Daily Themes 6 January 2012

New year, new hope, old problems

As we embark on the year ahead, there are a number of hurdles still to overcome. Most notable is the euro-zone debt crisis which, though off the front page for the time being, remains largely unresolved. However, with economic data in the US and emerging markets showing signs of improvement, we retain a degree of exposure to risk assets, especially in emerging markets, while maintaining a generally defensive posture.

Stronger economic data out of the US and China and the ECB’s provision of substantial liquidity to European banks, thereby reducing the chances of an immediate systemic financial collapse, led to a firmer tone for risk assets as the New Year began. However, a number of risks remain, especially in Europe, but also in the Middle East with increasing signs of tensions between the US, Israel and Iran.

We expect ongoing volatility in risk assets. In addition, a slowdown in global inflation and sub-par growth in the developed world (at best) should keep the admittedly dwindling band of safe-haven government bonds – Treasuries, Gilts, Bunds – in demand, despite already extremely low yields. Indeed, it is interesting to note that despite the recent rally in equity markets, US 10-year Treasury yields remain around 2%, continuing a theme of 2011 of bond markets being more cautious (rightly so) than equity markets.

On a brighter note, there are increasing signs that inflation globally is falling back. This is especially important for emerging markets, as the need to tighten monetary policy in response to higher inflation was one of the key reasons for the poor performance of emerging Asian equity markets, in particular, in 2011.

Year ahead full of event risk, especially in Europe

While Europe is not front page news at the moment, it could return to dominate headlines and investor sentiment any time, as the fundamental problems of a single currency without fiscal union remain unresolved. By the end of March, European policy-makers must agree the detail of their December plan for closer fiscal union, and the agreement must subsequently be ratified in member-state parliaments (possibly including referendums in some countries). The chances of setbacks along the way are very high, especially with French presidential elections scheduled for April and May.

Greece will need ongoing bailout funds from the EU/IMF on a quarterly basis, requiring more austerity measures against which its domestic population may eventually rebel. The Italian and Spanish economies represent circa 30% of the euro-zone and are falling into a deep recession. And though shorter maturity Italian and Spanish bond yields have fallen back, Italian 10-year bond yields are above 7%, a level widely seen as unsustainable. European banks, in many cases, remain heavily dependent on ECB liquidity and their appetite/ability to lend is still depressed.

As a reflection of these risks, S&P, a US-based ratings agency, placed the sovereign rating of 15 euro-zone countries on credit watch with negative implications on 5 December, with a chance of across-the-board downgrades before the end of January. This potential event itself represents a risk.

Improvement in US and emerging market (EM) macro data

The US manufacturing ISM rose from 52.7 in November to 53.9 in December, the best reading since June, led by solid gains in the production, orders and employment indices. On a downbeat note, the exports orders index remained near recent cyclical lows at 53.0 and macro surprise indices for the US, having trended upwards since July, appear to have peaked in early December and are now trending down, though still in positive territory. In China, the manufacturing PMI edged up to 50.3 in December from 49.0 in November, led by the production index, which rose to 53.4, the highest since May.

Risk assets can rally for as long as US and EM data continue to show a firmer tone, and the euro-zone crisis does not evolve to an even worse phase. However, the potential for something to go wrong in Europe is very high.

Select exposure to risk assets, especially in EM, but portfolios still defensive

As a result of the risks identified above, we reduced allocations to risk assets in late 2011 and increased allocations to high-quality government bonds, with the option to buy back risk assets should valuations become compelling or policy coordination improve. This policy coordination should include quantitative easing (printing money) by the European Central Bank and may also require outright reversal and pursuit of fiscal stimulus in major economies (US and China, in particular).

Indeed, valuations, though not at rock-bottom levels, are starting to look attractive in some Asian emerging markets. The current price-to-book of 1.2 times for the MSCI Hong Kong is below the long-term average, suggesting that markets have discounted a meaningful growth slowdown.

In China, we believe that continued economic combined with gradual policy easing will provide support to the Chinese equity market in 2012 and help reverse the underperformance of 2011. The MSCI China is trading at 9 times forward earnings and 1.4 times book value, both below their respective long-term averages.

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