Visibility on structural issues is needed for cyclical support
Risk assets, such as U.S. equities, have benefited to a large degree in Q1 of 2012 from fairly benign U.S. economic fundamentals. Execution on the corporate front, supportive credit conditions and a warm winter prolonged the Q4 2011 economic momentum into 2012. Looking ahead, further policy execution at a global level is needed in order to perpetuate the global business cycle; especially in the face of structural economic imbalances in the major economic zones i.e. U.S., Europe and China.
On the U.S. front, the ECRI’s forward leading indicator points to a moderate growth environment. Households continue to benefit from low mortgage costs and our expectation is for gasoline pressures to ease in the coming quarters. Along with low natural gas and electricity prices, consumers should thus get some financial relief. Moreover, on the monetary front, we note that inflation expectations remain stable. Excess money creation hasn’t been channeled into the real economy as credit. As we can see below, a big part of the Central Banks’s balance sheet expansion has been kept as excess reserves by financial institutions.
U.S. corporations have benefited from the Federal Reserve’s aggressive monetary accommodation in the past 3 years. At this stage, corporations, small businesses and households need visibility on the nation’s fiscal challenges, which are bound to become more apparent by year-end. The expiration of the Bush tax cuts and other stimulus measures is expected to cause a 3-4% GDP drag. Thus, our medium-term concern is that a policy vacuum due to the election period may dent corporate and household confidence.
In the past week, the IMF raised its global growth outlook to 3.5% and it increased its lending facility by $430bn. Moreover, its Fiscal Monitor publication highlighted several global structural challenges. The trifecta of sovereign debt, fiscal balances and demographics needs to be put on a sustainable path. Across both sides of the Atlantic, failure to tackle these challenges will likely jeopardize the low rate environment that current safe haven assets enjoy.
On the European front, fundamental growth and credit challenges are still evident. The ECB’s recent 3 year refinancing (LTRO) program may have provided much needed liquidity to the banking system but the root problems of the crisis still need to be tackled i.e. an over-leveraged banking system, excess sovereign debt and divergent competitive dynamics within the Eurozone. Perhaps the most visible risk is seen in Spain where the burst of its housing bubble has shaken the banking system and its domestic labor market (24% unemployment rate). Therefore, one should expect further episodes of volatility from Europe; particularly as national politics cause policy divisions.
On a more positive note, we expect secular trends in Emerging Markets and the U.S. technology, energy and industrials sectors to drive future equity earnings growth. With a strong U.S. energy policy in particular, we expect the energy sector to promote U.S. energy independence over the long-term which will enable U.S. manufacturing to have a strong competitive advantage vs. its global peers. Thus, energy independence can improve the nation’s fiscal path and help middle-class households grow their incomes via steady employment growth.
On the U.S. equity front, we note that the market has benefited recently from earnings upgrades. However, in the medium-term, selectiveness and a balanced portfolio positioning are in order. From a sector perspective we continue to avoid expensive areas such as the consumer discretionary sector. Thus, we favor more defensive sectors such as consumer staples, telecoms, utilities and healthcare that offer dividend yield support.
In conclusion, from a sentiment perspective, we note that the options market indicates that short-term demand for put (downside) protection is not high. Yet, the volatility futures curve suggests some restraint by year-end. Therefore, we maintain our cautious portfolio posturing and we retain our nimbleness in order to take advantage of selective risk-reward opportunities.
Christos Charalambous CFA
Senior Strategist
christos.charalambous@edgewealth.com
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