SINCE the middle of the year, equity markets have performed strongly, due largely to positive action from major global central banks.
Most significantly, moves by the European Central Bank have dramatically reduced the odds of a euro break-up, while the Federal Reserve in the US has reassured markets that easy monetary policy will be in place until, and perhaps even some time after, the economic recovery is completely assured.
In our view, the long-term outlook for “risk assets” continues to remain favourable, although we would highlight that the final two months of the year could be very testing for financial markets.
The key issue is whether politicians in the US will avoid the “fiscal cliff” next year, which would almost certainly send the country back into recession.
Also during this period, a leadership transition in China is taking place, while events in the eurozone never seem to be far from the headlines.
With thanks to the ECB, sentiment towards the eurozone has improved significantly since the summer months, with recent policy action dramatically improving the odds that the Euro-Area can continue to exist in its current form and avoid a further downturn.
A more positive tone has also been apparent from the political elite, with the establishment of a banking union by the end of 2013 recently agreed and the 500 euro European Stability Mechanism fund now in place.
Nevertheless, the macro-economic and fiscal outlook for the eurozone continues to remain somewhat of a concern. It is highly likely that the Euro-Area entered another recession in the third quarter, with very subdued growth perhaps the best case scenario for 2013.
Spain remains a particular cause of concern – GDP has declined for five consecutive quarters, unemployment is around 25%, bad loans in the banking system recently hit a record high and this year’s budget deficit target may well be missed (yet again!).
Nevertheless, the ECB’s pledge to do “whatever it takes” has led to a dramatic decline in short term Spanish (and Italian) borrowing costs.
Looking to Italy, the key area of uncertainty relates to the fact that the country will go to the polls early next year to choose a successor to the current leader Mario Monti (although Mario Monti has not ruled out continuing his leadership if the poll results are inconclusive).
Meanwhile, the probability of Greece leaving the euro in the near-term appears to have declined somewhat – Angela Merkel’s recent visit to the country was symbolic that Germany is perhaps willing to show more sympathy with troubled member states. Indeed, at the time of writing it seemed likely that Greece would receive its next bail-out tranche of circa 30bn euros and would also be given an additional two years to meet budget deficit targets.
In the US, developments on the US macro front have been particularly encouraging in recent months, despite high levels of political uncertainty. Third quarter GDP rose by 2% compared to a 1.3% increase in the second quarter. The employment picture also continues to improve, with the unemployment rate now at its lowest level since January, 2009, which has helped to promote spending – for example, auto sales in September increased at the fastest pace since March, 2008. The housing market, the cause of the initial crisis, also seems to have turned a corner recently, thanks to record low mortgage rates, a material fall in sales inventories (to long-term average levels) and improving lending conditions – house prices have risen 5-10% this year on an annualised basis.
As we approach year end, the key issue facing the US economy is whether the “Fiscal Cliff” in 2013 can be avoided – the economy could face a potential fiscal contraction next year of circa 4% of GDP if Republicans and Democrats fail to reach some form of compromise on fiscal issues.
For several months now, an economic slowdown has been apparent across a number of the major emerging market economies, including China. Chinese GDP in the third quarter rose by 7.4% year-on-year, the slowest pace since the first quarter of 2009, while 2012 looks set to be the slowest year for economic growth since 1999, due in part to the effects of the slowdown in Europe.
In response and with thanks to lower inflation rates, policymakers in China have been able to reduce interest rates and also recently approved 1trn RMB in new infrastructure projects. It is hoped that once the leadership change is finalised in November, additional measures to help the economy could also be announced and one should not underestimate the level of firepower available to policymakers in China. Indeed, there is already evidence that after seven consecutive months of slowdown, growth rates may finally begin to increase in the fourth quarter of this year.
After three consecutive quarters of decline, the UK economy finally grew in the third quarter by a much better than expected 1% – this was the strongest quarterly increase in GDP since the third quarter of 2007.
Although clearly encouraging, it is unlikely that this rate of growth will be sustained going forwards – the Olympics added around 0.2 percentage points to the headline figure, while second quarter GDP was favourably comparable because of the extra jubilee bank holiday. Indeed, for perspective, the economy is still around 3% below its pre-crisis level and has not grown at all over the past 12 months.
UK public borrowing also remains a concern, with the Office for Budget Responsibility borrowing target likely to be missed this fiscal year.
However, the labour market in the UK continues to improve, with the unemployment rate currently at 7.9%, from a peak of 8.4% late last year. This has been positive news for UK banks and should help to support asset quality and credit expansion going forwards.