Download Global Strategic Outlook (Full Version)

RCM Global Strategic Outlook

Q4 2009

Global and Economic Outlook

There can be no doubt that economic activity worldwide has at least started to stabilise, and may even start to grow from Q4 2009 on, at the latest. This is what various leading indicators are telling us. The monetary and fiscal policy stimulus around the world has not only helped stabilise the financial sector, but they have also revived the global economy. Tighter credit spreads have clearly supported the leveraged private sector. However, our medium-term outlook remains cautious, given the structural economic headwinds we are facing, and we expect global economic growth in the area of around 3% in 2010 which would still be below potential (global potential growth is around 4.0% – 4.5%). We would only expect a return to potential GDP growth once the private sector has de-leveraged enough, which we will think will only be the case at the beginning of the next decade. Regionally, we continue to prefer Europe on valuation grounds and because of the relatively stable financial position of core continental Europe (we now see moderate leverage of the private household sector). We are, roughly speaking, neutral on the US and Japan and are not chasing emerging markets equities at current rather high valuations.

Bond And Equity Markets

We find it very difficult to characterise the equity market rally since March this year as a bubble. We have to admit, though, that we may, one day, end up in a bubble given the monetary stimulus around the world. However, we would not expect developed equity markets to be the most likely candidates for this to happen to nor any leveraged asset classes, such as real estate or private equity, as credit availability is likely to be tougher going forward, given the expected tighter regulation of the financial industry and higher capital ratios. The asset class that is most at risk to finally end up as a bubble one day is Chinese equities and commodities – the latter because they are a derivative play on China. We remain neutral between growth and value and we are also balanced with respect to size.

Ten-year bond yields, which collapsed to basically all-time lows of 2% in the US in December 2008, have risen to 3.3% again. The fall in government bond yields late last year was a textbook-like precursor for rising equity markets. Going forward, we don’t expect any more support for equity markets coming from falling bond yields. Admittedly, as long as central banks are pursuing a quasi–zero interest rate policy (ZIRP), the long end of the curve is anchored. We would not expect 10-year bond yields to exceed 4% due, as the steepness of the yield curve would clearly attract buyers for long-duration bonds. On the other hand, we also expect the yield curve to remain structurally steeper at this juncture, as prolonged low short rates and an exploding government debt (we expect public debt to increase by around half over the coming three years as a consequence of the crisis) will lead investors to ask for a relatively high-term premium at the long end of the yield curve.

Asset Allocation

Overall, given the no-longer-attractive valuations in the US and the structural headwinds to economic growth, we have decided to remain strategically neutral on equities. Tactically, too, we remain neutral, as some of the most important leading indicators as well as earnings revisions balance may have run too far too quickly.

Thematic Piece: Assessing the US mortgage situation

The US is now three years into a very sharp and unprecedented housing price deflation. As global leading indicators have begun pointing to a recovery, and as investors have similarly priced in prospects for a recovery, it may be worth assessing how far along the US mortgage and real estate markets are in correcting prior excesses.

By way of summary, the results are mixed. Home sales, construction, and price activity are showing some revival in recent months in the US (as well as abroad), but loan seasoning in the US is demonstrating a migration of losses into the prime mortgage arena, while foreclosure activity remains high and climbing. Consequently, the trajectory of US household spending in any recovery is likely to remain subpar, as both households and their lenders engage in a period of balance-sheet repair.

US Outlook

Could 2H 2009 US real GDP growth track in the 4.0%–4.5% zone? Since the consensus is around 2.5% real GDP, and the US equity market remains a good deal above its 6th March intraday lows, evaluating the possibility of upside growth surprises may be especially relevant to long-only equity investors.

We are picking up evidence in recent months that the private sector is willing to spend more out of its income flows, so the impact of fiscal spending (especially infrastructure outlays) on economic growth is likely to prove more powerful into 1H 2010 than many now expect. So based on a plausible set of assumptions, without pushing the numbers hard, it is quite easy to put up 4.0%–4.5% annualised quarterly real GDP prints for the remainder of 2009, and a real GDP growth in 2010 could be twice current economist consensus assumptions and then drop to a below-trend growth rate of 2% in 2011.

Continental Europe Outlook

Looking into the final quarter of 2009, after what has been a turbulent period in the economy and markets, it is difficult to have strong conviction in the outlook given the mixed nature of signals as well as the speed at which events have unravelled. That said, we are gaining a better picture of where the economy stands, and what the market is expecting from it, by the implied valuations. This is a concern for us going forward, as many companies are now pricing in a very rapid return to peak margins; partly based on the higher level of trough margins seen this cycle versus those seen previously, as are result of the dynamism shown by corporations in cutting costs. This optimism may have been fostered by the success of the Cash for Clunkers initiatives in Germany and France and the liquidity infusions into the European banking system. At present, markets are pricing in a return to 1.5% three-month Euro Interbank Offered Rate (Euribor) by October 2010.

UK outlook

We can now see that the gloom of six months ago was overdone, but today the question has swung round the other way: is the optimism, most obviously seen in the equity market, justified? Whereas globally the answer can perhaps be summed up as a cautious yes, specifically from the point of view of the UK the answer is rather less clear. The economic data itself is mixed. The NIESR estimates that the UK economy stood still in the three months to September, but the PMI number for the all-important services sector rose to 55.3 for September (anything above 50 indicates expansion), and house prices have been rising. Overall though, it is hard not to believe that the Bank of England’s quantitative easing (QE) programme is having a flattering effect that will eventually unwind.

Japan Outlook

In the Lower House vote at the end of August, the Democratic Party of Japan (DPJ) had a landslide victory against the long-dominant Liberal Democratic Party (LDP). The end of a one-party-dominated system strengthened democracy in Japan. The DPJ won the election as a credible opposition party with a clear manifesto. Now, the LDP is no longer the largest party in the Diet for the first time since 1955.

In the short term, the DPJ’s policies have had both positive and negative effects on the market. However, we think it is at least true that the investors who have practiced ‘Japan passing’ in the past will now begin paying attention to this country, looking for structural changes and the effects of its economic policies.

Asia-Pacific Outlook

Asian policymakers have engaged in aggressive actions to forestall economic slowing. What should be kept in mind, though, is that these tools at their disposal are not being used to fix a broken banking system. And while their actions have been quite aggressive, total debts as a percentage of GDPs are still generally quite low relative to international levels, while monetary rates have been slashed to, or near, record lows, but generally from very high levels. The effects of this environment cannot be underestimated as being ripe for the formation of asset bubbles. Asian policymakers face a difficult period in the coming quarters: balancing the support for economic growth while avoiding inflating bubbles, stoking rampant inflation, or thrusting Asia back toward the edge of a deflationary vortex.

Commodities Outlook

At the time of writing, the CRB Index of commodity prices has yet to reach even a three-eighths retracement of its decline off the mid 2008 peak. Nonetheless, the strength of recent industrial commodity price rises has been aberrant, relative to historical commodity price recovery. This is especially true of base metals. After the very severe recessions of 1973–1975 and 1980–1982, the price of copper and most other base metals did not recover one-third of its decline in nominal terms for about four years after the commodity cycle trough. We have had the most severe global economic downturn since before WWII – where global industrial production fell by about 13% from a peak in 2008 to a trough early this year. Since then, there has been something of a rebound, although industrial production remains weak in many major economies. To the extent that speculative and manipulative forces have been contributing to the rise in commodity prices this year, actions on the part of concerned governments may curb these speculative pressures.

Past performance is no guarantee of future results. This document contains the current opinions of RCM and such opinions are subject to change without notice. This document has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.