Monday, 19 December 2011

2012 – a year of limited gains for equity markets

Mike Lenhoff's market tactics - 19 December 2011

Without putting too fine a point on it, the economic outlook for next year is lacking in promise – with one big exception.   

Over past months, consensus forecasts for GDP growth and corporate earnings in 2012 have been revised steadily downward. The downgrading of expectations is likely to continue. While equity markets have discounted the prospect of difficult times ahead already, they are still likely to grapple with the valuations that apply in an environment of great uncertainty for earnings growth.  

Yet against a discouraging backdrop, the US economy is regaining momentum after a disappointing first half for 2011. The economy will enter the New Year with continued support from the Federal Reserve, steady albeit modest job creation, rising capacity utilisation indicative of a likely pick up in investment activity and a recovery in bank lending to non-financial companies. While the risk of a relapse back into recession is not of a trivial order of magnitude, neither is it the one-in-three odds thought likely several months ago.

Furthermore, the US economy has two things going for it. First, productivity has grown rapidly since the recovery from the financial crisis, more so than in Europe. This has not only helped to contain unit labour cost growth but it has also been a factor behind the surprising strength of US corporate profitability. Second, as measured on a trade-weighted basis, the dollar has been on a steadily weakening path since the financial crisis, at least until recently. The combination means that the US has acquired an internationally competitive edge at a time when global trade is set for a further slowdown and this should help it retain market share, if not gain it.

That said the US is still a relatively closed economy. The share of exports in GDP is about a third of what it is for Europe and it remains largely driven by domestic demand. With employment growing and Fed policy committed to ensuring the trend remains firmly upward, domestic demand is likely to strengthen in 2012.  

Meanwhile the developing world is set to lose more momentum in 2012. This is partly the result of past policies geared towards restraint, partly the result of rising inflation which has also eroded real income growth, partly the result of the eurozone’s sovereign debt crisis – Spanish banks are big lenders throughout Latin America – and partly the result of the loss of momentum in the Chinese economy itself. According to a recent estimate China is likely to have contributed some 40 percent of the global economy’s growth this year. A slowdown in China puts global trade at risk, including commodity demand, much of which is supplied by the emerging economies themselves.

On the other hand, there is now plenty of scope for the policy makers to stimulate demand. Brazil has been leading the way among the BRICS by cutting interest rates. China is beginning to relax monetary policy but by means other than reducing interest rates. In general, we are likely to see the central banks of the developing world bring down interest rates in 2012 and we expect the loss of momentum to be arrested in the latter stages of the year.   More >

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