Outside the eurozone, the world economy is doing OK

With the US picking up and emerging markets ticking over nicely, the global economic picture isn’t as bleak as it looks from the eurozone, says Robeco Chief Strategist Ronald Doeswijk.

There hasn’t been much to smile about in the eurozone recently. The sovereign debt crisis rumbles on. The economic picture continues to deteriorate. And worries about a fresh credit crunch in the region’s banking system are intensifying.

But such a depressing picture is by no means universal across the globe. The economy in the US is picking up and emerging markets—while no longer motoring along at top speed—remain relatively robust.

“The eurozone debt crisis may make Europeans feel miserable about the state of the global economy,” says Ronald Doeswijk. “But from other vantage points, the picture is not so gloomy.”

Despite the eurozone’s slide towards recession, 2012 was actually a year of moderate economic growth across the globe. And the world economy remains on a path of moderate, below-trend growth. Doeswijk notes that producer confidence and retail sales data in developed markets both suggest that modest growth is set to continue.

Growth in emerging markets should be solid in 2012
Meanwhile, emerging markets should see decent growth this year as well, with 7-8% expansion expected in China and India. Economic growth in those countries, as well as Brazil, declined last year. That was actually good news, given the acceleration of inflation. The threat of inflation has subsequently fallen sharply, and some relaxation of monetary policy has already occurred. “We expect the brake on the economy to be released gradually,” says Doeswijk.

Still, fears about a hard landing for the Chinese economy have not disappeared. “But it does seem unlikely,” he says, adding that the three indicators favored by vice premier Li Keqiang—electricity production, railway freight and domestic credit growth—point to a controlled slowdown.

Eurozone debt crisis has capacity to derail global growt
Such prospects of solid progress may sound reassuring but, thanks to the eurozone debt crisis, there are no guarantees that the ‘muddling-through’ scenario will continue. It isn’t just that the debt crisis has brought uncertainty that is making companies reluctant to invest and consumers hesitant to spend.

More worryingly, it also still has the potential to push the eurozone into a depression and to drag the global economy into a recession.

“The debt crisis could still blow up the euro,” concedes Doeswijk. “But it is more likely that the ECB will do whatever is needed to ensure that Spain and Italy can refinance their debts at affordable interest rates.”

He believes that the ECB will do so because the collapse of the euro, which would be one consequence of a Spanish or Italian default, would entail vast costs. “That means that the euro is here to stay, although it is possible that Greece will not only default on its bonds but also leave the eurozone,” he adds.

Inflation: not an issue for 2012
In this brittle atmosphere, Doeswijk believes that inflationary risks in 2012 are limited. That is despite both overall inflation and inflation excluding volatile food and energy prices have increased.

The medium term picture is different, however: inflation risks remain. “After a debt crisis, the threat of inflation is always present, as a consequence of the ultra-loose monetary policy that has been implemented,” says Doeswijk. “In addition, the rise of the middle class in emerging markets is increasing the demand for commodities. Finally, aging might eventually lead to wage inflation.”

Lackluster prospects for equities
So how does this ‘muddling-through’ scenario—featuring continuing moderate economic growth and the ECB ensuring that Italy and Spain can refinance their debt at reasonable rates—translate into asset-allocation positioning?

Late last year, Robeco’s Financial Markets Research team upgraded its view on equities to neutral, as they felt that likelihood of further declines was no longer greater than the probability of a rebound. (Click here to read the original article outlining the move, “Better equity outlook as ECB looks set for expanded role”, 1 December 2011).

Doeswijk believes that the prospects for the asset class are still unexciting. “We are not forecasting strong returns for equities over the next few months,” he says. For one thing, he believes that the current earnings estimates are too optimistic. He expects low single-digit earnings growth at best.

“At this stage, we believe that positive surprises in the months ahead are unlikely,” he says. “As a result, from a starting point where valuation is neutral, we do not expect equities to stage a strong rebound.”

Emerging markets: the favorite region within equities
Within equities, the team remains positive on emerging markets, despite the disappointing performance in 2011. They put that down to inflation risks and risk aversion. Now, though, inflationary risks are falling and there is room to relax monetary policy. In addition, investor risk aversion has probably peaked.

Moreover, the deceleration of growth in emerging markets in 2011 should generally cease, even though China might fall a bit further. “Looking at fundamentals, emerging markets are a relatively cheap segment compared with developed markets, and have relatively sound fundamentals,” says Doeswijk.

The team maintains its negative view on European equities. Yes, it is true that Europe is cheap compared with the broader market, but more debt crisis-related volatility is likely in the months ahead. Moreover, the eurozone is in a recession, a development that is reflected in earnings growth and in earnings revisions, which are low compared with other regions’.

Doeswijk says the team is also negative on the Pacific region. “Index heavyweight Japan has negative long-term fundamentals. There is no short-term reason to change that view,” he notes.

Defensive equity sectors still preferred
For now, the team maintains its positive view on defensive equity sectors versus financials, although their conviction about this call is weakening. “There is no strong fundamental or quantitative signal calling for a change,” observes Doeswijk. “The debt crisis has not disappeared and the eurozone has fallen into a recession, while momentum and earnings revisions are no longer so clear cut.”

Neutral on real estate
The team continues to be neutral on real estate. “The outlook for real estate closely resembles the one for equities,” says Doeswijk. “We expect both asset classes to deliver moderate returns in our economic ‘muddling-through’ scenario.”

A number of factors are militating against more robust returns. First, the ratio of net debt to total assets, though decreasing, is still high from a historical perspective. Second, access to funding will be an important issue for the foreseeable future. And third, there is no significant difference between equities and real estate from a valuation perspective. The current price/cash flow ratio for real estate is 1.5x the one for stocks, which is in line with the historical average.

Corporate bonds are set to outperform government bonds

During the last month, the team became more enthusiastic about the prospects for corporate bonds. “We believe the most attractive trade at present is to be long corporate bonds—both investment grade and high yield—versus government bonds,” says Doeswijk.

What is behind this expectation that corporate bonds will outperform government bonds over the coming months? “The low economic growth that we expect should be enough to generate compelling returns relative to government bonds,” he explains.

Corporate spreads have widened to recession levels
Valuation is attractive, too, as corporate bond spreads have widened to levels typical for a recession, which is by no means certain to occur. “One could argue that spreads have risen too far, given that corporate balance sheets are healthy,” says Doeswijk.

Corporates are indeed loaded with cash: earnings have reached fresh all-time highs and the fragile economic environment is making companies reluctant to invest. These reserves are making them better-prepared for any new downturn or for higher interest rates. In short, there is a mis-match between corporate balance sheets and corporate bond spreads.

At the same time, government bonds are heavily overvalued, notes Doeswijk. “US and German yields are hovering around multi-century lows, generating negative real yields,” he says. Still, no dramatic sell-off of sovereign paper should be expected: with short-term inflation risks declining, it could be some time before long-term interest rates start to normalize.

Neutral commodities call maintained
The team maintains its neutral stance on commodities. On the one hand, they expect the long-term uptrend in commodity prices, which began at the start of this century, to continue.

On the other, a handful of factors are less propitious: the slowdown of emerging markets economies, tensions around Iran and—most importantly—the eurozone debt crisis. “For now, we regard commodities as a high-risk bet that we do not wish to make in the short term,” concludes Doeswijk.