DON’T FIGHT THE REFLATION TRADE
- The economic recovery is on track and growth is surprising on the upside, backed by a new round of policy stimulus.
- Better growth, combined with easy and easier monetary policy, provides a very favorable backdrop for risky assets.
- We expect equities in particular to outperform, while we advise investors to stay away from government bonds.
- The reflation trade, however, may not last very long, and investors should position for continued volatility and the possibility of sharp reversals.
European debt crisis will probably continue to generate volatility, it is not likely to be the trigger that ends the recovery in economic growth and financial markets. Instead, investors should watch closely for signs that valuations are becoming over-stretched or that central banks are losing enthusiasm for reflation – both of which we expect to see at some point during 2011, starting with the key emerging market economies.
Better growth, easier money bolster prospects for financial markets
It is hard to think of a time when the position and direction of global monetary policies relative to underlying growth and inflation fundamentals were as easy as they are set to be in the first half of 2011. The most recent comparison is late 1998, when the Fed eased policy into the tech-led economic boom to help contain the fallout from the LTCM and Russian debt crises. The market response was strong and straightforward: equities surged and bonds tanked, although within a couple of years each of these markets reversed course dramatically. While the current background is different from that in 1998 – monetary policy is easier now, the US and other developed economies have much greater levels of slack, and emerging economies are much stronger – it is instructive to note the initial market responses as well as what happened next.
Continued economic recovery should support commodity prices
Commodity prices are likely to perform well in the current environment. Estimates of demand from commodity end-users continue to be revised up in both emerging and developed markets. This is consistent with the fact that manufacturing indicators have held up surprisingly well, considering that most of the rebound in inventories is behind us. A weaker dollar would also boost commodity prices. That said, we do not expect the massive swings in prices that characterized the periods just before and after the financial crisis to return anytime soon, barring an unforeseen major geopolitical event. Supply and demand factors are more balanced, and speculative flows have not returned to earlier levels.
(Barclays: Долговые риски в Японии и США. Европа уже начала борьбу за чистые финансы, США – еще не начинали. Ну-ну)))
ASSET ALLOCATION
Equities are back
- Equity risk premiums are high enough to warrant an overweight position in equities relative to fixed income.
- Our call for equities outperforming fixed income looks stronger in the US than in Europe, where the ECB’s tepid approach to its own version of Large Scale Asset Purchases is unlikely to be a catalyst for a reduction in the equity risk premium.
- We recommend paring back exposure to the developing world, and favour investing in emerging markets through developed world companies with significant exposure to emerging economies.
- As deleveraging in the consumer sector and public sector continues to unfold, weare mindful of the market’s propensity to react aggressively to inflection points and expect increases in volatility as a result.
- In an environment of diminished correlation between asset classes, we expect relative value and carry trades to be more effective.
Делеверидж замедляет экономическое восстановление, но не останавливает его. Корпоративный сектор (в США) практически завершил процесс делевериджа, домохозяйства начали процесс после корпоратов, что и отразилось на слабом росте потребления. С потребителем не все понятно, так как доля долга все еще высока и часть делевериджа происходит в виде трансфертов со стороны госсектора. Последний не имеет опции дефолта или реструктуризации. (Это не проблема разве?)
The increase in correlation was exacerbated by regulatory capital pressure on the banking system (another area of deleveraging); however, as the global growth outlook stabilized and Basel III guidelines became reasonably clear, correlation began a steep decline. While we can make a case that the ‘new normal’ for correlation is higher than the prior cycle, we do not expect a return to the 2010 peaks in 2011 in part because, at least in the US, the financial sector deleveraging looks largely complete. The direction and level of asset class correlation is important when we consider the equity versus fixed income trade-off, as well as the allocation within equities or fixed income; in a lower-correlation environment, relative value and carry trades are set to be more effective.
EQUITY MARKET OUTLOOK
European equities continue to benefit from low valuation levels and moderate economic improvement, reflected in improving profitability and free cash flow generation. Driven as they are by an improvement in productivity, positive inflationary benefits and high exposure to emerging markets, we re-emphasize our 2011 year-end target of 325 (+23%) for the STOXX 600 and 3350 (+21%) for the Euro STOXX 50.
With earnings likely to rise smartly, albeit at a slower pace than in 2010, an improving macro outlook and ultra-easy Fed policy, our base case for the S&P 500 at year-end 2011 is 1,420. From a sector perspective, we are taking a much more aggressive sector stance entering 2011.
In Japan, we believe that the continued earnings recovery among Japanese exporters, combined with the expectation for depreciation of the yen against the dollar, will enable the Nikkei Average to test 12,000 at the end of 2011.
1. Valuations remain low
2. The structural reallocation
3. Potential upside macro surprises in the US and German economies
4. The prospect of higher headline inflation in developed economies
Risks to this optimistic view: Spain is the gorilla in the room
The European stock market is not the euro area economy
EMERGING MARKETS OUTLOOK
A crowded consensus
The economic and financial backdrop remains supportive of risky assets. Though lacklustre, the global economic recovery continues to look solid to us and should provoke fewer doubts from investors in the months to come. At the same time, monetary policy in the industrial economies remains in depression-fighting mode.
Facing headwinds from global rates markets, EM fixed income should deliver much less spectacular returns in 2011. We expect external debt to return about 4%, outperforming US Treasuries by 400bp or so. EM FX should continue to grind tighter, but returns will likely be limited by challenging valuations in many popular markets and official interventions designed to impede currency appreciation. EM equities and high-yielding bonds with equity-scale risks and returns should outperform in 2011.
We acknowledge that our assessment of the economic and financial backdrop is in line with a fairly widely shared consensus. Consensus opinion is not always wrong. But a broadly shared consensus tends to promote positioning that renders markets vulnerable to disruptive events that fall outside their base case. While we think it is too early to position on the basis of the many risk cases that confront investors, it remains important to ‘think the unthinkable’ and to look for hedges against tail risks.
