A cautious step forward

A cautious step forward

* We see signs that the two major downside risks that have been weighing on markets
– the euro area sovereign debt crisis imploding and the global growth slowdown –
are abating.
* Whilst we recognise that these risks remain substantial and do not expect any “silver
bullet” solution, we recommend that investors take the first steps toward careful
and directed market re-engagement.
* We favor assets with significant yield, low leverage and that are relatively insulated
from euro area risks. There are a number of sectors within US investment grade
credit that fit this description, and we now favour credit over equities more generally
on valuation grounds.
* But even under the best of circumstances we do not believe that markets are set to
stage a recovery anywhere near the magnitude of that which began in March 2009:
Market valuations are not as depressed, there are significant headwinds to mediumterm
growth prospects, and solving the euro area debt crisis will be a long and
difficult process.

We recommend that investors take the first step toward market re-engagement. To be sure,
the two major downside risks – the euro area sovereign debt crisis and the global growth
slowdown – that led us to recommend a neutral stance towards markets for the past six
months have not been resolved. Moreover, market volatility remains quite high and investor
sentiment and willingness to engage in markets has sunk to rock-bottom levels. This,
however, should not obscure the fact that there are signs of progress being made both on a
solution to the euro area crisis and on clarifying the course of global growth. Most
importantly, for the first time since the euro area crisis began, we see the building blocks of
a framework for a sustainable solution, one that potentially has the support of all the major
eurozone countries. This is not likely to be a silver bullet – certainly not a “bazooka” – and
the road will be long and full of pitfalls. But with the German government committed to the
euro and working with France to agree on enforceable fiscal rules, and with hints that
success on that front would allow for more significant official support for Italian and Spanish
bonds and eventually some form of “Eurobonds”, catastrophe seems increasingly unlikely.

As for growth, it has not quite hit bottom, but it is holding up better than feared and the
makings of a bottom and rebound by the spring are beginning to come into focus. The US
economy, which led the slowdown last spring, has begun to reaccelerate, suggesting a
reassertion of traditional global recovery patterns in which the US leads. Emerging
economies in Asia and Latin America, which experienced policy-induced slowing, have
started to ease aggressively. And while the euro area appears to have entered into recession
this quarter, the ECB looks ready to step up and support growth and financial market
liquidity in a serious fashion. It is also worth noting that European economic swings have
never been a major driver of the global cycle. Global growth, thus, increasingly looks as if it
is passing through a mid-cycle slowdown, with a turn for the better not far ahead. While the
rebound is unlikely to be dramatic and its duration is open to question, even modest
improvement will put to rest fears that we are heading for another global recession.

The mere containment of these negative tail risks should be enough to trigger the start of
investor re-engagement with markets after the turn of the year. Investors now have
extremely limited risk exposures and there are exceptionally favorable valuations available in
a number of asset classes. Experience shows that you don’t make money in financial
markets waiting for every “i” to be dotted and “t” to be crossed, and we believe that now is
the time to look for assets whose valuations have become attractive.

We favor assets that offer significant yield, low leverage and that are relatively insulated
from euro area risks. Investment grade nonfinancial US credit largely fits this description, as
nonfinancial US corporate balance sheets remain quite healthy, profits are strong, the US
economic backdrop has improved and spreads are historically wide. More broadly, the
recent underperformance of credit relative to equities leads us to shift our asset allocation
recommendation toward a preference for high quality credit, even as liquidity in the
secondary sector is likely to remain scarce due to regulatory uncertainty. We remain
underweight banks in general owing to regulatory and mortgage liability risks as well as
their sensitivity to the euro area debt crisis. However, we see some compelling valuations in
the debt and equity of insurance companies – whose prices have been hit along with the
rest of the financials – that have limited funding risk and balance sheet exposure to
peripheral Europe. We have shifted from overweight to neutral on US and emerging market
equities. US economic improvement seems at least partly priced in and fiscal risks are likely
to continue to weigh on the market. In EM, the long-term case for equities owing to
superior growth prospects remains intact, but it will take time for the recent shift from
tightening to easing to offset continued economic weakness. We expect equity volatility to
remain high, and suggest some strategies to take advantage of that, such as covered calls
on existing European equity positions. Meanwhile, rates on risk-free assets – those that are
left – are expected to rise as economic and sovereign risks abate somewhat.

The road map for the euro area
Investors have become jaded by the repeated failures of European policymakers to solve the
euro area debt crisis. A number of summits have come and gone, each one promising far
more than it delivered, causing financial market pressure to increase and spread to
systemically critical countries such as Italy and Spain. As a result, many investors are
starting to prepare for the worst, and this has contributed to the lack of engagement in
markets and associated illiquidity and volatility.

To be sure, the problem is complicated and not easily solved, Many have called for the ECB
to save the day with massive purchases of Italian and Spanish debt, but the central bank has
refused to do that, and that alone would not have solved the problem anyway. There is little
doubt that bringing down the debt yields of Italy and Spain is a key component of the
solution, but if investors are not convinced of the viability of the debt itself they will not buy
it. Without private demand, there is no sustainable solution, since it is unrealistic to expect
the central bank to buy all of the sovereign debt of individual member countries. What is
needed is an enforceable fiscal framework to assure investors that Italy and Spain will
pursue policies that will return them to a position of fiscal sustainability (i.e., enable these
countries to make good on their debt).

What has caused us to become more encouraged is that for the first time since the crisis
began there is an effort – led by Germany – to accomplish just that. In fact, Germany and
France are expected to present a plan for enforceable fiscal discipline for all euro area
countries at this week’s summit. In addition, the rise in yields has forced political change in
all of the peripheral countries that increases the chances that they can muster the political
support to implement the needed fiscal changes.

Unfortunately, the rise in yields also means that a widely accepted and enforceable plan to
adhere to strict fiscal guidelines among all euro area countries may not be enough to solve
the crisis. That is because bond yields of Italy and Spain have reached levels that are
inconsistent with fiscal sustainability. Unless investor confidence increases enough in
response to progress on fiscal coordination to bring these yields back down to the levels
prevailing before the summer, official financial support – coming from some combination of
the ECB, the IMF and the EFSF – will be necessary. Fortunately, there are signals – albeit no
assurances – that this would be forthcoming should strong and enforceable fiscal rules be
accepted and passed by the EU countries.

We do not mean to suggest that a solution will be easy or quick, especially with 17 euro area
countries involved. Even if enforceable fiscal rules and stepped-up financial support moved
forward, there would still have to be increased coordination for euro area debt financing –
some form of collective borrowing or Eurobonds – for a solution to be sustained over the
medium term. Encouragingly, there are also indications that German opposition to collective
financing would be softened if enforceable fiscal rules were put in place, and if individual
countries were able to provide credible guarantees (e.g., committing specific tax revenue
streams) that the debt would be paid down over a reasonable period of time. Moreover,
even though the implementation of these plans would take years, agreement on them by
the major euro area countries could well be enough to restore investor confidence and thus
provide needed relief to financial conditions. That is critical, since the erosion of investor
confidence in euro area sovereign debt has resulted in a deterioration in financial conditions
in the region – including bank funding problems, bank de-leveraging and credit strains –
which in turn, along with ongoing fiscal tightening, have plunged the region into recession.
Declining economic activity exacerbates fiscal problems, meaning that significant progress
in solving the crisis needs to come soon. “It has to get worse before it gets better” no longer
applies: things have gotten bad enough, and the time for action is now.

Mini-cycle approaching a bottom
The slowdown in growth that has rolled across the global economy over the past nine months
had a number of distinct causes. The US was the first to slow, somewhat surprisingly since it
did not face either significant policy tightening – as did most of the rest of the world – or
deterioration in financial conditions, as did Europe. The jump in oil prices, cutbacks in state
and local government employment (which averaged 40,000 per month for six months),
supply chain disruptions from the earthquake in Japan and a modest inventory cycle all seem
to have contributed. These hits have all either partially reversed or faded and US growth is now
showing clear signs of improvement. With inventories low and falling as Q4 began and
consumer spending and labor markets picking up, a quarter or two of stronger growth seems
very likely. The one remaining worry is the expiration of various stimulus measures on January
1. But with the Administration and both sides of the aisle in Congress agreed that the payroll
tax cuts and unemployment insurance should be extended, it is highly unlikely that undue
fiscal tightening derails the expansion, at least before next year’s general election.

Growth in Latin America slowed sharply in Q3 and softness is persisting in Q4. In emerging
Asia – particularly in China – growth held up longer, but a sharp slowing is under way now,
in manufacturing and in construction. In both regions the slowing was self-induced as the
authorities tightened policy to contain inflation, and in both cases they are stepping up
efforts to reverse the tightening to support growth. In China, declining real estate prices and
an increase in bankruptcies have spawned fears of a hard landing. But these problems can
be contained, as the balance sheets of households, banks and the public sector remain
healthy and leverage is far from excessive. While it will take several months before policy
easing efforts bear fruit, policymakers have the wherewithal and there is every reason to
believe that they will be successful in achieving their growth objectives.

In the euro area, the failure of the authorities to deal promptly with the crisis led to a
significant tightening of liquidity and a deleveraging process across the banking system is
now under way. This added to the downward pressure on the euro area economy already
coming from fiscal tightening, and we now believe that a mild recession has begun, with
negative growth in Q4 and Q1, before stabilization next spring. The risks of a sharper or more
extended contraction are significant, as the amount of bank deleveraging needed to meet
new capital requirements is substantial (see Euro area bank deleveraging: How much and
how painful?, 22 November). Nevertheless, we believe that with increased support from the
ECB and the German economy still showing underlying strength a severe European recession
is likely to be avoided, especially if there is progress toward a resolution of the crisis.
With increasing confidence that the next move in growth is up in most of the world outside
of the euro area and diminished risks of disaster in Europe, the probability of a global
recession has declined significantly. The current growth slowdown is far more likely to
prove to be no more than a mid-cycle correction (Figure 1) – admittedly one that has
triggered widespread fears of worse. The next move in growth will be up, and although it
may be little more than a wiggle, it will be significant in that it should calm current fears of a
global double dip.

Recent slowdown likely temporary

No clear sailing ahead
While we have become more optimistic about the growth outlook and prospects for progress
toward a solution to the euro area debt crisis, we are not ready to send out an all-clear signal
for markets because the risks, while looking better, are still significant, especially in the euro
area. Moreover, even under the best of circumstances we do not believe that markets are set
to stage a recovery anywhere near the magnitude of that which began in March 2009, when
the biggest recession since the Great Depression ended. That is because the markets have
come a long way since then and there are still significant headwinds to both global economic
growth and market performance. While we believe in a soft landing in China, we do not expect
the double-digit growth observed in recent years to continue in the years ahead. Policymakers
are aiming to achieve a gradual and controlled slowdown that reduces excesses in investment
and construction spending and weans the economy off its dependence on trade. More
broadly in emerging markets, policy never really became restrictive enough to bring inflation
down sufficiently, suggesting that it will be tightened again once the global economic recovery
is re-established and sufficient progress is made on the euro area debt crisis. Meanwhile, the
US recovery will not become a normal, full-fledged economic expansion until the housing
industry begins to return to normal (see US household balance sheets: What’s the problem?, 7
October) and, depending on regulatory developments, this could take some time. More
broadly, the developed world still faces significant excess sovereign debt, implying that fiscal
tightening will be the order of the day over the medium term, which, along with negative
demographics, will dampen growth prospects. On the financial side, the deleveraging of the
banks in Europe and the uncertainty surrounding new regulatory reform in nearly every region
of the world are likely to limit global bank credit expansion. Finally, geopolitical risks in the
Middle East and North Africa have not subsided, and remain a persistent threat to oil supplies
and hence the global economy.

In sum, we expect fears of double-dip recession and financial and economic implosion due to
a euro break-up to fade as we go into the New Year. While global risks remain substantial,
investors have already taken precautionary positions in response, and we believe that this
calls for careful and directed market re-engagement. But beyond the next few months, the
resumption of a rather tepid recovery in the developed world, growth in emerging markets
that is likely to be somewhat slower than seen in recent years, and a financial sector
adjusting to lower leverage ratios and new rules of the game suggests that financial asset
returns will be significantly lower over 2012 than those seen since the beginning of the
recovery in March 2009.