News and insight

After several months of positive surprises, economic data softened in March: on both sides of the Atlantic, and in China, key business surveys fell short of expectations, and of the previous month’s readings.

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Meanwhile, the Chinese government announced a lowered target for economic growth in its next five year plan; and at long last Greece finally defaulted on its sovereign debt, triggering the much-feared ‘credit event.

Our reading of these developments, however, is that they do not alter the big picture. Every business cycle is accompanied by ebbs and flows in inventory accumulation and final demand, and unseasonably-fine weather also has the potential to affect the monthly profile of activity during the first quarter.

As we see it, 2012 is still shaping up to be a year in which the global economy continues to grow above the stall speed at which corporate profitability begins to slide and deflation fears resurface: it will likely be supported by a modest acceleration in growth in the US that will help to mute the impact of a modest recession in the euro area and slowdown in China. This continuing recovery will likely help keep the return on shareholders’ funds firmly in double-digits in the developed bloc.

The main source of our glass-half-full assessment of the economic outlook continues to be the resilience of the US consumer, still the largest single customer for global business. Solid cashflow, underpinned by a rebuilt savings ratio and stronger disposable income than feared – the latter supported by a debt servicing ratio that in Q4 2011 fell to its lowest level since mid-1994, almost the lowest on record – is combining with a balance sheet in rude health (debt notwithstanding: see the October 2011 Compass) and rebounding employment and confidence to support ongoing growth in spending. We expect this to keep GDP growth in the 2-3% region in 2012.

In the UK, the political debate surrounding the budget – which has itself economically and fiscally neutral, and so unlikely to affect either growth or the UK’s credit rating – is we think masking a slightly firmer tone in the economic data, with the manufacturing sector in particular reporting relatively robust order books and output expectations in the last 3 months. Remember that this would not be the first time that the UK economy muddled through a period of fiscal austerity without sliding back into recession: now as (famously) in 1981 the private sector has taken some avoiding action by raising savings, and the monetary climate is much more lenient than the fiscal one.

None of this should be read as suggesting that we see the global outlook as rosy. Risks are very visible (in addition to oil prices, and ongoing worries about the pace of growth in Spain and Italy, there is also the unresolved issue of the US’ fiscal deficit, for example, and the impact that eventual retrenchment there could have on growth). But the investment mood for much of the last year has been resolutely pessimistic, and even modest growth in 2012 now would come as a welcome surprise to capital markets that we think are still priced for worse.

After a very strong start to 2012 – developed stock markets up by 12% in local currency terms to 19 March – risk assets have fallen back in more recent trading.

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Some profit-taking after a strong rally is unsurprising, particularly when there are such ongoing risks so visibly still in place. We would not pretend to be able to call the precise extent and duration of this setback, but we do think that for investors with the financial personality and circumstances to take a long-term view it likely represents an opportunity to add to positions, and to do so at the expense of positions in core government bonds in particular.

A key support for this view of course is a level of equity valuations that to us continues to look unremarkable, despite the market’s rebound. For the developed world, PE ratios for 2012 remain firmly below their relevant long-term averages. Of course, the earnings forecasts embodied in these could prove overly optimistic, particularly if we are wrong about that ongoing economic growth.

A key update lies ahead in the shape of the US Q1 reporting season that kicks off in April: the remarkable run of consecutive positive earnings surprises (twelve quarters to date ) must surely come to an end at some stage, and we know that many investors are nervous at what they see as unsustainably-high operating margins. But ongoing revenue growth, and an outbreak of relative stability in the financial sector after Q4’s trauma, may provide some support, and we doubt that analyst forecasts for 2012 as a whole are about to take a dive. We are ourselves relatively relaxed about the underlying trend in US profitability: we think that many investors’ fears are based on a mistaken belief that the lower profitability of the ‘seventies and early ‘eighties was somehow the 'norm' to which companies will revert, whereas we see it as an exception.

European companies face a more testing time, given the weaker domestic economy and risk of bank write-downs. Here, however, analysts have already cut their forecasts sharply, and the markets in any case usually take their lead from the US. Can you just cross-reference with the final version of compass to make sure this is right?

A further risk that we can pinpoint with some confidence in the months ahead is that posed simply by the calendar. A 'sell in May and go away' effect is very visible statistically in global as well as local markets – as fundamental analysts we might decry it, but since there could be some objective reasons for it we can’t ignore it. The chances of such an effect in 2012 seem likely to be greater if the market continues to perform in April, so the setback currently underway might perhaps partially defuse it.

Developed equities, and high yield credit, are the two asset classes that we think will benefit most on a 3-month and longer time horizon from the muddle-through scenario we continue to expect. But while we advise owning more of these than usual in a balanced portfolio – financial personality and circumstances permitting, of course – we also advise owning fewer core government bonds.

Again, this does not reflect a concern about the creditworthiness of the US, UK or German governments – whatever the rating agencies might say – as we expect these governments to continue to fully meet their obligations to bondholders for the foreseeable future. Instead it simply reflects a belief that these assets are expensive, and likely to fare badly in a scenario of continuing economic growth globally, and the avoidance of financial disaster in the euro area. In this context, the developed world central banks will eventually stop supporting the markets directly and indirectly and begin gradually to unwind their activities (and one day, of course, will start raising short-term interest rates).

Viewed in this context, it is tempting to see the rise in yields since February as evidence of a turning point. However, the 30-year bull market in government bonds has already outlived many of its obituarists, and we are not brave enough to argue now that this secular watershed is imminent. But we do see the backing-up in yields as a dress rehearsal for a more potent sell-off at some stage. If and when risk appetite does revive more fully, nominal 10-year yields are still so far below the plausible long-term growth rates in nominal GDP as to suggest that they might easily rise by a further 1.5 percentage points or so during the cycle, which might result in double-digit mark-to-market losses at some stage.

Many private clients in particular may view their bondholdings as the financial equivalent of a trusted family retainer: they have done a tremendous job of protecting and adding to their wealth for such a long time, and the positions are so firmly in profit, that as the bull market gets visibly long in the teeth and prone to accidents, its shortcomings may be overlooked and the bonds held to maturity rather than put out to grass. And of course, balanced portfolios should always hold some high-quality bonds simply for purposes of diversification. But for investors with new money to allocate to balanced portfolios, we think other positions should be built first.