Friday, July 12, 2013

H213: Limited systemic risks, low inflation & relative DM vs. EM growth improvement

My outlook and asset allocation for H2 2013 remain mostly unchanged (see also my strategy presentation from May Low systemic risks, low inflation and improving real growth): Systemic risks - which emanated mainly from the Eurozone - remain limited, inflation will be low for longer while real growth in developed markets can improve over the next quarters. On the other side, the outlook for several important emerging markets as well as commodity producing economies has been deteriorating.

The US economy has successfully averted the so-called fiscal cliff and following a period of subdued dynamic, growth should reaccelerate into year end. For one, the negative effects of the fiscal tightening enacted earlier this year should slowly fade while the housing market has turned around, the output of oil & gas is on a structural upward trend and the combination of an improving labour market, rising real wages and high pent up demand for consumer durables should support consumption growth. Furthermore, the monetary transmission mechanism in the US has been restored suggesting that the previously enacted monetary easing is increasingly hitting the real economy. As a result, the US Fed will start to taper its asset purchases in October and is likely to start rising rates in Q4 2014.
In the Eurozone, the economy remains mired in a mild recession. However, growth should gradually move into positive territory during the current half of 2013 and improve further going into 2014 even though it will remain below trend. For one, the negative growth effects from rising energy prices should fade while the negative growth effects from a restrictive fiscal policy environment should slowly become lower. On the other side, Spain, Portugal, Ireland and Greece have largely restored cost competitiveness and as a result the positive growth impact from net exports should increase. In line with the ECB’s forward guidance, there is no rate hike on the horizon for a long time and there remains a substantial probability for another cut in the repo rate, albeit a cut in the depo rate into negative territory carries a very low probability only. Furthermore, the ECB is likely to prevent an increase in EONIA levels and should be expected to counteract a further marked fall in excess liquidity.
Just as the growth environment in the US, Europe and also in Japan (amid the massive easing of monetary conditions) improves, it will become more difficult for a number of emerging market and commodity producing economies. China is actively trying to rebalance its economy, moving growth away from a credit-fuelled and resource intensive investment boom towards more consumption/services leading to significantly lower growth in the process. Moreover, a large number of emerging markets have seen a deterioration in their fundamental environment over the past years just as a constant stream of capital flowed from Europe and the US into their economies. Private sector credit growth has been rampant and financing conditions might become increasingly restrictive in an environment where the Fed ends its USD glut. In turn, risks will be rising over the course of 2014 that several EM central banks will have to start selling their foreign currency reserves in order to support its currency and domestic financial markets.
Those countries and markets which have been supported heavily by capital flowing out of the US and Europe (i.e. commodities, EMs) are most at risk of a significant underperformance as the combination of weakening fundamentals and the potential for a tighter monetary environment amid capital outflows demand its toll. On the other side, US, Europe and Japan should see a supportive mix of improving growth and an ongoing growth supportive monetary environment. In turn, risky assets and currencies of the EM/commodity producing world should continue to be sold on uptics whereas developed markets’ risky assets as well as US/European fx should be bought on dips. However, safe nominal and real yields have seen their lows and moved back on a rising path, especially in the US.