MARKET UPDATE December – Comment by Robert Parker

2011-12-21

The US: Risk of a return to recession greatly reduced

The current pattern of recovery in the US suggests that growth in the final quarter of 2011 will be 2-2.5%, supported by export growth, investment spending and "reasonable" consumption. In the first half of 2012, assuming the payroll tax reduction is extended, growth should hold close to 2%. If the tax reduction is not extended, growth will be slightly less than 2%, but, critically, the risk of recession in the US has been reduced significantly. For 2012 as a whole, real GDP growth should expand by 1.8%-2.5% on most scenarios.

Europe: The struggle continues

European economic prospects are worse than in the US or Japan and a number of countries, notably Italy and Spain, will experience contracting GDP in 2012.  German growth is likely to be less than 1% and for the eurozone as a whole, growth will be below 0.5%.  The risk to this forecast is on the downside in the event of no satisfactory resolution to the eurozone crisis.

Japan: Recovery stalling

After the 5.9% annualised increase in real GDP growth in the third quarter, trend growth over the next six months is likely to return to less than 2% annualised.  Although the BoJ will keep interest rates at 0-10bps and maintain QE and foreign exchange intervention, the effectiveness of monetary policy is weak unless QE is significantly expanded.

Market implications

• Equities: Although equities remain supported by several factors, including valuations, risk/reward in other asset classes and investors running record levels of cash, investor flows into equities will likely be slow and defensive given the increase in geopolitical risk in the Middle East, the lack of confidence that the EU plan will be implemented, the lack of progress in 2012 on dealing with the Japanese and US budget problems and given recession risk in the eurozone.

• Bonds: In the euro sovereign bond markets, stresses are likely to remain significant.  Although the central case is that Italy will succeed in refinancing its first quarter 2012 auctions, 10-year yields are likely to remain above 6% for both Italy and Spain, with current spreads remaining elevated for France and Belgium.

• Commodities: Logically, the lack of clear resolution to the eurozone problem should drive gold higher towards US$1,900 per oz by mid-2012, however note that for all commodities, the equity of commodity companies is cheap relative to the commodities themselves.

• Currencies: Given the high probability of the ECB easing, the euro should now break down into a new range of 1.20-1.30, while the BoJ should hold the yen above 75 and likewise, the Swiss National Bank (SNB) will hold the Swiss franc above 1.20 against the euro.  Sterling, given poor economic fundamentals and an easy monetary policy, will remain undervalued.  The overvalued commodity currencies are vulnerable to investor profit-taking.

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