Despite the gloomy reactions to US economic data during the summer, the US should outperform Europe on account of a narrowing trade deficit in the third quarter. With recessions in the south very likely, Europe is relying on export-dependent Germany. However, consumption growth there remains too weak to support strong economic growth in the currency union.
While stock markets should close the year higher, growth moderation is not sufficient for a sustained stock market correction. Yet, bond markets are due for a correction as record-low yields on high-quality debt are pricing in a relapse into recession.
To the relief of many, the world economic recovery continues and, for the current year, the major industrialised economies are likely to record positive growth rates ranging from 1.5-3%, with growth rates moderating in the second half of the year. Despite these positive notes, there are signs of a slowdown in US economic growth and these have come surprisingly early. Despite a change of trend in the labour market, the private sector is still not creating enough new jobs to boost consumer spending and push up tax revenue, but it is likely that special factors are concealing a more solid underlying picture. Judging from the expenditure breakdown of US gross domestic product (GDP) in the second quarter, economic growth was pulled back as a result of unusually high imports that are likely to be reversed in the current quarter.
In the post-war era, two double dip recessions occurred, first during the oil crisis of the 1970s and then again in the 1980s, thanks to Volcker’s disinflation measures. In order to prevent a third such occurrence, the Federal Reserve (Fed) adopted a more flexible stance. At the Federal Open Market Committee (FOMC) meeting in August, the Fed departed from its exit strategy in favour of liquidity management, focusing instead on maintaining the size of its own balance sheet rather than following the traditional targets of inflation and interest rates. For many market participants this was not enough, but the Fed’s liquidity-supporting securities holdings looked set to be held steady for the foreseeable future. In September, the Fed added that it was ready to be more aggressive, if needed. Furthermore, the corporate sector, armed with healthy balance sheets and high cash reserves, is on a growth trajectory – buoyant capital spending is modernising the economy, investment is being stimulated by the low level of interest rates in comparison with attractive returns on equity.
As we head into the fourth quarter of the year, it cannot be denied that Europe has generally surprised us, in a positive way. However, the debt crisis will soon put the brakes on the European recovery with a sluggish 1% growth in GDP after a weak first quarter. At first glance, the only convincing performer is Germany as its exports expand vigorously. However, despite being the fourth largest economy by nominal GDP, Germany alone cannot sustain the eurozone’s recovery and we can expect export growth in Germany to decelerate, revealing a weak underlying economic structure in Europe. Most importantly, the banking sector remains vulnerable to the sovereign risks in the south, and in the north, the Irish banking sector suffers from an ongoing correction in the national housing market and ongoing competitiveness is another factor. A relatively high inflation rate makes it impossible for the country to profit adequately from the weak euro.
Asia on the Rise
As the European outlook seems bleak, emerging Asia’s star seems to be rising, as the growth differentials to the US and Europe continue. Positive signs crop up across the region as economists in Singapore and Indonesia debate the inflationary impact of rising house prices and full capacity utilisation. While China has managed a soft landing, and growth appears to be picking up again, relatively closed economies such as Indonesia can use their monetary policy to manage their economies after their external debt levels have fallen over the past few years. Furthermore, trade is shifting from industrialised countries to Asian neighbours.
In addition, Asian growth should be shifting to domestic consumption, seeing that the conditions for that are in place. Over the past 20 years, Asian emerging countries have seen a significant increase, and should continue to rise further in the near future. China, among others, may be approaching a turning point. At the beginning of industrialisation, the primary sector had a seemingly endless pool of employees, and this ‘excess supply’ prevented excessive wage pressure in the tertiary sector. As the pool of the traditional sector workers continuously shrinks, however, there is a certainty that wages will rise, despite wage increases having been traditionally smaller than growth in productivity. This is especially relevant as the number of young employees is expected to fall by a third over the next 12 years. Along China’s coast, where industrialisation began, large companies have recently increased their wages significantly. As a result, consumption quota will increase. The share of consumer spending is only about 36% of the Chinese GDP, making it the lowest value among major economies. By way of comparison, the rate in the US stands at approximately 70%.
Since the publication of weak macro numbers in the US, investors have been agonising over whether this surprisingly early weakening of economic growth might herald a renewed slide into recession. If it does, equity markets will find it hard to maintain their current levels. Encouraging first-half corporate results and low equity valuations would not be enough to prevent an equity market correction, though they should limit the scale of the losses. Otherwise, the predominant mood of scepticism among investors will provide interesting opportunities for investment in equities.
Reaping the Profits of the Asian Rise
Investors who want to benefit from the rise of the Asian middle class and growing private consumption in emerging countries should be very selective. Index investments consist of 20-25% export-oriented and 30-35% financial equities. In addition, local companies are not the only winners as US or European companies have become the main beneficiaries in some industries, such as luxury goods. With that in mind, a broad diversification is essential, particularly when investing in emerging market equities. A basket consisting of a large number of the most promising companies would be an appropriate solution.
Current yield levels suggest that bond investors are expecting a relapse into recession accompanied by deflationary tendencies. This appears overdone. Hence, the G7 bond markets are expensive and a correction is overdue. Bond investors should take this possibility into account in their investment decisions, hold an underweight in government bonds and keep their maturities relatively short.
A significant fall in inflation expectations in recent weeks was an important factor in pushing yields down. Many investors adequately appear to have put aside their inflation worries.
Looking at the current evidence in the market, it is unlikely that there will be further substantial falls in inflation expectations. The price of wheat will soon cause a slight acceleration in food prices and consumer price indices are normalising now that the low oil price in spring 2009 is dropping out of the calculation. While US banks are slowly relaxing their lending standards, planned VAT increases will push up consumer price inflation in some countries, at least in the short term.
Emerging Asia currencies have probably seen most of the appreciation this year and the central banks across the region are postponing further monetary policy tightening. Recently, the central banks of Korea and Indonesia stayed below expectations, which reduces the upward pressure on most currencies, except the Chinese renminbi (RMB). As for how the RMB will develop, that will depend highly on the politics of the currently tense US-Chinese relations prior to the mid-term elections in the US.
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