Cyclical and structural trends are at a crossroads
U.S. investors have been implementing asset allocation decisions amidst an uneven cyclical recovery and in the context of an imbalanced global economy. In addition, investors have had the challenge to allocate capital in an environment of uneven global policymaking which has stretched the boundaries of fiscal and monetary programs, particularly in the developed economies. At this juncture, global central banks are highly accommodating in an attempt to cushion economic growth and stabilize the financial system. The challenge now is to motivate and empower the corporate sector at the middle of this cyclical recovery to spend its solid surplus savings more aggressively, in order to alleviate pressures from fiscal deficits and elevated debt levels. Given this medium-term uncertainty, we favor a balanced portfolio stance that is income and late-cycle oriented.
On the U.S. front, economic data continue to support a moderate growth environment. The most recent manufacturing surveys point to a growing economy, with improving trends in the labor market. Positive trends in commercial and industrial lending support the recovery of small and medium sized businesses. Risk sentiment in the debt capital markets is also business friendly. Moreover, the ECRI leading economic indicator has continued to improve. As we have highlighted in past articles, we expect the energy, technology and industrial sectors to promote growth in the U.S. economy, along with a well-capitalized banking system.
Given the slack in capital resources and labor markets, the U.S. economy still offers growth potential. Despite last year’s credit incentives, we note that American business investment is close to 30 year lows. In the face of declining productivity growth, the challenge now is for the corporate sector to plough back its recovering profits by investing in capital equipment and by hiring labor in order to grow. To be sure, slower earnings growth and flattish margins are to be expected in the middle of the business cycle i.e. when revenue and EPS growth rates tend to normalize towards the trend in nominal GDP growth. Moreover, as the U.S. has been facing a balance sheet recession at the fiscal and household front, the challenge is now for policymakers in the U.S. to provide visibility with regards to the very serious fiscal and entitlement issues that have been pushed into 2013.
The corporate sector has the balance sheet capacity to perpetuate this later stage in the business cycle. Yet, given the likelihood of a medium-term policy vacuum until the Nov elections, one has to provide for some portfolio protection. This can be achieved by allocating capital to more defensive, yield oriented instruments, whilst retaining sufficient nimbleness to take advantage of good risk-reward entry points.
On the European front, ample ECB liquidity has prevented bank failures and as we highlighted in recent articles the focus is now on growth (or lack thereof) and how the intra-Eurozone structural imbalances get addressed i.e. competitive issues in Southern vs. Northern Europe. On the banking side, credit creation in the periphery is also a focal point. Ultimately, despite elevated oil prices, the ECB still needs to devalue the Euro materially in order to offset severe austerity measures that are currently planned across the Eurozone. Lastly, we expect the upcoming elections in Greece and France to create some uncertainty in the marketplace.
From a global market perspective, we note that the U.S. housing market looks attractive. Housing as judged against rents and income appears undervalued, especially when seen against other major economies. To be sure, the foreclosure pipeline will take 4-5 years to be cleared but we believe the housing market is in a bottoming process that will incrementrally give support to the U.S. banking sector, small businesses, household wealth perceptions and overall credit conditions.
Historically, declines in housing prices have been precursors of recessions. As the Economist table indicates below, housing markets particularly in Europe show signs of over-valuation i.e. in France, Belgium, Sweden, the Netherlands and Spain. This perspective adds another layer of risk to Europe’s fiscal, credit and growth challenges. Therefore, one needs to see further policy response from Europe’s leaders and from the ECB in order to prevent a severe recession.
With regards to risk sentiment, we note that risk assets have benefitted from low volatility in the absence of significant negative headline risk and on the back of relatively positive U.S. economic data. We note that even though short-term volatility is subdued, the VIX futures curve shows some concern towards year end. Furthermore, we highlight the elevated state of short-term leading indicators such as copper, oil and the AUD/USD.
In conclusion, we acknowledge the positive drivers that have supported risk assets in the past quarter and we look ahead for the ensemble of risks and opportunities that the marketplace will likely present to us. Therefore, at this juncture we maintain a balanced portfolio approach with a preference for income generating instruments and securities that offer good late-cycle cash flow and earnings visibility.
Christos Charalambous CFA
Senior Strategist
christos.charalambous@edgewealth.com
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