Strategic thoughts on markets and economies

With so many risks unresolved – the US fiscal cliff, Euroland growth, China’s next moves – in one sense we need to take a big picture view, and in another we need to watch the data like a hawk. This paper is focused on some of the bigger picture developments, which help shape our understanding of what’s going on and what likely lies ahead.

Beginning with a UK domestic focus, relative economic momentum has slowed but is still better than the global norm, and the co-operation between the central bank and the Treasury in the UK is better than in any other major region. This leads us to believe that QE will become more unconventional more quickly than elsewhere (through the funding of banks – or even infrastructure if necessary). This should support growth and the pound is cheap.

On the US front, economic and earnings momentum still looks at least okay and US housing could add 1% to GDP directly and indirectly, whilst the banking system is working, with loan growth now clearly positive, consumer leverage is back to trend, corporate sector fundamentals look strong (leverage low, profitability and cash flow high. Old capital stocks requires an increased corporate investment) and shale gas and oil fracking could add 0.2%pa or more to GDP. But US equities aren’t cheap – only during the TMT bubble was the price/book relative to global markets higher and we need to see some resolution to the fiscal cliff to ensure fiscal uncertainty does not harm the positive outlook for the US private sector. If Mr Obama’s proposals on capital gains and dividend tax rates are fully implemented, this would take c5% off the S&P’s fair value.

As for Euroland, macro momentum is awful. European PMIs are currently consistent with c- 1% GDP growth, and structural problems dominate. These include European banks (ex Germany) reducing their lending by 2%-5% (lending conditions in Europe remain tighter than any other region), the strength of the euro and fiscal tightening (1.9% of GDP this year; yet, admittedly next year this should ease). There are also some signs of complacency on European risks, with only perhaps 60% of the required adjustments in Euroland complete – and issues that remain include growth, solvency of the insolvent and the need to recapitalise peripheral banks directly with ESM funds. Meanwhile the euro remains too strong with 10% on the euro’s trade weighted value taking 1% off nominal GDP, and 54% of European earnings are from outside the euro area. Significant euro weakness is needed to drive down the household savings ratio in core Europe (which is between 11% and 20%) and thus rebalance European growth. Valuations are very attractive on trend earnings and on P/B ex financials, but not on actual earnings and at this stage, it’s hard to identify any trend. But there is value in Europe with cheap dollar earners, and prices moving to discount material bad news.

With Japan, monetary policy remains overly tight and economic momentum has slipped sharply, with corporate earnings momentum poor. Japan faces a severe long-term fiscal challenge – assuming that real rates move in line with real trend GDP growth, it would need to tighten fiscal policy by 9% of GDP to stabilise government debt to GDP ratios.

Amidst these uncertainties, the relative economic momentum of global emerging markets (GEM) is improving, with PMIs relative to developed markets turning up. Yet GEM’s price to book relative to global markets is at 2008 lows, and the implied earnings growth premium is 17% as against a possible actual 40% growth premium. What’s more, further QE in the developed world will lead to capital inflows into emerging markets and excess liquidity has already started accelerating. At the same time there’s significant policy flexibility in GEMs, given relatively underleveraged government and private sector balance sheets, high nominal rates and far fewer inflationary constraints to easing than was the case last year. Meanwhile the structural drivers of growth – balance sheet re-leveraging, urbanisation, higher school enrolment, cheap unit labour costs and the productivity catch-up – all have further to go.

These are important themes for asset allocators and instrument selectors, with the bottom line being that there are plenty of opportunities for those that take a global approach to the management of risk assets.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla