Overview
The debt ceiling and threat of a U.S. government shutdown have come and gone (for now), while sequestration has come and stayed. And still, the market rallies.
There is a clear sense that “things are improving”. To us, it’s not so much that the economy has improved but rather that the number of visible crises has abated, which has permitted investors to recognize 1) that key fundamental forces have been and remain relatively positive, and 2) there are few obviously profitable places to put one’s money.
So, is there anything scary left under our beds? We’re watching slowing earnings growth, reduced fiscal stimulus, Europe and emerging markets weakness.
North America
Tony M. Caxide, CFA®
Chairman - Senior Investment Council
U.S. growth remains OK, reined in by debt reduction. The private sector is well on its way. The public sector started longer ago and has progressed further than most believe, but it has a long way to go. At the federal level, deficits have fallen from 10% of GDP to a near 4% pace. This “tight fiscal policy” hurts growth near term but reduces economic risk, which investors like.
Other factors remain supportive. Monetary policy remains as positive as ever. Commodity prices fell by over 20% in the last two years. Private-sector balance sheets are much stronger. Our banking system is well capitalized. And we are sourcing less of our energy from volatile regions. What’s not to like? Well, valuation has come from cheap to fair while earnings growth is slowing.
Japan
Jeffrey G. Wilkins,
Deputy Chief Investment Officer
Japan’s new Prime Minister, Shinzo Abe, has deftly set Japan upon a bold new path of significant monetary easing, including the purchase of longer-maturity and riskier assets by the Bank of Japan, in his efforts to end deflation and return Japan’s economy to sustained growth. While structural reform is still needed for Japan to be competitive longer term, the results of “Abenomics” have been remarkable in the past several months alone. Since Abe took office in December, the yen has depreciated over 23%, making Japanese exports that much more attractive, and the Topix has appreciated over 55% in anticipation of a re-inflation of Japan’s economy and corporate profits. Several economic indicators are also beginning to improve.
Europe
Jeffrey G. Wilkins,
Deputy Chief Investment Officer
Europe’s economy remains mired. The recently released negative first-quarter GDP report is the sixth consecutive contraction.
Past efforts to bring budgets into balance have focused on fiscal tightening – higher taxes, fewer government expenditures. Recent discussions, however, are more focused on stimulating the economy. The European Central Bank’s willingness to buy bonds on the open market and the reduction in the Refi rate to .5% are steps in that direction. Plus, not all has been lost from the tightening. Many decades-old social norms have changed (later retirement age in Italy, fewer mandatory paid vacation days in Portugal), which is already leading to improvements in productivity in the much-maligned “periphery countries”.
UK
Jeff (Shengde) Liu, CFA®
Managing Director, Portfolio Management
The UK avoided a triple recession, as the first-quarter GDP remained positive. March industrial production rose more than economists forecasted. The property market is showing signs of recovery after officials started the Funding for Lending Scheme. And other indicators, from house prices to PMI indexes, all suggest that the economic recovery gained some momentum.
Although there are some doubts whether this momentum can be maintained, we believe the loosening monetary policy will continue to provide cushion to the economy. Several indicators point to improving UK corporate earnings from the trough last year. As a result, we maintain our neutral weight with an up bias in the UK in our more risk-tolerant strategies.
Emerging Markets
Jeff (Shengde) Liu, CFA®
Managing Director, Portfolio Management
Signs of improvement in emerging economies at the end of 2012 did not continue into 2013. China’s economic growth lost momentum in the first quarter, and Xi’s anti-corruption campaign may also be creating uncertainty and hampering demand. Trade balances from India to Indonesia and Brazil to Mexico all deteriorated due to continued weak demand from Europe. A longer-term concern hovering over investors’ minds is the possible secular increase in labor cost. Average pay in emerging Asian economies doubled between 2000 and 2011, compared with a 5% increase in developed countries (Bloomberg, April 3, 2013). Brazil also suffered a profit squeeze due to high wages and government-inflicted business costs. As a result, emerging markets (EMs) have underperformed year to date.
Even as we note economic sluggishness in EMs, we also observe that valuation appears cheap. We’ll continue to watch these developments closely