A sharp change in sentiment, but how long will it last?

The early 2012 rally by risk assets is likely to peter out in the months ahead, cautions Robeco Chief Economist Léon Cornelissen, given that the problems in the eurozone have not been sorted out definitively.

Risk assets had a very good January. Global equities had gains of almost 5%, while real estate and emerging debt were up by more than 6%. Emerging markets equities had a particularly robust month, returning more than 10%, erasing a good part of their underperformance over the last six months.

A number of factors were behind markets’ enthusiastic start to the year. First, the fundamental macroeconomic picture has improved. Recent US data has been better than expected and there is a growing conviction that China will avoid a hard landing. “Macro data suggests that the probability of a double dip continues to decline,” notes Léon Cornelissen.

Second, there has been a positive shift in the eurozone debt crisis. By taking a more aggressive approach—via offering banks unlimited three-year loans (the so-called LTROs) with low interest rates and eased collateral requirements—the ECB has succeeded in calming the crisis, not least by allowing Italy and Spain to refinance themselves at acceptable rates.

Third, there is the seasonal factor. This is the market pattern in which performance is weak in summer and not so weak in winter. And that is a source of support for equities that will remain in place in the months ahead, as the seasonal factor continues through April, though becoming less pronounced. Moreover, economic growth is set to continue, even if positive surprises are unlikely. That is another plus-point for equities.

Rally of risk assets set to fade
But that isn’t the whole picture. Léon Cornelissen warns that several negative factors are lurking in the background and their emergence could well signal a reversal of the new-year exuberance. “We expect the rally of risky assets to fade in the months ahead,” he says.

For one thing, no definitive solutions have been devised for the problems in Greece, which will not be put on a sustainable path even if the latest rescue plan is concluded successfully, and Portugal. The latter was downgraded to junk status by S&P and will probably need a new bailout package at some point this year.

In addition, the economic downturn will continue to put pressure on Italy and Spain. “The debt crisis is far from solved,” says Cornelissen. “The fundamental weakness of the southern periphery needs to be addressed, while the new, more-integrated fiscal set-up for the eurozone—including rules for dealing with participating countries that fail to meet their obligations—has yet to be finalized.” A third complicating factor is this year’s French elections.

Given the scope for bad news on these issues, the Financial Markets Research team maintains a relatively cautious asset allocation positioning. They are neutral on equities, real estate and commodities. They prefer corporate and emerging markets debt to government bonds, which are heavily overvalued.

Global economy in cyclical recovery phase
But let’s have a closer look at the macro picture. Overall, the current global macroeconomic environment can be characterized as a cyclical recovery that is being tempered by structural problems. One consequence of these structural problems is that economic growth is set to be lower than the trend growth of the past.

“Our baseline scenario is therefore one of stagnating economic recovery, to which we give a 70% probability, while we feel that there is currently a 20% chance of a double dip occurring,” notes Cornelissen.

US economic resurgence picks up pace
Even so, recent macro data has generally been pretty resilient. The US is a prime example. The manufacturing PMI there has been on the rise since October 2011 and the recovery in the labor market persists, as highlighted by the 257,000 new jobs reported in January and the fall in the unemployment rate to 8.3%.

Europe revealed unexpected resilience in January
The eurozone’s debt-related problems may be far from solved, but the region’s economy also showed surprising strength in January, led by Germany and France. The Eurozone Composite PMI rose from 48.3 in December to 50.4 in January, signifying expansion. And while activity is still contracting in Italy, Ireland and Spain, even their PMIs improved in the first month of the year.

Says Cornelissen: “The apparent stabilization of business conditions is welcome news after the decline in the last quarter of 2011”.

There was good news from the UK, as well. Both the manufacturing and services PMIs jumped sharply in January. In the meantime, inflation is falling dramatically, dropping to 4.2% in December from the peak of 5.2% in September. “That is increasing the leeway for additional quantitative easing by the Bank of England,” observes Cornelissen.

Trade deficit points up Japan’s vulnerability
Japan missed out on the good news in January. For 2011, the country suffered its first trade deficit for 31 years. Exports fell by 2.7%, in part due to damaged supply lines, in part due to the slowdown of the world economy. Car exports plunged by almost 11%.

Meanwhile, imports rose by 11%. Energy imports soared, with natural gas up by 38% and crude oil by 21%, a consequence of the closure of most of the country’s nuclear power stations.

“The deteriorating trade balance has refocused attention on Japan’s heightened vulnerability, given its record-high sovereign-debt ratio and its unfavorable demographics,” says Cornelissen.

Emerging markets’ inflation is coming down
In emerging markets, inflation is declining and the authorities are—one way or another—switching to a policy of monetary easing. Consider India. The benchmark wholesale price index is—finally—coming down. And it is falling rapidly, dropping from a high of 10.0% in September to 7.5% in December. The central bank has indicated that it is prepared to lower rates if inflation declines further, which is likely.

More rate cuts are also likely in Brazil. The central bank has lowered rates by 200 basis points since August because of the slowdown of the economy, even though inflation—at 6.4%—remains far above the target rate of 4.5%.

Chinese inflation trended marginally lower (to 4.1%) in December. There is a growing conviction that China will be able to avoid a hard landing. “In any event, the Chinese government has ample room for maneuver should it turn out to be necessary to give the economy a boost,” says Cornelissen.

Equity gains likely to be held back by debt crisis
So how does the continued ‘muddling-through’ scenario—featuring continuing modest economic growth, an on-the-ball ECB but also an unfinished crisis that has temporarily abated—translate into asset-allocation positioning?

That combination means that the outlook for equities is only neutral. “We believe the worst of the debt crisis is now in the past, but the exit will not be smooth,” says Cornelissen.

Emerging markets: the favorite region within equities
Within equities, emerging markets are still the Financial Markets Research team’s favorite region. “They are benefiting from declining inflation risks, looser monetary policy, decent growth data and a turn in risk aversion,” points out Cornelissen.

As well as these favorable macro factors, he judges emerging markets to be undervalued by some 10% relative to their developed counterparts. And while corporate governance is a negative that would justify a discount, these markets do not have the sovereign-debt issues that plague developed markets at present. “We would thus see an equal valuation as reasonable,” he says.

North America preferred to Europe & Pacific
The team’s other regional preference is for North America over Europe and the Pacific region. In Europe, they expect further currency weakness in anticipation of the ECB’s next three-year tender, while sentiment is sensitive to economic data in Spain and Italy.

Meanwhile, earnings revisions in the Pacific are very weak, which is in part a reflection of the strength of the yen. “We doubt whether the region is as cheap as many believe,” notes Cornelissen.

Defensive equity sectors no longer preferred
At present, the team does not have a pronounced view on sectors. In January, they dropped their preference for defensives over financials. “Defensives’ momentum weakened further, while downward earnings revisions also hurt defensive stocks,” explains Cornelissen.

They now have a slight preference for cyclicals (industrials to be more precise, which combine decent momentum and relatively good earnings revisions) above financials, as they remain reluctant to walk away from their negative view on financials. “We acknowledge that an unlimited amount of almost-free money is positive for the financials sector, but we doubt their long-term potential,” he says.

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

While it is encouraging that analysts have not downwardly revised their earnings estimates for real estate companies over recent months, 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.

Government bonds out of favor
The team is negative on government bonds. Although short-term inflation risks are low, quantitative easing, the aging of the population and the swift rise of the emerging middle class are factors that could very well drive consumer prices higher a few years down the road.

At the same time, government bonds are heavily overvalued. US and German yields are hovering around multi-decade lows, generating negative real yields: US and German ten-year yields are currently at 1.8%, against respective headline inflation rates of 3.0% and 2.7%.

Continued outperformance by corporate bonds expected
“We believe corporate bonds to be more attractive than government bonds, as there is more scope for spreads to narrow,” says Cornelissen. Indeed, the team expects both investment grade and high yield bonds to continue their outperformance of government bonds.

One side effect of the unlimited amounts of cheap money that the ECB is flushing into the banking system is to narrow other yield spreads. In the US, meanwhile, the recovery is just weak enough to trigger further quantitative easing.

“The combination of weak growth and increasing liquidity should propel corporate bond spreads closer to their historical median spreads,” says Cornelissen.

Attractive prospects for emerging debt
Cornelissen and colleagues also prefer emerging markets debt to government bonds. On one side are the positives in emerging markets. Emerging debt is benefiting from the improving inflation prospects and decent growth outlook for emerging markets. Moreover, sovereign-debt problems look set to remain confined to developed markets. On the other side is the unattractive valuation of sovereign paper.

The team has a slight preference for corporate bonds over emerging debt. They view the former as a safer option.

Neutral commodities call maintained
For commodities, the team maintains its neutral stance. On the positive side, they expect the long-term uptrend in commodity prices to continue. No major slowdown should be expected in emerging markets from here, while developed markets—with the exception of the eurozone—look as if they will avoid a double dip. The demand for commodities should thus continue to grow.

In the short term, however, the team takes a neutral view. “Momentum has not been convincing in the recent months, while oil reserves are still a bit higher than average,” explains Cornelissen.