Another year of sub-trend global growth The global economy looks to have finished yet another lackluster year on a soft note. After a robust 4% gain in the first full year of the recovery in 2010, global GDP decelerated to a 2.7% pace in 2011 and now appears to have slowed further to a disappointing 2.1% pace this year.
Our base case scenario is that global GDP growth has bottomed and will pickup pace gradually over the course of 2013, but will still end the year having expanded at a sub-trend pace for a third straight year.
This global 2013 outlook will mask shifts across regions. While the US will continue to be growing just below trend over 2013 as a whole, our assumed benign resolution to the US ‘fiscal cliff’ will take a heavy toll early in the year. By contrast, we expect the Euro area to remain in a soft recession in 2013. We believe that increased monetary and fiscal easing will lift Japan out of recession next year. In China, the newly empowered policymakers are no doubt breathing a sigh of relief to see growth lifting after bottoming earlier this year - we expect China to continue growing at around 8% next year.
Against the backdrop of an economic outlook for another year of subtrend growth, major central banks have all engaged in multiple forms of unconventional policy that have had a powerful impact on financial markets this year and will continue to do so next year:
1) The prospects of a sharp deceleration in the near-term and only modest growth for next year as a whole will push the Fed to take further steps. We expect QE3 to be expanded further next year, in particular following the Fed’s announcement of a 6,5% unemployment target for its QE program. We expect the Fed to add $1 trillion in mortgage backed securities and US Treasuries to its balance sheet, which stands now just under $3 trillion.
2) The ECB’s ‘bazooka’ through its OMT program has had a very calming effect on markets this year by significantly reducing borrowing costs for Spain and Italy. Several economists have revised their odds on “Grexit” down from 90% to 50%. Last week S&P even raised Greece’s credit rating by six notches to B-. We expect Spain to ask for official help from the ECB in H1 2013.
3) In Japan, the political pressure to fight deflation is building as economic performance deteriorates. In response, new incoming LDP leader Shinzo Abe called for the Bank of Japan to increase the inflation target to 2% and work more closely with the government. Also here we expect another round of asset purchases beyond traditional government bonds purchases.
What does this mean for financial markets in 2013?
We think that 2013 promises modest capital gains in ‘risky assets’ driven by forceful central bank action, allowing a further fall in event risk perceptions and a continued recovery in global growth. What we learnt from investing in 2012 is that fluctuations in perceived event risk have become a larger driver of market returns than the usual fundamentals of economic growth and company earnings. This is a force we must now fully respect. We have also learnt that monetary policy has been a constant support for markets over the past few years and will likely strengthen further in 2013.
We are approaching 2013 with marginally less event risk than a year ago. China’s economy has landed and not crashed, and is already rebounding gently. No country has exited the Euro area, yet, and the ECB has succeeded in stabilizing its sovereign debt market, even as the region remains mired in recession. US fiscal risks, in contrast, have risen as both sides of the political spectrum have moved to a game of chicken into year-end.
Given our macro outlook we will continue to apply our investment strategy focused on cash-flow generation into next year. We believe that this strategy is best suited in an environment characterised by a still high level of market and economic uncertainty. Our main positions will continue to be in global high-yield bonds and global high-dividend yielding equities. Given the very significant performance of high-yield in 2012 and the more limited upside offered by the asset class currently, we are recommending a certain amount of rotation out of bonds into equities for next year. The model portfolio we recommend for our traditional investors will be still be tilted towards bonds (65%) vs. equities (35%).
Despite the very strong results in 2012, we maintain a positive outlook for the high-yield market. This is driven by what we consider to be solid fundamentals, with corporate balance sheets typically flush with cash and earnings holding firm for many high-yield issuers. Given our expectations for modest growth, benign inflation and low rates, demand for high-yield bonds should remain solid overall as investors continue to look for yield in the low rate environment. Furthermore, we expect high-yield defaults to remain below their historical average.
Our preference for high yield bonds is also linked to our expectation of a modest rise in interest rates next year (approx. +0,5% on the 5-year Treasury rate). Even under this assumption, the predicted spread compression of high yield bonds will more than offset the Treasury rate increase, leaving us with a total return expectation of 7-7.2% for 2013. A similar return cannot be expected from government bonds or investment-grade corporate bonds which will suffer more heavily from the rate increases.
As for equities, the risk premium imbedded in them relative to bonds and cash remains near 50-year highs. This is because end investors appear to be shunning equities in favor of corporate bonds in the current low growth environment.
We continue to favour stocks that offer an interesting dividend-yield premium vs. their corporate debt yield. Our model portfolio yields an average 5,5% with a beta of 0,85. The stocks that we have picked are heavily biased towards real assets: energy, real-estate and market leader companies that have shown a track-record of passing on price increases to their customers.
We believe that 2013 will be a year where stock and bond picking will play a much more important role than in 2012, as valuations have become quite stretched in some corners of the markets. We issue a warning signal to investors looking to invest passively by simply replicating the overall market.
Risks to our views:
1) The US fiscal cliff is not fully solved– but instead gets a few ‘band-aids’ that are not meaningful reductions in the nation’s budget deficit or public debt. This would trigger another round of credit rating downgrades (also by S&P), weaken economic growth and seriously affect market confidence in US securities.
2) In Europe, while Mr. Draghi’s OMT programme has reduced tail risks in the Euro area, it has not eliminated them altogether. The main risks that remain are as follows: Spain’s economy suffers a more dramatic downturn and political brinkmanship fails to activate the OMT aid package. Italian political outlook remains unclear with potential for a chronically weak government.
3) The Chinese ‘soft landing’ fails to confirm itself and Chinese GDP growth continues to drop below 7% as the real estate markets show increasing signs of bursting.