Macro outlook - 15 december 2009

The global economy is recovering surprisingly strongly, says Léon Cornelissen, senior strategist with Robeco’s Economic and Financial Markets Analysis team. With modest growth forecast for 2010, the risk premium should continue to decrease, making room for further rises in stock prices.

The global economy is doing rather well, given the circumstances. That said, the recovery process is gradually moving into a more difficult phase, in which the monetary and fiscal authorities will start to scale back their extraordinary support measures. Fortunately, points out Léon Cornelissen, the authorities would rather err on the side of caution in this process and are thus in no hurry to implement their exit strategies. “We do not expect rate hikes from the major central banks before the second half of next year at the earliest,” he says.

Despite these relatively favorable conditions, the Dubai World debt standstill illustrated that equity markets can quickly become nervous. Cornelissen thinks that the Dubai crisis has only limited regional significance. “In a recovery process, major setbacks such as Dubai World are inevitable, but do not constitute a threat to the ongoing recovery,” he notes.

On balance, the US macro picture is brightening
In the US, macro news has been mixed. Disappointing purchasing manager data for November pointed to moderate growth prospects and an absence of inflationary pressure. The news from the US housing market was also equivocal. Pending home sales for October were better than expected, existing home sales are rebounding convincingly and the S&P/Case-Shiller indices suggest an ongoing recovery of housing prices. But housing starts disappointed in October and mortgage delinquencies are still on the rise. Meanwhile, US policymakers are probably silently applauding the US dollar’s slow decline against the euro.

Dubai World put heavily indebted Greece into the spotlight
Despite the strong euro, the eurozone economy is doing rather well. This is illustrated by the ongoing rise of German producer confidence, which has risen for eight months in a row. Yet the modest economic recovery in the region is unlikely to be strong enough to provoke significant inflationary pressures.

The Dubai World debt standstill put the spotlight on the eurozone’s heavily indebted countries, such as Greece and Ireland. Greece is in particularly dire straits, as the new government suddenly doubled its projection for its 2009 deficit to above 12%. Nevertheless, Cornelissen thinks that a Greek default in the present circumstances is unlikely. He points out that with the Dubai theme fading away, credit default swap rates, for Greece among others, are coming down.

In the UK, third-quarter growth figures have been revised up to -0.3%. A positive reading is expected for the fourth quarter. The UK economy is clearly recovering, albeit at a slower pace than previously expected. As a result, the Bank of England is unlikely to extend its quantitative easing program further. No rate rise should be expected before the fourth quarter of 2010.

Japan concerns are weighing on Pacific region
Japan’s third-quarter growth was remarkably strong at 1.2% qoq. But this positive news was overshadowed by worries about the recent strength of the yen and worsening headline deflation (2.5% in October), which are leading to doubts about the sustainability of the recovery.

Cornelissen sees no respite from these problems. The government’s ability to maneuver is limited by the country’s high debt ratio, while businesses are cutting back spending at a record pace. “That is particularly worrying, as it highlights their lack of faith in the durability of the recovery,” he says.

China’s economy is growing strongly again. In the third quarter, growth amounted to 8.9% on a yearly basis. The Chinese authorities continue to resist the rising pressure to allow the yuan to strengthen against the US dollar. Yet they also have to worry about real-estate bubbles and the excessive gains in domestic stock markets. “In fact, it is in the best interests of the Chinese economy to allow a stronger yuan,” says Cornelissen. “Now that deflation is abating  there should be room for a gradual appreciation of the yuan over the next year.”

Elsewhere in Asia, India grew by an impressive 7.9% in the third quarter, beating even the most optimistic forecasts. But with inflation hovering above 11%, pressure is increasing for the central bank to hike rates; some action is likely in the first quarter of next year. The Indian economy could easily grow by more than 7% in 2010.

Further gains likely for equities and other risky assets
Dubai World’s late-November request for a debt standstill rattled the markets. But as the risk of contagion is limited, the correction was small and short lived. Cornelissen thus expects stock markets to continue to set new highs. “Moderate economic growth and rebounding earnings are a good mix for equities, especially given the low level of interest rates. In addition, deflation risks should gradually wane,” he argues, reiterating his positive call on the asset class.

A rise in risk appetite should also allow further gains for equities, as well as other risk assets. The VIX index—the so-called investor fear gauge—is still hovering around the 20-25 mark, which is an elevated level compared with its long-term history. “Given our moderate-growth scenario, we are forecasting a drop by the VIX to the 15-20 region. This suggests there is an opportunity for further price increases for risky assets,” concludes Cornelissen.

Within equities, Europe and emerging markets have the best prospects
But which markets will do best over the rest of 2009 and into early 2010? Cornelissen is upbeat on the prospects for equities in Europe and emerging markets. A gradual economic recovery is taking place in Europe, while short-term interest rates there should remain low for a while, as current inflation risks are low. In addition, European equities are attractively valued compared with other regions, with an undemanding P/E ratio of 12.6x and a reasonably good earnings outlook. Moreover, relative momentum supports the case for Europe.

Emerging markets are favored because of their strong economies and neutral valuation. Cornelissen does not expect Dubai World to derail the good relative economic performance. “With equity risk premiums set to fall somewhat further, emerging markets are an obvious candidate for future outperformance,” he says.

US and Pacific equities are out of favor
With emerging markets and Europe preferred, equities in North America and the Pacific retain their out-of-favor status. The performance of North America is being hindered by further weakening of the dollar. Finally, Cornelissen see little prospect for outperformance by the Pacific region, given that Japan is his primary deflation candidate. Neither momentum nor valuation makes a strong case for the Pacific.

Bonds: investment-grade corporates favored over government bonds
Cornelissen remains neutral on government bonds, which benefited from safe-haven demand at the end of November, when Dubai World reminded investors that government-related entities do not automatically have government guarantees.

Short term, the outlook for the asset class is reasonable. “Central banks are talking about exit strategies, but talk is cheap,” notes Cornelissen. “As inflationary risks in the short term are marginal, there is no reason for the major central banks to lift rates within the next six months.” Indeed, commodity prices did not extend their October rally and increases in employment costs are no threat due to high unemployment.

In the medium to long term, however, the prospects for government bonds are unattractive, as the scarcity theme could well return from 2011 onwards, pushing up inflation. In addition, rising debt-to-GDP ratios may take their toll.

Corporate bonds are more interesting than government bonds. For one thing, investors will reap higher running yields. At the same time, a further—albeit limited—decline in spreads is likely further into the economic cycle. Within corporate bonds, Cornelissen prefers investment grade to high yield: the risk/reward trade-off for credits is more appealing than for high yield.

Property set to underperform equities
Finally, Cornelissen feels that real estate is less attractive than stocks. “The asset class has been at the center of the credit crisis and conditions are still tough,” he says. That is highlighted by the state of earnings revisions: while analysts are upgrading their expectations for equities, their forecasts for REITs’ earnings are little changed.

That isn’t the only negative. Industry executives even expect an increase in distressed sales in most commercial real estate markets, after an improvement in the second quarter. Finally, valuation also favors equities, as the P/E ratio for stocks is around 14x, while it is 22x for REITs.