Citi Research and co-authored by Robert Buckland, Global Equity Strategist; Willem Buiter, Global Chief Economist; Tina Fordham, Senior Global Political Analyst; Matt King, Global Head of Credit Products Strategy; David Lubin, Head of Emerging Market Economics; Minggao Shen, Head of Research for China; Ed Morse, Head of Global Commodities Research; Ebrahim Rahbari, Economist, Global Economics; and Markus Rosgen, Head of Regional Strategy.
Most investors look forward to 2012 with a sense of cautious optimism that things will be brighter. This year looks to be one where we seek to get ourselves out of the doldrums and get our confidence back. We will encounter challenges on the path to growth – in addition to a certain amount of ‘baggage’ that we carried forward from last year, despite us wishing it would disappear with the turn of the calendar page.
Globally we expect the economy to grow 2.5% in 2012, down from about 3% in 2011 and from over 4% in 2010. Compared to a typical recession, today’s gross domestic product (GDP) growth is somewhat weaker than expected and unemployment is still much higher than one would expect to see at this point in the recovery.
Governments, households and financial institutions are working to pay down debt levels that have been building up over the past 30 years. The question that needs to be answered is whether the world can deleverage without this having a knock-on effect on asset prices and economic growth. We think confidence could be the determining factor.
The crisis in Europe continues to be a drag on the global economy, with the sovereign and banking crisis likely to lead to a protracted recession in the eurozone. Although the euro area will be under intense strain, we believe it will likely remain intact and, given the high costs of exit for any member country, a break-up of the eurozone has less than a 5% probability.
Despite the obvious macro headwinds, global corporate earnings and cash flow continue to grow at a solid rate. While these are typically a positive sign for investment and job growth, high levels of volatility and ongoing uncertainty of late have resulted in a noticeable slowing of capital expenditure (capex) investment by corporates over the past two years. With the cost of equity high and the cost of debt unusually low, corporates have instead been using cash to buy cheap equity or pay big dividends. Although this should continue to support stock prices going forward, it remains to be seen if economic growth can recover without an increase in capex to fuel job growth.
Discussion around tail risks will continue to make headlines in 2012 as investors and corporates worry about the potential of the ‘next shoe to drop’. The fate of the Chinese economy and whether its growth engine can continue to drive global demand is a concern, but we believe rebalancing to promote structural and marginal demand would lay a solid footing for continued growth.
2012 Investment Themes
1. Europe: crisis outlook
We expect the euro area sovereign debt and banking crisis to intensify further in 2012. We do not, however, expect the euro area to break up in 2012 or the following years, nor do we expect the disorderly default of a euro area sovereign. The risk that either or both of these disaster scenarios materialise is, however, non-negligible.
In our central projection, two or more insolvent sovereigns (Greece, Portugal and possibly Ireland) undergo orderly debt restructuring in 2012-13. We also expect a ring-fencing of the illiquid but most likely solvent sovereigns (Italy, Spain, Belgium, France and Austria) through greater European Central Bank (ECB) involvement, enhanced euro area-wide fiscal facilities and extra-EU assistance, most likely organised through the International Monetary Fund (IMF).
Incremental fiscal tightening, structural reforms, tight financial conditions and a continued ‘uncertainty overhang’ will strongly weigh on domestic demand and push the euro area into recession in 2012. We also expect a further GDP contraction in 2013. Then and thereafter, very loose monetary policy and external demand will prop up growth, while domestic demand is likely to remain weak.
2. Global politics: vox populi
2011 was, from a political perspective, a ‘year of living dangerously’, dominated by the collision between sovereign debt dynamics and weak leadership in the developed world, political change and conflict in Middle East and northern Africa (MENA), and rising social unrest globally. 2012 is shaping up to feature the continuation of these themes plus two more: a concentration of elections and leadership transitions in some of the world’s largest economies, and rising geopolitical tensions.
In our view, the risk from this more unstable political outlook against a worsening global economic backdrop, as well as growing scepticism that politicians possess the will or the capacity to act, will bear great significance for markets. The post-financial crisis recalibration between government, society, and markets is still evolving.
3. Payback time: de-lever decade
Over the past 30 years, the global economy has produced strong and steady GDP growth accompanied by a rally in asset prices. This growth, however, has been accompanied by an increase in borrowing. Given the current economic climate and the recent focus on sovereign debt and on debt in general, it is increasingly clear that the next 10 years are unlikely to see debt levels increase.
The question that needs to be answered is whether we can run the process in reverse – deleverage – and not have a knock-on effect on asset prices and economic growth. The good news is it’s all about confidence. The bad news is that this makes for a very uncertain environment. This is positive for fixed income investments, which over an extended time horizon seem likely to offer better risk-adjusted returns than riskier vehicles such as real estate or equities.
4. Lost decade: how to survive
Many investors are of the view that major developed economies are on the threshold of a ‘lost decade’ – a long period of low growth – as governments, households, and financial institutions work to pay down debt. Surprisingly, equity market performance in ‘lost decades’ has not always been poor. Companies that have done best during these ‘lost decades’ share common characteristics. They look for new sources of demand, they have pricing power, they are effective in managing costs, and they de-equitise. So if we are at the beginning of a lost decade, we estimate regional allocation should be overweight those markets where there are clear signs of inflation, attractive valuations and rising earnings per share (EPS).
Within this context, we view the UK as well placed to survive a lost decade. Our simple framework highlights why equities in the European Monetary Union (EMU) periphery could be exposed if economic growth remains sluggish. Unlike the US or UK, the European periphery does not have its own central bank or currency. Therefore, these countries cannot rely on easier monetary policy and weaker exchange rates to help deliver nominal growth supporting company profits and stock prices.
5. Financial repression: good in emerging markets
One idea gaining visibility these days is that the best solution to the developed world’s debt problems may be ‘financial repression’. This refers to a family of policies – interest rate ceilings, reserve requirements, capital controls, transaction taxes, liquidity requirements, regulatory bullying and outright state ownership – designed to create a financial system that is more inclined to assist a government in refinancing its debt. Assuming that advanced economic policymakers move steadily back to the future to create a financial system that acts more like a captive market to absorb government paper, we ask the question: how would policymakers in emerging market economies view all this?
Roughly speaking, we think the answer is: quite favourably. First, there is plenty of emerging market economies that are already financially repressed, and whose policymakers would likely be reasonably happy staying that way. A second reason has to do with global capital mobility. A move towards financial repression by developed market policymakers could set the stage for more limited global capital mobility, and since this could reduce the risk of ‘destabilising speculation’ in emerging market currencies, it is likely to win support among many emerging economy policymakers.
6. De-equitisation: truly global
De-equitisation is now a truly global theme that is being reported by all of Citi’s regional strategists. It is about companies returning capital to shareholders through buybacks, dividend increases and cash/debt financed merger and acquisition (M&A). The rationale to de-equitise has hardly ever been stronger, especially in lowly rated developed markets. Even in some emerging markets, which have traditionally been areas of significant equitisation, Citi strategists report that companies are looking to accelerate capital returns.
The capacity for companies to support their share price through capital returns has helped limit the downside in stock markets through the early autumn, in our view. As the benefits from de-equitisation remain compelling, we believe that they will continue to be ready buyers, even if investors are not. This corporate demand for equities should continue to support stock prices going forward.
7. Asia: dividends or buybacks?
In the developed markets, corporates engage in M&A, buybacks and pay dividends.
In Asia, two out of these three options are a rarity, but dividends are available. The family ownership structure that is prevalent through Asia makes hostile takeovers nearly impossible, and in the same vein it makes share buybacks difficult. The easiest way to keep harmonious relationships among the family is through the payment of dividends. That explains why 93% of companies in Asia ex-Japan pay them. Over the past 10 years, dividend investing in Asia has led to outperformance. Dividend investing has outperformed growth. With dividend coverage and free cash flow high, dividends are not under threat in Asia.
8. China: rebalancing required
China enters the second year of the 12th five-year plan facing tremendous external headwinds; the euro area is expected to fall back into recession, reducing demand from China’s biggest external
market; growth in the US will likely remain subpar, increasing the chances of trade and currency related frictions; domestically, a hard landing can be avoided, but major structural hurdles need to be removed to ensure a smooth migration to a slower but more balanced growth environment; and leadership changes during the period pose both uncertainties and opportunities.
Against this backdrop, the economy could hit a soft patch in early 2012, coinciding with a property market adjustment and external weakness. In preparation, the focus of macro policies has already shifted from anti-inflation to growth stability. We expect prudent monetary policy to normalise liquidity and proactive fiscal policy to forestall downside risks. We forecast growth to slow to 8.4% in 2012, and see a deeper-than expected euro area recession, QE2 in the US and, undershooting of property prices as the main risks to our growth forecast.
9. Oil in 2012: risky to growth
Oil demand is largely a function of GDP growth and the impact of oil prices is visible in the changing ratio between the two. One of the persistent themes is living through 2008 all over again and that seemingly robust oil market fundamentals are going to give way in the face of a rapidly deteriorating macro environment. We look at the world rather differently and instead believe that oil could pose a significant threat to the macro environment. The redundancy in the system is slim and the threats to supply are many. In addition, the long list of world geopolitical issues involve significant threats to major portions of the world’s oil supply, such that the risk of an oil price spike is significant in 2012.
Despite the risks, we expect prices to be range bound between US$100 and US$120 and averaging US$110 in 2012 and US$120 in 2013. Simply put, we think that oil supplies are constrained for the next two-three years, as we just do not see enough liquid supplies coming to market to allow for unconstrained demand growth.
10. Gold: where to now?
Gold has performed outstandingly from 2009 to 2011, with a compound annual growth rate (CAGR) of over 25%. This has been a function of its special status as a universally accepted medium of exchange and financial store of value.
In our view, during periods of macrofinancial uncertainty (which we expect to continue for the foreseeable future), there are three major macro-financial factors that should drive nominal and real gold returns:
- Denomination effects from inflation and currency adjustments.
- Real interest rates.
- Financial demand for gold as a safe haven and source of liquidity.
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