By Mark Burgess, Chief Investment Officer at Threadneedle Investments:
After we cut exposure to European and Asian equities during the strength of the first quarter, we saw equity markets soften in April, with continental European bourses experiencing sharp declines.
Risk premia are extremely high across most markets. High yield bonds are discounting a lot of bad news, while low forward and historic P/E ratios, and dividend yields that in many markets exceed government bond yields, make equities look attractively valued versus their recent history. But government bond yields look to be at rock-bottom levels, with inflation-linked bond yields offering investors the ‘opportunity' to lock in negative real rates of return for the next 15 years. And cash offers next to nothing. For the first time in a generation, the prospective risk-free return looks more like a return-free risk, and investors wishing simply to maintain the real value of their assets are forced to buy assets that are traditionally extremely volatile, such as equities. In this context, we have been comfortable taking a modest amount of these high risk premia in exchange for the meaningful risks on the horizon, and maintain our overweight in non-eurozone equity markets, concentrating what eurozone equities we have in Germany.
The market has increasingly moved its economic forecasts towards our more conservative views. However we increased our forecast for US economic growth in 2012 from 1.5% to 2% after some strong first quarter data. Despite this upgrade, we remain of the view that the US economy will slow in the second half of the year. Our view is driven by an expectation that capital expenditure and a ramp-up in employment will be impeded by uncertainties over the fiscal environment at the end of the year. As things stand, there is a ‘Fiscal Cliff' which will see an extremely sharp contraction in government spending and a rise in personal taxes, taking around 3.5% out of the economy. Our economic forecasting group expects that there will have to be some agreement between Democrats and Republicans to smooth the fiscal austerity programmed into the government's plans, but not until after the November elections. Conversations that we have had with management at large US companies so far confirm our worry that investment decisions are all being postponed until after fiscal clarity is delivered. Furthermore, it will become incrementally harder (absent a major market dislocation caused perhaps by an event in Europe) for the Federal Reserve to apply new unconventional monetary stimulus as the election approaches in November, and this poses a potential threat to the stability of the bond market.
Coming back to Europe, the new Greek government is going to have to implement further austerity measures which will reduce GDP by another 5%. This is being done at a time of rising unemployment, with youth unemployment reaching 50%. The social consequences of Greece entering its sixth year of recession are clear, and maintaining social cohesion during periods of massive austerity is going to be profoundly difficult. This is true to a lesser extent of Spain, Italy and even France, and is perhaps one of the reasons that talk of a ‘growth pact' has started to be mentioned by European politicians and authorities. This leaves Germany looking increasingly isolated, a situation likely to be exacerbated with the election of Francois Hollande. Heightened tensions look likely to cause financial markets some difficulty. Within our European fixed income exposure we continue to be positioned extremely defensively where we need to take exposure to the market.
Economically, we find it hard to get excited about the prospects for the UK. With its main trading partners across the Channel stuck in an economic-financial-monetary-political quagmire, the coalition government's austerity only just beginning to bite, and the (at least) temporary cessation of quantitative easing, we maintain our forecast for zero growth in 2012, and have initiated a forecast for an extremely anaemic pick-up to 1% GDP growth in 2013. We are finding plenty of high quality companies, and remain overweight UK equities due to the attractive valuation of their international earnings. Gilts, on the other hand, offer little value and we have been looking for opportunities to reduce exposure in our fixed income allocations to UK interest rate risk.
Despite our gloomy economic views on the developed world, we find plenty of things to be excited by in the other 50% of global GDP represented by emerging markets. Real consumption growth is healthy, and - in contrast to the developed world - policy tools to support growth abound. The political challenges associated with both the Chinese political transition and the economic rebalancing away from fixed asset investment are not to be overlooked, but we believe that the earning potential of emerging market growth in selected developed and emerging companies remains undervalued.
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