CURRENT ECONOMIC VIEW

End December 2011

General

To forecast is more than ever an art rather than a science as the world is starting 2012 with more questions than answers. The euro zone crisis will likely continue to dictate the path between equilibrium and instability, whereas the US should be able to continue to postpone recession, mainly through unorthodox monetary policy. Loss of faith in the ability of politicians to deal with structural issues will keep investors prudent despite the relatively attractive valuation on risky assets. Equity markets are in oversold territory and we are ready to buy should potential solutions to the sovereign crisis arise. The euro zone economy has already fallen into recession and the credit crunch is hurting global growth. The euro-zone crisis has entered a more dangerous and unstable phase with contagion moving to core euro zone countries, but the 9 December EU heads of state meeting brought some solutions and the recent decision by the European Central Bank to inject Eur490bn capital to the system via 500 Banks also halted the decline temporarily. The Germans might concede to the ECB acting as lender of last resort as an essential but inadequate solution provided political leaders commit to closer fiscal and political integration, although Britain vetoed a recent effort to bring about closer union. Any further delays in tackling the euro zone crisis will exacerbate the risk of a deep recession and increase the odds of a euro zone break-up. Italy has borrowing needs of Eur440bn in 2012, while Germany has to roll over Eur273bn next year and around Eur580bn over the next three years. The risk of an S&P downgrade of France’s AAA rating is increasing; this would further impact the ability to leverage an already challenged rescue fund.

United States

We remain below consensus forecasts for US growth, this year and next (2011 US GDP at 1.7%, 2012 US GDP at 1.9%). After 2.5% in the third quarter, the US economy may end 2011 growing at its fastest rate in 18 months as analysts have increased their forecasts for the fourth quarter – to around 3% on average. Behind the revised fourth quarter forecasts: consumers have not cut back on spending even with the turmoil in world financial markets, putting pressure on companies to rebuild inventories they ran down because of concerns about Europe. Improvement in the US unemployment rate is key to the sustainability of GDP growth. Although lagging, it is a significant economic and political indicator (expected at 9.0% in 2011 and 8.8% in 2012). Nonfarm payroll employment rose by 120,000 in November, whilst the unemployment rate fell to 8.6% from 9.0% in October, its lowest level in more than two years thanks partially to a fall in the active population. The Super-committee failed to reach an agreement on its deficit reduction target, which will result in automatic spending cuts from 2013 (unless vetoed by President Obama). This is a negative outcome for growth and a positive one for bonds. Combined with relatively disappointing macroeconomic data and lower inflation figures, this supported the Treasury market especially the longest maturities.

United Kingdom

The Bank of England (BoE) surprised the markets with the resumption of its QE programme, saying it will inject £75bn into the economy. The larger-than expected allocation for QE2 is a sign of how bad things are in the UK economy, as the government attempts to keep the AAA credit rating through spending cuts whilst trying to avoid hurting the fragile recovery. The Bank kept its lending rate unchanged at the historic low of 0.50% and is not likely to hike rates before 2013. The minutes of the October Bank of England’s meeting also revealed that the Monetary Policy Committee had in fact considered an even larger purchase program of £100bn. On the economic front, UK annual inflation data topped 5%, adding to concerns the economy could face a prolonged period of elevated inflation and stagnant growth. Activity indicators are pointing to a weaker growth environment and stagnating job creation. Chancellor George Osborne’s Autumn Statement highlighted sharply reduced forecasts for growth to 0.9% this year, down from 1.7% and to 0.7% next year.

Continental Europe

The region is unlikely to avoid a recession this quarter and next given the ongoing sovereign debt crisis and as fiscal austerity measures are implemented. With even the ECB forecasting a mild recession by year end, the only question is how severe it will be. At the 9 December EU meeting, European leaders, except for the UK, agreed on a pact aimed at saving the euro. British Prime Minister, David Cameron, demanded a series of safeguards for UK-based financial services, which were deemed unacceptable by all the other EU members. The UK veto forced the 17 euro zone (EZ) members to opt for an intergovernmental deal that will have to be negotiated outside the EU legal framework, with nine other non euro members looking to join. In a historic breakthrough, they agreed on much closer fiscal integration, with strict rules and semi-automatic sanctions to enforce budget discipline. The summit also approved an additional Eur200bn contribution to the International Monetary Fund, improving its ability to help struggling countries. The ECB, however, gave no sign that it had agreed to increase the bank’s intervention in euro zone sovereign bond markets. Mario Draghi did not weaken his stance but financial markets seem to believe that the ECB cannot backstop banks effectively unless it backstops governments as well. He subsequently allowed a funding window for EZ banks, 500 of which borrowed Eur490bn. The summit has opened the door to some form of fiscal union but the path will be long and significant structural reforms are still needed to move towards an optimal currency area. In the meantime, volatility will stay high as investors continue to question the implementation risks and the long-term solution to the crisis.

Japan

The evidence from survey indicators is strengthening, with the economy apparently recovering from the earthquake, as the reconstruction operation continues. Nevertheless, the absolute level of activity remains significantly below its pre-earthquake level. A further contraction was recorded in Q2 although not as severe as anticipated, despite rapid monthly improvements in activity. The current account is expected to deteriorate as capital flows are required to pay for the rebuilding programme, but should recover as the rebuilding comes to an end. GDP is expected to contract by 0.8% in 2011, but to rebound strongly in 2012, recording growth of 3.5%. Since late October Japanese equities have lagged other major markets questioning the decision to remain overweight to the region to benefit from a post-earthquake economic recovery. The Q3 GDP number was in line with expectations (6% annualised) pointing to the recovery but it seems that export growth and industrial production are below expectations partly due to weakening global economic growth.

Pacific/Emerging Markets

Emerging stock markets are seen by investors as high-beta plays on the global recovery and risk appetite. Following a couple of years of rapid growth, emerging economies are cooling down. This process should continue and might be further amplified as the developed world’s macroeconomic expansion is being revised downwards. The Chinese economy is slowing down, which confirms the soft-landing scenario. Emerging market (EM) economies are, on average, well positioned to weather a global slowdown. Should the world’s economy decelerate significantly, one would see a downturn in EM countries; however, compared to 2008/09, this would now occur from a more solid (i.e. less overheated) growth base.

Bonds

Relatively disappointing macroeconomic data and lower inflation figures have supported the US Treasury market recently, especially the longest maturities. Other core government bond markets (UK Gilts, Swiss Confederation bonds) also gave positive returns in the Quarter. Satellite fixed income lost most of the October gains, especially higher beta sub-asset classes such as emerging debt in local currency, subordinated debt from the financial sector and corporate high yield. Although we agree that purchasing 10-year Treasuries yielding less than 2% is not a great carry trade (income generator), from a long-term/buy-and-hold perspective, we do not expect the US sovereign bond market to collapse. The outlook for European Monetary Union (EMU) government bonds is less clear. Should politicians fail to find a solution, all yields would trend higher. Otherwise, peripheral spreads could narrow modestly, at the expense of German Bunds.

Currencies

The US Dollar Index (DXY) trade-weighted dollar has increased by 5.1% in the Quarter. The US dollar continued to be essentially dependent on the global risk environment. In November, it was supported by safe haven flows due to the ongoing euro zone crisis. Indeed, after a few days of hope, the 26 October EU meeting disappointed as it failed to be followed by concrete measures. The euro remained under sustained pressure as the European sovereign debt crisis deepened in November. Funding costs for Italy and Spain reached dangerous levels and the crisis even threatened France. We continue to favour a stronger US dollar as it remains the best safe haven from economic or political crises. This means it will be the beneficiary of further risk aversion, which can be expected as a consequence of the global financial crisis.

Financial Markets December 2011