Global Strategic Outlook Q2 - Executive summary

Inflation risk in the medium term?

There is currently hardly any topic on which economists’ views diverge as much as the medium-term inflation outlook in industrialised economies. The ‘hawks’ fear that the massive expansion of central bank balance sheets would ultimately end in significantly higher inflation rates. This line of thinking reflects the very monetarist view that “inflation is always and everywhere a monetary phenomenon”, as Milton Friedman once said. Economists, taking the opposite view, point out that post the burst of the global real estate bubble and the emergence of the eurozone debt crisis as one of its collateral damages, the underlying inflationary pressure in the developed world is quite limited. We would like to highlight three observations with respect to inflation and inflation expectations. Firstly, inflation seems to be sticking and unexpectedly high. The second observation worth mentioning is that the consensus has systematically underestimated inflation rates in G7 countries by around 0.25% per year since the early 2000s. The opposite was true in the 1990s, when inflation rates were consistently overestimated. Thirdly, despite inflation being higher than suggested by the current output gap and having surprised on the upside for many years, inflation expectations have remained, on average, anchored, both in the US and in Europe. The key question for inflation going forward is: will central bankers absorb excess liquidity in time? If not, there is a clear risk that inflation expectations could start to edge up.

US equities outlook

While corporate profit margins are extended and are likely to decline as fiscal consolidation proceeds, we think a thorough analysis of the macro profit equation indicates that likely profit margin compression may be manageable. It is clear that the combination of a large fiscal deficit and a low household saving rate has been supporting historically high corporate profits. Some margin compression over the next two years is likely unless residential and non-residential investment improves more than we have seen in recent cycles. With nominal and real corporate bond yields and mortgage yields at historical lows, such a response is not out of the question, but would probably require greater confidence amongst businesses and households about future income streams.

European equities outlook

European equities made a strong start to 2013, building on the momentum established in the second half of 2012. Whilst equity and credit markets had remained quiet in terms of news flow, this was always going to change during the early months of 2013 as the Italian elections loomed large. Recent news on the recovery of Cyprus has again deepened concerns that EU decision makers have learnt nothing over the last three years as they bizarrely decided to forcibly tax the deposits of taxpayers and voters even below the Government-guaranteed balances, thereby hitting both domestic and international (largely Russian) depositors. This sets another dubious ‘first’ for Europe to add to the scalps of sovereign haircuts in Greece, senior bank bond holders in Ireland, subordinated bond holders in Holland and now depositors in Cyprus. Earnings in Europe have come through quite well, although consensus still sees declining earnings growth expectations and, following the Italian election results and weak PMIs across Europe, it is reasonable to expect little if any earnings progress this year as economies are in recession and austerity in implementation.

Asia-Pacific equities outlook

Overall, we expect that regional growth will still be slower, partly as a result of the still uncertain economic conditions in Europe, affecting Asian exports, and partly due to slower Asian consumption growth. Generally low inflation in the region, coupled with capital flows, should continue to set the stage for Asian economies to head into an environment characterised by an ideal balance of stabilised growth and relatively benign inflation expectations over the coming quarters. Developed markets, while far from normalised, are at least demonstrating a more stable trend: the return of rising inflation expectations, regional currency movements and policy responses, three of the most relevant macro factors to affect the Asia region over the coming quarters.

Equities outlook – style

Global fixed income outlook

We stand by our view that the global economy is set for an acceleration of economic activity, mainly out of Asia, other emerging markets and the US. Globally, business surveys and leading indicators have continued to improve slightly. At the same time, activity data point to an improving trend after being rather on mixed recently. Overall the outlook for the US economy looks brighter than for other developed markets. As we observe no underlying upward pressure for inflation, we expect the Fed to keep interest rates low and continue with asset purchases for the time being. Data published during the month under review suggest that the Japanese economy remained in recession during Q4. In contrast, the current flow of activity indicators turned positive. Also, business surveys hint to an improvement going forward, driven by the significant shift in government policy. In Europe, it appears that the competitive gap across the eurozone is narrowing, as evidenced by the improvement in the trade balance in the periphery and a stabilisation in Target2 balances. We also see signs of stabilisation in economic momentum, albeit at a low level.

European fixed income outlook

Asia-Pacific fixed income outlook

Multi asset outlook

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