2Q Reality Check...

1Q12 was a quarter that defied expectations. Despite simmering tensions in Europe over its sovereign debt crisis, financial markets built on the momentum that had begun in November last year to propel risk assets higher.

At the start of the year, we forecast that 2012 would be more favourable to risk assets and pointed out that valuations were attractive and with central banks keeping monetary stance accommodative, all that was needed was for risk premium to recede. We got that bit right except for the timing. We were initially expecting better times only during the latter part of the year. But global equities roared back with an 11% gain in USD terms during the first quarter capping one of its best starts to the year in a decade.

Notably, for the period, most major asset classes – equities, credits and commodities – appreciated. The exceptions are government bonds and the USD – the typical bastions of global safe haven. Clearly, this is an indication of a better risk taking environment. Three major themes have dominated global markets during this period which resulted in lowering risk premiums that we had expected.

First and foremost, the critical point in the European sovereign debt crisis seems to be behind us. The risk of a break-up of the Euro-zone and an implosion of its banking system have receded dramatically after the actions of the European Central Bank (ECB) to pump money into the banking system as well as the successful and orderly restructuring of the Greek government debt. Additionally, the Euro-zone governments have also agreed on raising their financial firewall to 700 billion Euros by combining the temporary European Financial Stability Facility (EFSF) with the new European Stability Mechanism (ESM).

The second big factor was action by the major central banks to continue to flood the financial system with liquidity. The ECB has effectively staged a back-door quantitative easing (QE) by lending over 1 trillion Euros to European financial institutions with two tranches of three-year funding operations, or LTROs in December and February. Meanwhile, in January, the US Federal Reserve took a historic step by setting an inflation target of 2% and at the same time signalled its intent to keep interest rates near zero until late 2014 and did not rule out a third round of QE. And across the Pacific Ocean, the Bank of Japan (BOJ) unexpectedly added 10 trillion yen to its quantitative easing while taking a leaf from the Fed, also announced an inflation target but at 1%. These actions by the G3 central banks effectively set a dovish tone to global monetary policy in the foreseeable future.

Third, but not least, is the stronger than expected economic recovery in the US even though the current pace still pales in comparison with most other recoveries, including the one following the Great Depression. Both the manufacturing and services sector indicators have continued to signal expansion while the housing market has bottomed. More importantly, the unemployment rate has come off from above 9% since October with more than 1 million jobs created since then. Consequently, consumer confidence has recovered and consumer spending is on the rise. With this trajectory, the US should be on track to beat IMF’s projection of a 1.8% GDP growth for 2012.

Over the past few months, we have added incrementally to equities as our investment framework, which looks at critical drivers such as liquidity, earnings, valuations, interest rates and technicals, has turned constructive in January. In particular, the single most important factor in our decision has been the receding tail risk of an implosion in the Eurozone. This has allowed for the equity risk premium to fall and for investors to once again focus on fundamentals. In addition, the leading central banks have committed themselves to inflation targeting which given the anaemic state of the global economic recovery means they will continue to hold rates at the current super low levels and to stand ready to provide further liquidity if and when needed.

So far, so good. Equities have recovered 20% from their October lows. The S&P 500 index is back at levels last seen before the Lehman crisis. Can the rally continue?

From a valuation standpoint, there is still significant room for further re-rating. Over the past decade, equity returns have failed to keep pace with corporate earnings leading to falling multiples during the period. The flip side of this de-rating is the rise in the equity risk premium. The excesses in the corporate world, the banking systems and the deterioration in the fiscal state of governments in the West have led to greater market volatility which in turn led to investors demanding a higher risk premium for holding equities over bonds.

 

A critical factor to this equity re-rating and a fall in the equity risk premium is the trajectory of the global economic recovery, especially in the US and China. A sustainable recovery that is characterised by virtuous circles where rising incomes and demand reinforce one another will give markets the impetus to re-rate. And although events in Europe will still matter, we believe that for the moment policymakers there have effectively kicked the can down the road.

In late March, Fed Chairman Ben Bernanke mused about the state of the US labour market and pointed out that improvements in the US labour market have not exactly been matched by growth in final demand. Friday’s disappointing US employment report where the economy added just 102,000 jobs compared with an expectation of over 200,000 seemed to have vindicated his concerns. Investors are starting to ask if the current momentum will give way to a sluggish second half repeating the pattern in 2010 and 2011.

That said the labour situation, although critical to a follow-through in final demand, is not the only driver. Other factors such as global manufacturing activity, new orders and bank lending have shown signs of improvement as well. Moreover, it is far too early to surmise that the US labour market has started to contract with just one dismal job report. 

In our view, the likely outcome is continued job gains in the months ahead but it will be somewhat choppy. We have to constantly remind ourselves that recoveries following financial crises are typically long drawn affairs. This one is no different. With the deleveraging still ongoing, it will be a while before the economy returns to a more sustainable equilibrium level of employment. Meanwhile, the markets will continue to require validation through economic data. Consequently and commensurately, the re-rating process will also be long drawn and choppy.

As for China, markets remain pessimistic as indicated by the continued underperformance of Chinese stocks, emerging equities and currencies as well as industrial metals. Investors were spooked by the Chinese government’s target of 7.5% GDP growth and worried about an economic hard landing. We believe those concerns are overblown. The lowered target reflects a shift away from growth at any cost to a desire to seek a more balanced and sustained economic growth path through rebalancing away from external demand to domestic consumption. Our view is that policy easing and rising real incomes as well as the transition to a new political leadership will be supportive of this rebalancing. But as usual markets will tend to overplay this worry until the new paradigm is validated.

Fundamentals aside, the tail risks of an oil shock from Iran’s nuclear intransigence and a financial meltdown in Europe have receded. Oil prices may be at elevated levels, but a diplomatic resolution could quickly push premiums down. For Europe, we maintain that it is best to view the debt crisis as an ongoing one. The process of adjustment, deleveraging and convalescence will be long drawn and choppy with episodes of backsliding. This may force risk premium to stay higher than normal but from where we are today, there is still room for the risk premium to fall.

Therefore, all things considered, we view the recent market consolidation as temporary and probably necessary to move on to the next phase. While we do not expect the next phase to be as strong as the recent months, we retain our constructive portfolio stance to risk assets. Specifically, we continue to be overweight in equities and credits. Our equity exposures are currently concentrated in the US and Asia while we run market neutral strategies in Europe. In fixed-income, we favour selective high yield corporate bonds as well as Emerging Market debt but we stay very defensive with regard to duration. We are also keeping some exposure to gold and alternatives for diversification purposes. Our underweight allocations are on government bonds - nominal and inflation-linked. While we are not ready to call for a bear market in bonds given the accommodative bias of the major central banks, current yield levels are just plain unattractive from a risk-reward perspective. 

In many respects the investment outlook for 2012 looks distressingly similar to the final months of 2011. That is to say the challenges and outcomes will remain dominated by concerns of the past year, namely the Eurozone crisis and doubts about the sustainability of the global recovery. The implication is that financial markets will remain largely range-bound and characterised by elevated levels of volatility and unusually high correlation amongst risky assets.

2011 was not a great year for investors. Global equities lost 10%, giving back all of 2010 gains, and to be only partially offset by a 5% return on global fixed income. Commodities were down 8% while the credit component of spread products suffered significant losses. The world economy grew at a sub-par 3% in 2011, less than the 4% of 2010.

2012 is starting out to be rather similar. In terms of economic outlook, the consensus forecasts suggest another 3% global growth. Despite a modest re-acceleration in the US, the global economy will remain hamstrung by slowing growth in China and India, mild recession in parts of Europe and an anaemic recovery in Japan.

The bright spot now seems to be in the US where we are seeing cyclical improvements in manufacturing, consumer confidence and the labour market. It looks likely that US growth will top the 2% consensus forecast for 2012. Still, the structural forces of deleveraging of the household, banks and state governments will continue to hold back growth potential. Moreover, partisan politics is likely to prevail through to the November Presidential election, preventing meaningful progress in fiscal and regulatory reforms until 2013. 

The outlook for the Eurozone is rather dim with consensus forecast of a mild recession in the first half of 2012 and recovering later to close the year flat. Worsening the outlook is further fiscal tightening and more restrictive credit conditions. The risk is clearly on the downside. Also, the private sector which is one of the few bright spots in Europe could be severely hampered if the flow of credit is disrupted by continued stresses in the banking sector. 

Japan is still plagued by anaemic growth notwithstanding government spending to repair the damage wrought by last year’s earthquake and tsunami. The strong yen continues to hamper Japan’s large multi-national corporations which are heavily reliant on exports. Adding to this, the ruling Democratic Party of Japan has been largely ineffective in tackling economic issues as it is busy grappling with an internal revolt over its decision to raise the consumption tax from 5% to 10% by 2015 risking the chance of a snap election in 2012. 

And in most emerging economies, growth is likely to slow in the first part of 2012 due to the lagged effects of policy tightening as well as the adverse impact from the Euro crisis. This has the effect of negating the positive momentum in the US. However, with inflation peaking, we believe some of these countries such as China and Brazil will reverse their tight policies in the first half of 2012 to refocus on growth.

Besides economic doubts, the more pressing issue continues to be the Eurozone sovereign debt crisis. After what seems like a never-ending stream of summits in 2011, policymakers in the Eurozone have yet to find a lasting solution. Investors continue to be worried about the government funding needs this year – Eurozone governments will need to refinance more than €1 trillion of maturing short-term and long-term debt in 2012. The focus is now squarely on Italy which many consider as too big to fail and hence a real test for the crisis. With yields on Italian 10-year bonds above 7% and Europe's bailout fund having to offer higher interest rates than in the past to place €3 billion of debt, markets will continue to be vexed.

All said we believe the problems of 2011 – doubts about global cyclical recovery and the euro-zone structural debt crisis – will continue to pre-occupy investors’ minds and remain a source of sharply shifting risk premiums in the initial months of 2012.

However, it is also important to note that in several respects 2012 is different from 2011. For one, market prices have already factored in most of the current woes. The US 10-year Treasury yields have dropped more than 100 points in 2011 and are now trading just below 2%. Gold is some 13% higher while equities are anywhere between 10-30% lower, except for US equities which closed 2011 just about flat. During the year, global corporate earnings continued to grow by 5% which means price-to-earnings multiples have fallen even more and are now at levels similar to the first quarter of 2009 before the market recovery.

True, these levels do not matter much if global risk premiums continue to rise because of the unabating macro and event risks. But it does suggest a couple of things. First, the winning strategies of 2011 – US Treasuries, high-grade bonds, precious metals, JPY, CHF and the US dollar – look less compelling at current levels. Second, should these macro risk factors start to recede, the scope for a massive rebound is good especially coupled with a market positioning that is still highly defensive. 

The second difference is inflation. For most of 2011, emerging markets (EM) especially in Asia and Latin America were battling rising commodity and asset prices – a result of the massive domestic credit expansion as well as capital inflows from developed economies. Policymakers in these emerging markets tightened policies and allowed their currencies to strengthen fuelling hard-landing worries and resulting in massive underperformance in their equity markets. In the final months of 2011 however, inflation seemed to have peaked and asset prices started to correct. Some, like Brazil, Thailand and Indonesia, have started to cut key interest rates while most have also allowed their currencies to depreciate against the USD. In China, policymakers have cut banks’ reserve requirement ratio and started to focus on growth initiatives. The expectation of a stabilisation in EM growth together with a more durable US recovery could potentially offset the negative impact of a Eurozone recession provided it is shallow and temporary.  

For these reasons, 2012 should turn out better for risk markets albeit with continued volatility. We expect a reversal of 2011’s performance which started out strong and then crashed. 2012 will instead start with a surplus of pessimism and defensive positions, with upside surprise in the second half from receding risk of a Eurozone break-up and a more durable global recovery.

The implication for our asset allocation is to continue with an underweight stance in government bonds (both nominal and inflation-linked), a slight underweight in equities and overweight in corporate bonds and precious metals.

When we will start to become more positive on risk assets will depend largely on the evolution of macro risk factors which include stress points in the Euro-zone, China real-estate and US fiscal policy as well as the strength and sustainability of the global cyclical recovery.

Of the various risks, a break-up of the Eurozone ranks as the highest risk because of its size, leverage and inter-connectedness. It could potentially dwarf the impact of the Lehman collapse. With the benefit of hindsight, our current view is neither a dissolution nor an instant resolution. Instead, as German Chancellor Angela Merkel suggested, the move towards a resolution is like running a marathon. It will be incremental with many setbacks. Unfortunately this timeframe doesn’t sit very well with investors who are getting impatient causing shifting risk premiums in the markets.

The correction in Chinese property market is a concern given the export and manufacturing slowdown at the same time. However, the current slowdown has much to do with policy tightening and can arguably be reversed. As for the property market, the current leadership left no doubt that they are bent on pricking the bubble before it could impose more deleterious effects on the economy like in the US in 2007-2009. We believe they will continue to micro-manage the sector with administrative tools while allowing for looser monetary and fiscal policies to tackle the economic slowdown. This is definitely a risk factor we do not want to underestimate or overplay but must be monitored closely. On the US fiscal issue we see the standoff between the two political parties as continuing to the November Presidential election but with neither side risking a collapse.

All said it is too early to abandon the defensive position. Stay tactical and there should be opportunities to redeploy some time during this year.