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Despite some weaker data points in the EU and China, the last several months have delivered a pleasant economic surprise with global GDP appearing to have recovered to around trend-like growth led by a pick-up in manufacturing output, specifically in the US and Asia ex China. Some of this rebound is attributable to temporary supports, however, and there may well be a loss of momentum in Q2. In general though, most commentators believe the global economy bottomed in Q4 last year and expect a gradual improvement as the year progresses.
Of course both the EU and China are experiencing the self-inflicted effects of a policy induced downturn and slowdown respectively. The impact of fiscal austerity is being felt virtually throughout the EU but especially in Southern Europe, while the Chinese authorities tightened monetary policy to lower inflation, as well as rein in an overheating property market and a local government lending boom. The result is forecast to be a mild euro area recession this year and weaker but still strong growth in China. While the authorities have little shorter-term scope to improve the position in Europe, at least the Chinese authorities can relax both monetary and fiscal policy to avoid a hard economic landing.
Policymakers in the US, Japan and the UK have all turned to monetary stimulus to strengthen their economies and, while this has certainly provided some support, the key difference between expected near trend growth in the US and a virtually stagnant UK economy, is that the latter embarked on an onerous fiscal tightening programme that, along with high levels of policy-induced inflation, combined to severely squeeze real household incomes. Over the balance of the year most commentators expect economic conditions to gradually improve in the UK and, hopefully for the US economy to transition from the recovery phase to a self-sustaining expansion. Whether this can be maintained through next year as the US begins to tackle its huge budget deficit, however, will be one of the key debating points later in the year.
Growing confidence in the global economic outlook has certainly been reflected in the financial markets in recent months. With nearly all central banks committed to stimulating monetary conditions, either via QE (mainly bond purchases) and holding interest rates at rock bottom levels or, as in the EU, through support for the banking system i.e. the ECB's €1tr two-stage LTRO programme, this encouraged investors to return to risk assets with February recording particularly strong gains. Markets began to run out of steam somewhat in mid-March, however, with profit-taking in some of the highly successful reflation trades. Even so, equities, corporate bonds, commodities, EU peripheral bonds and higher beta countries and sectors generally still produced decent returns over the two-month period.
Progress from here on may be more difficult, however, with risk assets no longer significantly undervalued. Worries persist that a further spike in the oil price, a Chinese hard landing and ongoing EU recession/debt issues, with Spain now at the centre of attention, could undermine still fragile confidence. Rising main market government bond yields also recently entered the equation and, after a period of strong returns and one-way markets, the next few months may prove more problematic with far greater volatility in prospect.
Irish government bonds also benefitted from the rally in riskier assets with 5-7 year bonds returning a very impressive 4.2% over the two months. Yields fell across all maturities with 9 year yields, at 6.8%, the lowest since November 2010. Two to five year notes have converged around 5.0%, suggesting that Ireland could now finance itself in the market at a sustainable rate.
This eventuality could be compromised, however, should the economy not grow in line with medium term forecasts and, unfortunately, recent hard data has disappointed. Q4 2011 GDP contracted by 0.2% resulting in the country slipping back into technical recession. Ireland's recovery is very export intensive and, in the short run, it is clearly vulnerable to demand shocks from the EU, US and UK.
The very latest survey data is more encouraging, however, with the manufacturing PMI indicating a real improvement in conditions for the first time in five months, while the NCB Ireland Services Business Activity index showed continuing positive sentiment. The March quarterly Bloomberg survey of Irish GDP estimates showed a sizeable improvement with 2012 growth forecast at 0.4% compared to -0.8% previously.
Over the January to March period the Irish stockmarket once again produced excellent gains with the ISEQ index some 8% ahead (9% in the prior two months), outpacing all the main European and most world stockmarket indices. Such a strong move was mainly attributable to a 24% jump in the share price of Kerry Group, Ireland's leading food company, which accounts for 11% of the ISEQ index.
Prospects for the major asset groups:
- Short term interest rates - with short rates at rock bottom levels in most major financial centres, QE (unconventional monetary policy) continues to be the main policy instrument to further ease monetary conditions. The ECB looks set to keep its official rate at 1.0% following the completion of the 3-year LTRO programmes and some disappointing inflation data. As yet there is no sign that short rates will do anything other than remain close to zero for some considerable time to come.
- European and international fixed interest - the main change in international markets was a spike higher in yields in mid-March on better US economic data and Federal Reserve comments suggesting QE would not be extended past June when the current programme (Operation Twist) ends. All the main markets initially followed US yields higher but most of the rise was retraced (German bunds all of it and more) by month end. German bunds outperformed significantly while improved sentiment toward Portugal resulted in 40% gains! Italy and Spain failed to hold their lower, LTRO driven yields and the latter faces increasing investor disillusionment that it can overcome its fiscal austerity/growth paradox. In general, main government 10-year real yields are still negative so returns can only be minimal, if positive at all. Corporate bonds offer better value but with yields at all time low levels many investors are hesitant in committing new funds other than coupon reinvestment.
- Property - there is little change to the difficult outlook for the Irish commercial property market. Good interest persists for main office buildings in Dublin but with no finance available prices of secondary and tertiary assets continue to tumble. This is not helped by distressed debt portfolios being marketed by leading Irish lenders and NAMA is trying to break the financing logjam by providing vendor financing in order to achieve clearing prices for both debt and property values. UK commercial property values are also under pressure, having fallen for four consecutive months, and property futures now indicate zero returns in 2012.
- International and European equities - after a long run of improving global economic data and a substantial reduction in most financial risk measures following the ECB's 3-year LTRO programme, momentum has begun to stall with concerns, principally about Spain, have come to the fore once again. Given the scale of the rally in equity markets a correction and period of consolidation is overdue and may already have begun outside of the US. Higher beta markets have underperformed recently and there may well be further downside for EM, Europe and cyclical sectors. That said, the downswing in cyclical momentum is expected to be fairly shallow and any stockmarket setback neither too sharp nor overly prolonged. A neutral view on most regions is retained and, from a stock perspective, the long-term preference remains for strong companies with exposure to growth markets and higher yielding stock with growing dividends irrespective of sector.
Yield is becoming nigh on impossible to find without taking high levels of risk. Central banks are set to stand put on short rates for the foreseeable future while main government bond 10-year yields remain around 2.0% and are generally negative in real term (i.e. after inflation). Corporate bond yields are at or close to all time lows and, with the probability of rising government yields, there is the prospect of capital losses offsetting income pick up. Even UK property's mouth watering 6.5% yield now comes with a major health warning that capital values might decline by a similar amount. This leaves what policymakers have hoped for all along, the eventual shifting of monies to higher risk assets, including equities, to secure a decent yield. The UK and Europe, for example, provides many high quality, low beta companies with strong balance sheets offering yields in excess of 4%.