Friday, July 27, 2012

Central banks will have to 'push the string' further


Business Times: Thu, Jul 26

THE recent rash of interest rate cuts by central banks in Europe, China and the United Kingdom suggest a degree of concern is setting in about the slower rate of economic growth in the second quarter of 2012. Despite this, stock markets around the world have been remarkably upbeat since mid-June 2012, perhaps anticipating another round of strong profit reports in the July 2012 reporting season for corporate earnings.

We expect that global economic growth will resume a mild improvement in the third quarter of 2012 in line with similar seasonal recoveries in the preceding three years. A likely announcement of further quantitative easing by the United States Federal Reserve (QE3) later this year will also boost growth expectations.

However, concerns about the political impasse in the US over resolution of the looming cuts to government borrowing and significantly higher taxes will prevent a sustained rebound in risk-asset markets.

Eurozone leaders yet again pulled the regional growth outlook back from the abyss to place markets in a risk-on mode by late June 2012. Investors reacted positively to initial progress on creating a eurozone banking union. While this can be seen as a further step towards a more cohesive economic and monetary union and a critical condition for solving the current crisis, the more pressing hurdle will be getting countries to relinquish sovereignty over their banking systems and boosting the size of the European Stability Mechanism (ESM).

These measures taken together break the "negative feedback loop" between the separate issues of European sovereign over-indebtedness and looming insolvency of the euro area banking system. Hence, we could see optimism returning to financial markets in July and August. We are, therefore, increasing our tactical asset allocation exposure to selected equities and high-yield bonds and reducing our holdings of defensive US treasuries.

While economic data from the US and China will continue to be downbeat, we would "buy the dips" to acquire risk assets on cheap valuations. This strategy is predicated on expectations that the US and China central banks will announce strong monetary stimuli late in Q3 2012 which will fuel more risk-on sentiment in markets at the end of 2012.

The good news from the US is that after several years of stagnation, the US housing sector is finally showing some signs of life. The slow pace of home construction in recent years has resulted in a very low inventory of new homes for sale. A modest upturn in new home sales since last summer has prompted home builders to gradually increase the construction of new single-family homes. We may be at the start of a slow but steady process whereby the wealth effects of recovering home prices encourage US consumers to spend more, which will ultimately lift the global economy.

Also, the recent rapid fall in commodity prices will help to lift the purchasing power of consumers and restore confidence among firms. At the margin, it also provides some room for further policy easing should global growth sag more rapidly than expected. From a fundamental perspective, valuations are attractive, corporate earnings remain solid and technical indicators suggest that markets may be poised for the next "risk-on" phase for the next few months.

What will have a bigger impact, though, in the next three to six months will be the implementation of large fiscal spending projects in major emerging markets. Brazil and China have targeted higher state spending in sectors as diverse as direct consumer spending subsidies on purchases of durable goods, healthcare and housing. China's economy will also respond more readily to further expected cuts in bank reserve ratios which are at historic high levels. Thus, we expect that the cyclical trough for the growth of China's economy will likely take place around mid-year, to be followed by a modest recovery taking growth back to over 8.5 per cent in H212 once fiscal and monetary stimuli start filtering through.

Along with the People's Bank of China (PBOC), central banks in Brazil, Australia, India and Vietnam have announced rate cuts this year. These moves signal a start to more monetary accommodation by emerging market (EM) central banks in the months to come. This is likely to prove a significant departure from the tightening stance of monetary policy in these markets since 2010. The considerable impact these coordinated monetary easing moves will have on global growth is currently being under-estimated by markets, we think.

Also at play are structural shifts in the flow of global savings which will boost growth in emerging markets, especially in the South-east Asian region. Consequent to the March 2011 tsunami, evidence has mounted of a surge in Japanese foreign direct investment into selected emerging markets in South-east Asia and Latin America. This factor has also lifted industrial growth across these regions in a manner similar to the last time Japanese firms looked offshore in the 1990s after the onshore Japan property and equity market commenced their decade-long decline.

Expectations of further aggressive interest rate cuts in emerging markets should offer support to EM bonds and equities during the current risk-on phase in markets. Asian high-grade bonds offer good value compared to comparable high-grade bonds elsewhere.

We continue to advocate a thematic approach for investing in equities, bonds, real estate and alternative investments with specific focus on:

Asean high economic growth;
US economic recovery in the property, consumer durables and shale-oil and gas sectors;
Emerging market consumer spending;
High-dividend equities and high-yield bonds;
Wireless technology linked to social networking;
Longer-term inflationary concerns linked to excess money creation.
A final note on currencies: the standard pattern over the last three years has been for the major tradeable currencies to fluctuate in fairly wide, albeit, predictable, bands.

The risk-on, risk-off pattern of market behaviour has been reflected in strength for the US dollar (along with the pegged Hong Kong dollar) and the Japan yen during periods of risk-off market sentiment, and vice versa during periods of risk-on.

It is, therefore, intriguing that the risk-on sentiment in equity markets and high-yield emerging bond markets has not spilt over as yet into the euro and the pound sterling crosses. Nor have most Asian currencies strengthened against the greenback as much as the Australian dollar has in late June 2012.

It would appear that euro and pound sterling weakness could be attributed to rate cuts by the respective euro area and UK central banks in July 2012, which were anticipated. We think the US dollar will eventually give up some of its gains later in August/September 2012 when the announcement of QE3 by the US Fed becomes likely.

In Asia, on the other hand, there appears to be a conscious policy by most central banks to keep their currencies mildly under-valued against the greenback to stimulate exports to the important eurozone area and US markets. Even the governor of the PBOC has pointed out that he thinks the renminbi has reached "equilibrium" against the greenback and the renminbi has weakened slightly against the US dollar in recent months.

It is, therefore, likely that the Australian dollar sticks out as the main beneficiary currency of risk-on. This is partly due to Australia's structural strengths of a highly competitive export mining sector and low debt-to-GDP ratio, along with a rapidly growing population from a low base. It also benefits from offering investors the highest yielding high-grade sovereign and corporate bonds anywhere.

The writer is managing director and head of Investment Strategy for Asia, HSBC Private Bank

  
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