Published December 20, 2012
This year has been one of double-digit gains in global markets, but for most global investors it has not felt so sanguine. That said, we are cautiously positive on the prospects for 2013.
Equities are historically cheap versus bonds, and if the ‘near death experience’ of the global financial system is behind us we can now contemplate a rocky path to normalization.
Longer-term, investors must position themselves for the reality of a growth- saturated world in which sustainable growth and innovation will become the primary drivers of performance.
Valuations are attractive
Although markets have risen this year, investor sentiment has remained cautious, at times defensive, and often driven by macro event risk rather than company fundamentals. This caution stemmed from the fragmentation related to subdued growth and low visibility as well as the process of giving life support to a global financial system undergoing deleveraging. It also resulted from the on-going structural pressures of demographics, climate change and the emerging market supercycle.
As the economy starts to normalize, including interest rates over the next two years, we are positive on the outlook. With equities extremely cheap compared to bonds, as witnessed by the equity risk premium, we expect companies to arbitrage between the two segments of the financing market to borrow, restructure or support M&A and investors will start re-allocating to equities after extraordinary profits in bonds.
Is Europe reaching a trough?
Good news in Europe has been scarce this year. It has been a very tough year from a fiscal retrenchment perspective and the impact this has had on growth: Europe is now officially in recession and the IMF forecasts a decline in GDP of 0.4% for the full year. However, in terms of the debt crisis, a lot of progress has been made. The economic conditions in peripheral Europe remain extremely tough but long-term structural problems are being addressed in most countries. Meanwhile, short-term market pressures are being eased by unprecedented policymaker action.
Ireland is addressing its banking sector problems, meaningfully reducing its deficit and is seeing modest growth. Portugal’s fiscal balance is also improving and like Spain, it is addressing competitiveness. It has a tough road ahead but will benefit from broad political backing for reform. Greece is making more progress in its agreement with its creditors than many expected at this stage, and a Greek exit, while still a possibility, is far less likely than six months ago. Recently Greece has posted three consecutive months of current account surplus. This is a significant achievement and suggests the controversial option of austerity might actually work!
Encouragingly 2012 could represent the peak year for austerity in Europe which would bode well for 2013. There is a change of tone among leaders and economists in favor of measures that promote growth without undermining the important progress of the last two years. Although in absolute terms the fiscal stance in the region will tighten in 2013, the pace of discretionary fiscal consolidation is likely to slow and tackling structural deficits rather than the headline deficits seems to have taken priority.
This is not happening everywhere. Although the French President highlighted the importance of growth initiatives, his September budget showed plans to fill 2/3 of the €30 billion gap through tax increases while targeting the large corporate sector. This has already impacted business activity and confidence while failing to address France’s sharp decline in competitiveness in the last decade.
A report by prominent French industrialist Louis Gallois laid bare the urgency of a major overhaul of tax and labor policy. Although the President is unlikely to take up many of the recommendations, he has recently announced a cut to payroll taxes of €20 billion. On its own this will not turnaround France’s declining competitiveness, but if it signals a policy shift it will be good news.
The supercycle is as strong as ever
Emerging markets have suffered this year from a mixture of slowing global demand and tightening measures aimed at cooling inflation. However, the emerging markets supercycle theme remains as relevant as ever and indeed the size of the emerging market consumer market surpassed that of the US for the first time this year, and is now worth $14 trillion.
With the global economy slowly recovering – and as risk appetite returns – prospects are improving for next year. According to analyst forecasts, global emerging markets will see GDP growth recover from 4.5% this year to 5.1% in 2013. This will support growth for companies with emerging market exposure wherever they are listed in the world.
The slowdown in Chinese growth has been a particular cause for concern as some investors have mistaken it for a ‘hard landing’ in our opinion. In fact, the slowdown has been necessary to achieve a more sustainable level of growth. GDP growth will likely improve next year as the new government team led by Xi Jing Ping gradually starts implementing policies. In recent weeks, a slew of key economic indicators have ticked up with manufacturing returning to growth, industrial output accelerating to 9.6% year on year and fixed asset investment rising.
China’s new leader is a pragmatic diplomat and could bring the second largest world economy to a more prominent global geopolitical role, more in-line with its economic power. This might entail a change in foreign policy over the next decade. While defense spending has grown at a fast pace, doubling since 2006, it is still small when compared to the US which is approximately six times larger in absolute terms. While we should not expect drastic change in Chinese military positioning in 2013, China’s ambitions in the South China sea should not be ignored and will shift geopolitics in Asia and potentially globally.
Will the US fall off the cliff?
The US, meanwhile, remains the bright spot in the developed market world. Economic data have been patchy but on balance set it in good stead for 2013 with the obvious caveat that the fiscal cliff needs to be dealt with in such a way that the economy continues to adjust without tripping. In particular the improvement in the housing market should continue which will have a positive impact on confidence, jobs growth and tax revenues.
The most likely fiscal cliff scenario is for a compromise involving fiscal consolidation worth around 1-1.5% of GDP which would dampen growth but is unlikely to push the economy back into recession. We should be open to the possibility that sequestration could be enacted in early January which would provide the sufficient catalyst for both parties to come to an agreement as the markets fear this eventuality.
Beyond 2013: positioning for saturation
Growth in the boom years was based on a resource-intensive model predicated on high levels of debt. The events of the last five years have proven this level of debt to be untenable, but it has been less widely acknowledged that it is also unsustainable from a resources perspective. The world population this year surpassed seven billion and by 2050 we are on track for a further 30% increase. Similarly, the pace of GDP growth has accelerated: as a result, resource usage has increased dramatically and commodity prices have risen.
To achieve forecast GDP growth, the OECD expects that 35% more food, 37% more energy and 70% more resources will be needed. Yet analysis by the Global Footprint Network suggests that we are already using planetary resources at 1.5 times the rate at which they can regenerate.
The depletion of the planet’s resources is not news. But the point is, it is misguided to believe the global economy has the means to return to such unsustainably high levels of growth given the environmental constraints and the need to re-build the economy without recreating the debt bubble.
This need not be a pessimistic endnote. On the contrary, there are abundant opportunities for investors to exploit but it may require a change in mind-set from the previous decade. Careful stock picking will be all the more important as investors understand how this slow-growth world will impact companies and look for investments with sustainable growth trajectories. Further, innovation will become an important differentiator as gaining the competitive edge becomes even more rewarding.
Given that the US and China have stabilized and will slowly improve in 2013 while Europe’s deterioration decelerates, the scope for global equities to perform in 2013 is, in our view, quite positive.
We should not ignore potential volatility in Europe or the Middle East, but given equity valuations, the appeal of increasing exposure to one’s portfolio or pension plan is strong.
Sectors such as industrials and commodities have been undermined by the fear of a global collapse and therefore provide attractive upside potential.
Keeping in mind longer-term issues is also essential to position the portfolios adequately for further structural changes as well as betting on companies with superior structural growth, top leadership teams and strong balance sheets.
Virginie Maisonneuve is head of global and international equities at Schroders.
The views and opinions contained herein are those of Virginie Maisonneuve, Head of Global and International Equities, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. For professional investors and advisers only. This document is not suitable for retail clients.