Global cyclical slowdown keeping policymakers on alert
Financial markets are assessing the current slowdown in global economic growth and the prospects for additional global monetary accommodation. In the context of a dis-inflationary backdrop, it is likely that central banks in developed markets will continue their accommodative stance. In Europe, expectations have been rising with regard to a looser monetary stance by the ECB. In emerging markets, the monetary outlook remains fairly mixed due to structural reasons e.g. excess credit creation in China. Whilst the U.S. equity market is pressing against a four year high, we are tactically selective in our risk exposures as there may be further global cyclical risk which is currently under appreciated. As such, we maintain our focus on income generating instruments (MBS) and late-cycle equities with healthy balance sheets and steady dividend growth.
As we can see below, global cyclical data has been softening. The growth outlook remains challenging in Europe and emerging markets have lagged vs. previous business cycles. Interestingly, countries such as China, Russia, Brazil and India are lagging in areas that should drive their future growth i.e. consumption in China, manufacturing in Russia and Brazil, and investment in India. Therefore, apart from weak developed market aggregate demand, the global economy is facing some structural hurdles in emerging markets. Thus, from an investment perspective, we are monitoring the durability of the current business cycle which is now well into its fourth year. We prefer exposures to late-cycle and secular growth themes such as healthcare, software and commercial aerospace. We also have a preference for large-cap and mega-cap equities that have healthy balance sheets and the capacity to grow their dividend streams.
In the U.S., we closely monitor credit conditions. To be sure, a well-capitalized banking system, a recovering housing market and corporate balance sheet rebuilding are encouraging factors. The U.S. consumer is also at an advanced stage in its debt deleveraging process. However, we note that despite an accommodative Federal Reserve, credit creation appears to be slowing down. Housing activity has been firm but we note that business expenditures remain tempered. Therefore, the U.S. growth outlook remains in an uneven trajectory and the labor market in particular is still showing signs of weakness; as displayed by the declining participation rate. In our view, the acid test is whether further monetary accommodation can be effective in the face of structural hurdles e.g. aging demographics and a broad deficiency of labor skills that are needed in a high value added U.S. economy. At a minimum though, we expect the low rate environment to persist in the context of a low growth and low inflation backdrop. Thus, we expect strong demand for income generating instruments such as MBS.
In Europe, with growth and inflation slowing, government bond yields continued with their decline. In Spain and Italy, we attribute some of the decline in yields to increased purchases by domestic banks and pension funds. Economic fragmentation, rising unemployment rates and elevated non-performing loans are ongoing issues in the Eurozone. We remain skeptical that growth can rebound solidly without fiscal burden sharing and extensive bank recapitalizations in Southern Europe. In our view, ECB balance sheet expansion alone cannot revive credit creation without political compromises and reforms in core economies such as Spain, Italy and France.
In equities, we are monitoring the relationship between emerging market equities, energy prices and the USD. Further USD strength may pressure the cost of USD denominated funding to emerging market economies. In such a scenario, global growth may face further headwinds. From a U.S. equity perspective, the 2013 rally has continued, with the majority (73%) of S&P 500 constituents beating Q1 2013 EPS expectations. We note however that the pace of revenue surprises has declined in Q1 to 40%. Therefore, at this stage of the business cycle, we remain selective in our sector and stock selection; with a preference to late-cycle sectors such as healthcare that offer us better earnings visibility. Moreover, we continue to assess the cyclicality of operating margins as labor costs appear to have bottomed. Lastly, from a technical perspective, we note that elevated levels of margin debt may be pointing to market complacency.
In conclusion, the global growth outlook remains challenging and policymakers need to do more in dealing with structural hurdles such as fragmented credit conditions in Europe and economic transitions in emerging markets. From our perspective, in a zero-rate environment, we maintain our focus on income generating instruments and dividend growing large-cap equities.
Christos Charalambous CFA
Senior Strategist
christos.charalambous@edgewealth.com
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