DECEMBER 2012
ECONOMIC AND INVESTMENT COMMENTARY
Fundamentals: A long way to go
Poor economic conditions didn’t seem to matter in 2012, with risk assets taking their cue from central banks and riding a wave of liquidity to record strong gains. Looking at 2013, advanced economies still have obstacles to clear, with debt problems likely to weigh on both the short and medium term. Emerging markets look much better placed and should be the engine of growth in 2013. In this edition of Fundamentals, Legal & General Investment Management’s economists and strategists highlight the problems ahead for the global economy in 2013 and what this means for the key asset classes. The global economy’s fundamental economic problems remain, meaning sub-trend growth is here for some time.
INSIDE: Market overview: Cliff on, cliff off Snapshot: Emerging markets to decouple in 2013 UK forecast: ...And a happy new year?
GLOBAL GROWTH IN 2013 World trade and global industrial production stalled in the summer as companies reacted to an escalation of the euro area sovereign debt crisis, a slowdown in business investment and an earlier inventory build. But heading towards year end, the global economy has shown some signs of stabilisation, with business surveys increasing slightly from depressed levels. Growth is expected to
improve gradually through 2013 (figure 1), but this is almost entirely driven by better prospects in emerging markets (figure 2). Advanced economy growth is likely to remain barely positive and clearly not sufficient to address medium-term fiscal concerns. Risks are skewed to the downside. The most immediate danger is the US fiscal cliff. While a compromise is expected to emerge before Christmas, failure to reach an agreement would lead to a potentially severe US recession with global repercussions. In Europe, recent policy action has bought some breathing space for
DECEMBER 2012
ECONOMIC AND INVESTMENT COMMENTARY
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the entire euro area would still leave open the risk of a full-scale banking crisis. This danger could be mitigated if the ESM were allowed to directly recapitalise the banks, but disagreement over the treatment of legacy assets could prevent a deal. In the medium term, austerity is still likely to weigh on growth for some considerable time across the euro area and the region remains vulnerable to adverse shocks and fiscal slippage. Ultimately a move towards closer fiscal and political union seems more likely than a full euro break-up, but it may require further bouts of market pressure to reach this goal.
Global industrial confidence and GDP
16 12 8 4 0 -4 -8 -12 -16 -20
7 5 3 1 -1 -3 -5 -7 -9
Forecast
98
99
00
01
02
03
04
05
06
07
08
09
10
11
12
Annualized % change on previous 6 months
Index balance
Figure 1. LGIM global GDP and new orders to inventory balance
13
Global new orders - inventories (LHS) World GDP, % change on previous 6 months, annualized (RHS)
Source: LGIM estimates, EcoWin, Markit
the European sovereign debt crisis, but further austerity and structural reforms are necessary to restore public finances to a sustainable path. EUROPE The euro area is likely to finish the year in recession, led by a large decline in industrial production, but the easing in financial conditions should help growth stabilise in 2013. This improvement is based on the expectation that the ECB will at some point begin its outright monetary transactions (OMT). Ironically, this has allowed Spain to delay entering an official programme (which is a necessary condition to trigger OMT). The markets may need to force Spain’s hand to end this stand off. The threat of a Greek exit has diminished for now, following a fresh round of financing, but domestic politics remain fragile and austerity fatigue could still trigger another round of euro exit fears. Germany has been impacted by the global trade slowdown, but should be well-placed to recover as trade picks back up again. The German labour market is relatively tight and decent wage gains should deliver reasonable consumer spending in 2013. Growth in other parts of the euro area is likely to disappoint consensus expectations (figure 3). Austerity in Spain is in the process of
intensifying and this could deepen the contraction in output over the next couple of quarters. Italy is likely to experience a further deterioration in its labour market and contraction in domestic demand and this won’t be helped by uncertainty around the general election likely to occur in 2013. France is struggling with an uncompetitive economy and increasingly onerous tax environment.
US US growth has been mixed with weak capital goods orders offset by decent retail sales and an improvement in consumer confidence and the housing market. The open-ended nature of the Fed’s asset purchases is potentially powerful as it sends a strong signal about the Fed’s willingness to inflate. But following President Obama’s re-election victory, attention has turned to the
Progress towards a European banking union has slowed in recent months and while some form of supervision seems likely to emerge next year, the lack of a deposit guarantee scheme covering Figure 2. LGIM growth forecasts vs. consensus
LGIM Country
CONSENSUS
LGIM 20142017
2009
2010
2011
2012
2013
2013
UK
-4.0
1.8
0.9
-0.1
0.6
1
US
-3.1
2.4
1.8
2.2
1.0
2
2.5
Euro area
-4.3
1.9
1.5
-0.4
-0.6
-0.2
0.75
Japan
-5.5
4.6
-0.7
1.6
0.4
0.8
0.5
GDP, % yoy
BRICs (unweighted)
1.25
1.7
8.1
5.8
4.6
5.6
5.3
5.5
-2.1
4.2
3.1
2.5
2.4
2.7
2.9
UK
2.2
3.3
4.5
2.7
2.6
2.2
2.25
US
-0.4
1.6
3.2
2.1
2.3
2
3
0.3
1.6
2.7
2.5
1.8
1.9
1.9
US Fed level
0.1
0.1
0.1
0.1
0.1
0.1
2
UK base rates
0.5
0.5
0.5
0.5
0.5
0.5
0.5
ECB base rate
1
1
1
0.7
0.5
0.63
1
World CPI, % yoy
Euro area Year-end level
Source: LGIM estimates, EcoWin
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Figure 3. LGIM Euro-area country forecasts vs. consensus 2013 euro area GDP forecasts - LGIM vs. consensus
% change on year earlier
1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 -2.5 -3.0 Euro-area LGIM
Germany
France Consensus
fiscal cliff. Negotiations are likely to be fractious, but some agreement should be reached before Christmas. However, the amount of fiscal tightening could still be greater than assumed, particularly if the payroll tax cut is allowed to expire. In addition, the fiscal multiplier could also be relatively large unless the Fed is able to engineer an offsetting real exchange rate depreciation. This could lead to a pronounced slowdown in early 2013. Prospects later in the year should then improve, providing some of the medium-term fiscal uncertainty can be removed, even if this plan fails to put US public finances on a long-run sustainable path. UK The UK economy is likely to remain on a sluggish growth path at best. Activity rebounded in the summer, but this appears due to the unwinding of temporary factors and the lift to spending from the Olympics. A combination of fiscal austerity and weakness in the world economy should prevent any meaningful recovery. Quantitative easing has paused for now while the MPC assesses the impact of the ‘bank funding for lending’ scheme. These measures should help protect the UK to some extent from a further deterioration in Europe, but are unlikely to generate significantly stronger growth, particularly in the near term.
Italy
Spain
Source: EcoWin, LGIM estimates
EMERGING WORLD Emerging markets can’t completely decouple from advanced economies, but growth can improve providing western imports at least maintain their recent pattern of stagnation. Trade within emerging markets has become increasingly important and the degree of policy flexibility is currently greater than they have ever enjoyed historically. The threat of a Chinese hard landing appears to have receded following stronger data in the last few months. Fiscal policy loosening seems to be already reflected in infrastructure investment and this should lead to a modest increase in growth in 2013. Brazil has also shown an improvement in growth following earlier interest rates cuts and India has recently embarked on some much needed reforms which have helped to stabilise its currency and lift stock prices.
GOVERNMENT BONDS Western bond markets outside of those engulfed in sovereign debt concerns have become even more expensive over the last year. Government bond yields in the US, UK and Germany appear to be priced for a bleak growth outlook. Yields are likely to remain low while growth is weak and central banks promise to keep short-term rates low for the foreseeable future. But any hint of a normalisation could lead to an abrupt repricing. Yields in the crisis-ridden euro area economies also don’t offer particularly good value after the autumn rally. Spreads can compress further if growth surprises positively, but equally there is a significant risk of fiscal slippage and it remains to be seen how effective OMT will prove to be when triggered. There are also major fiscal challenges in the US and UK which ultimately make a low growth and low yield environment unsustainable. The outcome of the US fiscal cliff negotiations will provide some indication of the willingness of the US to tackle its long-term fiscal issues. The UK has at least attempted to reign in the deficits, but sluggish growth has meant revenues are in danger of continuing to undershoot. A downgrade in 2013 now seems likely.
Figure 4. Corporate bond yields and government yields 9 8 7 6 5 4 3 2 1 0 2002
2003
2004
2005
2006
Implied government bond yield (%)
2007
2008
2009
2010
2011
2012
Corporate bond excess yield (%)
Source: Bloomberg
DECEMBER 2012
ECONOMIC AND INVESTMENT COMMENTARY
their superior growth prospects, which should help reverse this year’s underperformance. Our least favourite region is the US, where equities are relatively expensive and tend to underperform rising global markets.
Figure 5. LGIM estimate of commercial real estate risk premium Estimated risk premium vs 3-month treasury bills
Prime UK property risk premium
8 6 4 2 0 -2 -4 -6 00
01
02
Current
03
04
05
06
07
08
09
10
11
12
Average since Q3 1972
Source: LGIM estimates, CBRE, Datastream
CORPORATE BONDS Corporate bonds have proved to be an excellent investment in 2012 with central bank money printing driving government bond yields down as well as boosting corporate bond credit quality by averting the risk of euro area break-up and global recession. Unfortunately, applying liquidity solutions to solvency problems only provides temporary relief and, as we head into 2013, corporate bonds no longer provide investors with much protective yield. That said, in a world of ultralow yields, the pick-up offered by corporate bonds is quite attractive compared to government bond yields (figure 4). Companies have managed to keep themselves in good shape and therefore default rates are unlikely to spike higher barring a tail-risk event. Corporate bonds are therefore likely to see their fair share of demand in the coming months as newly printed money searches for a relatively safe home. However, unless policymakers can take advantage of the temporary respite afforded to them by the sticking-plaster solution of flooding the market with liquidity, fundamental economic and solvency problems will return to the fore. It is therefore likely that volatility will increase at some point in 2013, and investors may take advantage of yield compression at the beginning
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of the year to de-risk portfolios and await more attractive entry points EQUITIES After a volatile but profitable 2012, we expect another positive year for global equities driven by the two main factors for equity performance: earnings and valuations. A slight acceleration in global GDP growth should be sufficient to deliver mid-single digit earnings growth over the next year, a reversal from 2012’s earnings decline. On top of the earnings growth we see room for some re-rating as equities in most regions trade below what we consider fair value in a low growth environment. The catalyst for slightly higher price to earnings ratios should come from continued extremely accommodative central bank policy, investors shifting allocations into equities in search of yield and the prospects of further earnings growth heading into 2014. Despite the positive macro backdrop, 2013 is likely to be another volatile year as politics remains on the agenda on both sides of the Atlantic. History suggests it would be dangerous to assume Europe will not at some point be a source of volatility again in 2013, at least temporarily raising the risk premium investors demand for holding equities. On a regional basis , we particularly like emerging market equities given
COMMERCIAL PROPERTY UK commercial property has experienced wide divergence in 2012 – prime quality property has held up in value whilst poorer quality assets have suffered from a lack of investor demand. Capital values for the overall market are likely to have fallen by around 4% over the course of 2012. More positively, whilst the process of deleveraging continues to be a major issue for the asset class, we are now seeing more evidence that capital is flowing from new investors to replace the finance previously supplied by the banks. Looking ahead, we expect rents to remain broadly static in 2013. Building on the relatively high income return provided by commercial property, the valuation case is becoming increasingly powerful. Our estimate of the risk premium, the extra return provided by property over and above riskfree rates, has moved substantially above average (figure 5). Over the long run, this measure has proven to be a good leading indicator of subsequent returns, suggesting a relatively favourable point in time to access the asset class. But in a sluggish economic environment, we retain the view that performance differences between sectors and locations will remain wide by historic standards. Delivering outperformance for investors will rely on identifying resilient niches of the market and diligent execution of asset plans.
DECEMBER 2012
ECONOMIC AND INVESTMENT COMMENTARY
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Market overview: Cliff on, cliff off
EQUITY OVERVIEW
As at 28 November 2012 Total return (denominated in £) Country
UK
2012 year to date* (%)
2011 Calendar year (%)
10.0
-3.5
US
10.9
1.2
Europe
13.7
-14.7
Japan
-0.9
-12.9
Asia
14.5
-12.9
Source: Datastream, FTSE® indices shown *as at 28/11/2012.
cliff. Equity markets held up relatively well given the lack of real positive developments on the issue. Typically, US treasuries have rallied as investors become increasingly concerned as the yearend approaches with no concrete decision in place. Yields on US 10-year treasury bonds have fallen to 1.64%. There were, however, some positive data releases with signs of improvement in hiring activity, consumer spending and confidence. Although a pronounced slowdown in early 2013 may occur, prospects may improve later in the year, assuming some of the medium-term fiscal uncertainty can be removed.
UK
Canadian governor Mark Carney was announced as the next Governor of the Bank of England and will arrive from his present position as head of Canada’s central bank next summer. Canada posted a shallower recession than any of its G7 counterparts (in 2009) and has subsequently managed a stronger recovery than Germany. In contrast, Britain’s GDP is still below pre-2008 levels. Encouragingly, in the UK labour markets have remained strong, mainly because of the flexibility shown by people looking for work. This should help to sustain the momentum of any improvement in business and economic growth. Gilt yields moved a little lower over the month with current 10-year gilt yields at 1.79%.
EUROPE
Grecian agreements Greece reached a deal in late November which aims to place it on a more sustainable fiscal path by targeting a reduction in its debt to GDP ratio to 124% by 2020. The market response to the Troika’s package was rather muted. This may be due to the ambiguous conditions surrounding the debt buyback scheduled to take place over the next few weeks. Nonetheless, Greek 10-year bond yields did subsequently move lower to 16.25%, and the equity
US
Near the edge Markets in the US have been relatively illiquid during November. Attention was elsewhere, first with the superstorm Sandy and then the US elections. With the re-election of President Obama, attention returned to the fiscal
Figure 1. Major equity markets – total returns (denominated in £) World equity markets, total returns
The media and markets are focused on the resolution, or lack thereof, of the imminent fiscal cliff, the spending cuts and tax increases in the United States. While both the Republicans and Democrats agree that additional tax revenues are needed, they have yet to reach a consensus on how these additional revenues should be raised. Delays in reaching a compromise is little comfort to investors seeking progress on its management. The Organisation for Economic Co-operation and Development (OECD) recently released its semiannual forecast, the general theme of which was that the global economy still faces significant challenges.
140 130 120 110 100 90 80 Nov 11
Dec 11
Jan 12
Feb 12
Mar 12
Apr 12
FTSE All Share FTSE W Asia Pacific ex Japan FTSE W Japan
May 12
Jun 12
Jul 12
Aug 12
Sep 12
Oct 12
Nov 12
FTSE W North America FTSE W Europe ex UK
Source: Datastream, FTSE® indices shown
ECONOMIC AND INVESTMENT COMMENTARY
market rose slightly. Turning to Spain, the election results in the Catalan region added to the uncertainty surrounding the Spanish bailout. The lack of clarity on how the distribution of the austerity drive between Madrid and the regions would work was muddied further. Despite this uncertainty, Spain’s 10-year yield changed little at 5.55%.
06
Figure 2. Major bond markets – total returns (denominated in £) 120 World bond markets, total returns
DECEMBER 2012
115 110 105 100 95 90 Nov 11
Dec 11
Jan 12
Feb 12
Mar 12
Apr 12
UK Benchmark 10yr Gilt German Benchmark 10yr Bund
May 12
Jun 12
Jul 12
Aug 12
Sep 12
Oct 12
Nov 12
US Benchmark 10yr Treasury Japan Benchmark 10yr JGB
Source: Datastream
JAPAN
Still struggling Recent data releases from Japan show no sign of let-up for the Japanese economy. In October, year-on-year exports to the EU fell 20%, while exports to China slumped by 11.6%, in part due to tensions over disputed islands in the East China Sea. Capital expenditure is down 3.2%, the second largest fall since the 20082009 recession. In response, 880 billion yen ($10.7 billion) in fresh spending was approved at the end of November, more than double the package announced in October, to try and boost the lagging economy. This was well received and equity markets subsequently rose. The country is now beginning to prepare for elections likely to result in the inauguration of Japan’s seventh prime minister in six years. The Japanese 10-year government bond yield reached its lowest level in nine years (0.718%), as aggressive easing is set to continue until inflation targets are met.
ASIA PACIFIC/EMEA
FIXED INTEREST
Postive potential
Credit quality
Brazil’s central bank opted to keep interest rates unchanged at 7.25% in November, which ended a series of cuts since last year. Brazil is attempting to combat inflationary risks whilst facilitating domestic economic growth. The inflation target remains at 4.5% and the central bank feels the best way to achieve this is through longterm stable monetary conditions. Confidence indicators for China’s economy are at the highest levels for more than a year. Stock markets lifted after China’s manufacturing sector expanded for the first time in 13 months in November, as the figures fuelled speculation that a long slowdown in global output is coming to an end. In contrast, India’s GDP growth was dragged down by subdued manufacturing output growth of 0.8% on the year. Such low growth adds to the difficulty of reigning in the fiscal deficit.
Ongoing central bank stimulus, liquidity support and a general consensus that the ECB will inevitably do whatever is needed have brought more and more investors to the corporate bond market, where spreads have continued to tighten. As the year end approaches however, investors may start to see the credit market as overvalued and move into ‘safer’ investments. No constructive outcome has emerged from the fiscal cliff negotiations and underlying macro fundamentals remain weak. Core government bond yields have lowered across the board since October as the lacklustre forecast issued by the OECD may have spooked some investors back towards the perceived safety of core government bonds.
DECEMBER 2012
ECONOMIC AND INVESTMENT COMMENTARY
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Snapshot: Emerging markets to decouple in 2013 LGIM expects a modest cyclical recovery in emerging market (EM) growth in 2013, despite an anticipated slowdown in the US and ongoing recession in the euro area. This decoupling reflects the growing importance of domestic drivers of growth in the emerging world, rising intra-EM trade linkages and a more supportive macroeconomic policy environment. Domestic demand has been the main driver of GDP growth in the ‘BRIC’ economies (Brazil, Russia, India and China) since the middle of the last decade (figure 1). China has seen a trend decline in the share of exports in GDP since 2006, while Brazil remains a relatively closed economy, dominated by the service sector. Strong labour markets, robust wage growth, residential construction, infrastructure investment and expanding credit have helped generate internal growth momentum. Figure 1. Aggregate BRIC contributors to GDP growth*
Percentage points
12 10 8 6 4 2 0 -2 2001
2002
Consumption
2003
2004
Investment
2005
2006
Government
2007
2008
Net Trade
2009
2010
2011
2012F
2013F
GDP
Source: *GDP weighted at 2011 market exchange rates National Statistics offices, Datastraeam, LGIM
These factors should help cushion the impact of stagnant export demand in the advanced economies on EM growth. At the same time, a rising share of EM exports are destined for other developing countries – according to the United Nations, ‘South to South’ trade accounted for 54% of EM exports in 2010, up from 40% in 2000. Enhanced policy flexibility has also helped EM economies become more resilient to global shocks. Strengthened external finances, improved fiscal positions, less volatile public debt structures and lower inflation have created more room for counter-cyclical monetary and fiscal policies. A recent study by the IMF highlighted the beneficial impact that greater policy flexibility has had on EM economic performance in recent years (figure 2).
% of EM's with characteristic
Figure 2. Indicators of emerging market policy space 100 80 60 40 20 0 1970s
1980s
1990s
Single digit inflation High international reserves (> global average)
2000–07
2008–09
2010–11
Low external debt (
