-for-clunkers program ended in August. And after improving for a couple of months, the US housing market suffered a dip in August.

That’s not all. Unemployment has risen to 9.8%, the highest level since 1983, and non-farm payrolls dropped for the 21st consecutive month. Final data showed that the US economy contracted by 0.7% in the second quarter. Despite the recent weakness, Cornelissen believes the US is pulling out of recession. “We expect the US economy to return to growth again in the third quarter,” he says.

European economy continues to gain strength
The eurozone economy also contracted in the second quarter, shrinking by 0.2% qoq. “But this does not change the overall picture of a European economy that is gaining strength; we expect a positive growth figure for the third quarter,” says Cornelissen.

He is particularly encouraged by the rise of the purchasing managers’ index for the eurozone services sector, which in August moved above the 50 level that marks the border between growth and contraction. In addition, foreign manufacturing orders rose strongly in August, despite the strength of the euro. A similar acceleration of the recovery is taking place in the UK.

Pacific worries are intensifying
Not all regions are bouncing back so strongly. Cornelissen says he has become more hesitant about the prospects for the Pacific region, which includes countries such as Australia, Hong Kong and Japan, over the last month. Japan, in particular, is a concern.

True, the Japanese economy came out of recession in the second quarter, growing by 0.6% qoq. But the strength of the yen, which appreciated by 6.9% against the US dollar in the third quarter, is hurting the Japanese economy. Japan profits from the demand from China and other emerging nations but exports slumped by 7.0% mom in August.

In addition, unemployment is high, significant deflation (2.2%) is becoming a real threat to the economy and business confidence remains low. Cornelissen is particularly concerned by the revelation in the Tankan data that businesses are aiming to cut spending more than they expected three months ago.

The picture is more favorable in China, which is on track for growth of slightly over 8% this year. September saw the strongest manufacturing expansion in 17 months, boosted by the stimulus package and record loan growth. Other Asian economies are also showing signs of increasing robustness.

Equities now in favor
Against this macro backdrop, Cornelissen has made a couple of major asset-mix shifts. First, he has become more favorable about equities. Previously, Robeco’s Economics & Financial Markets Analysis team was neutral on the asset class, due to expectations of a deterioration in the macro picture.

As we have seen, the data weakened as forecast. What was unexpected was the minimal impact such a decline would have on equities. “We underestimated the levels of liquidity in the market,” concedes Cornelissen.

In fact, the continued gains in recent weeks, not only for equities but also for government bonds and risky assets, point to large volumes of money, boosted by the huge amounts central banks have injected into the global financial system, seeking out investments with better potential returns than offered by cash at present.

Cornelissen expects no let-up in this process. Indeed, in the final quarter of the year, he believes that more investors might be lured into the market, in part due to the need to catch up in performance before year-end. “As a result, we expect some moderate gains for equities in the months ahead, notwithstanding the huge rebound from the March lows,” he says.

Two further positives for equities are earnings, which are faring better than expected, and a potential revival of M&A activity. The multi-billion deals announced in late September by Abbott and Xerox suggest that such a pick-up could already be underway.

Emerging markets equities back in favor
In a second asset-mix change, Cornelissen has become more positive on emerging markets equities. Indeed, he now reckons that they, along with European equities, offer the best investment prospects. He has shrugged off his earlier short-term doubts about emerging markets, when some local weakness in China’s stock markets hurt sentiment towards the wider asset class.

“As the worries concerning an aggressive withdrawal of monetary stimulus in China have eased and growth there continues to impress, we have put aside our short-term reluctance and have embraced the long-term attractive appeal of emerging markets again,” he explains.

Although valuation is no longer a driver for emerging stock markets—they are trading broadly in line with developed markets on a number of measures—he points out that economic conditions there are generally better than in developed markets, and that momentum has picked up again.

Prospects for Pacific equities are poor
With emerging markets and Europe preferred, that means that equities in North America and the Pacific are out in the cold. Negative factors for the US are the heavyweight stimulus needed to fire up the recovery, a mediocre earnings-growth outlook for 2010, continued dollar weakness, the 2009 and 2010 budget deficits, and the high debt-to-GDP ratio.

In the Pacific region, Cornelissen fears that deflation in Japan could become sticky, while relative performance is lagging. He has low expectations for equities in the region.

Bonds: investment-grade corporates still preferred
Cornelissen remains neutral on government bonds. It is unlikely that central banks in the major markets will start to raise short-term interest rates, which would hurt bonds, before the second half of next year. After all, inflation is set to remain low due to the moderate nature of the economic recovery.

But this is offset by concerns about inflation pressures resuming after 2010, fuelled by increasing wealth in emerging markets. “Moreover, we expect investors to become increasingly worried about the aggressive monetary policies that are in place, as well as governments’ budget deficits and rising debt-to-GDP ratios. The latter makes inflation a tempting option to help normalize the leverage in the world economy,” says Cornelissen. On balance, then, he expects no major shifts in long-term interest rates.

Corporate bonds continue to have better prospects. Within this category, Cornelissen 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. Cornelissen says that these yields are now at levels that he feels are normal in the current macroeconomic conditions. Given the questions being asked about the sustainability of the recovery, investment-grade bonds look more attractive.

Real estate set to underperform equities
Finally, Cornelissen feels that real estate is somewhat less attractive than equities. “Real estate is a late-cyclical asset class and investors are now anticipating a recovery, as they should. But we wonder whether it has gone too far,” he cautions, pointing to a gloomy earnings outlook and high valuations.

Indeed, earnings revisions for the MSCI World REITS are mainly declining and analysts are forecasting no earnings growth in 2010. Yet investors are paying roughly 22 times the expected earnings over the next 12 months for REITS. That compares with a multiple of around 15x for equities.