Friday, 5 April 2013

American resilience...

We have spent recent years watching, and responding to, an increasingly positive backdrop for US equity investors. What began as a defensive way of playing the equity recovery has morphed to become a fully-fledged secular growth story. We have observed that US economic growth is underpinned by twin structural strengths: the housing market as a multi-faceted driver of wealth and income; and the US Industrial renaissance.

These themes have certainly captured the market’s imagination with the S&P500 and Dow Jones Industrial Average both making new all-time highs. At this point it seems to be sensible to consider what risks to these well-trailed stories the market might be complacent about.

Apart from these new highs, March also saw the sequester come into effect, meaning the imposition of $85bn of cuts, split equally between defence and non-defence spending. The sequester’s impact might cause investors to curb their enthusiasm. Sequestration was conceived as a last ditch compromise to avoid default back in 2011. Back then its architect, Senate Minority Leader Mitch McConnell, designed it in order to force a bipartisan super committee to come together and forge a path to debt sustainability.

Opinions are divided over whether these cuts will go ahead as negotiations seeking a grand bargain continue. The most hopeful outcome would be a bill arising in the Senate and based on negotiations between McConnell, Vice President Joe Biden, and Majority Leader Harry Reid.

There remain several hurdles to the deal: it would need to find greater savings than the existing sequestration package in order to win the support of fiscal hawks (indeed many would argue that it needs to go significantly further to restore America’s long term fiscal sustainability); it would need to find these savings without increasing taxes in order to obtain the support of the Republicans, many of whom have pledged not to raise taxes during their tenure; and it would need to do so without dismantling the controversial Obamacare (Patient Protection & Affordable Care Act) which may otherwise be the only lasting legacy of eight years of the Obama Presidency.

A grand bargain, therefore, would be positive for equities and might even hasten the withdrawal of Federal Reserve stimulus. In the absence of such a deal, however, the fiscal headwind must be expected to exert some influence on America’s recovery. The Congressional Budget Office estimates this at around about 800,000 full time equivalent jobs, although such forecasts are prone to error. Such cuts would probably mean a slower recovery, but that would not reverse the positive drivers of the nascent US industrial revolution.

…European despondency

By contrast, the outlook for the Eurozone remains bleak. Until recently we celebrated signs of a more benevolent attitude from the Germans toward their Mediterranean cousins. In March negotiations over the Cypriot bail-in rather quashed those hopes. In reality Cyprus’ size and unique circumstances made it insignificant as a proxy for the wider Eurozone.

We still, therefore, harbour hopes of more benevolent Germans – particularly after their own PMIs disappointed so dramatically – but we must be realistic about what likely form it might take. The Germans may well sanction some loosening of policy from the ECB, but it seems highly unlikely that it would be enough to prompt them into fully-fledged quantitative easing. Policy options so close to the zero-rate band look limited.

Weak European demand has been one of the major thorns in the side of the UK’s economic recovery. Real growth continues to flat line but, from a debt sustainability perspective, the steady deceleration of nominal GDP growth is perhaps more worrying; absent a recovery, the deficit will need to be tightened even further to stabilise the debt to GDP ratio. From the UK’s perspective the good news is that employment is growing. Jobs growth slowed but remained positive in January, implying lower benefits expenditure and higher tax revenue. This ought to improve the public finances.

So far little benefit has accrued to growth, partly because of offsetting contractions in trade and government spending. More broadly it appears that the shrinking household disposable incomes as a result of weak wage growth and high inflation have created economic pessimism. As we discuss in the context of interest rates it is challenging for monetary accommodation to trump fiscal consolidation.

The Committee discussed again the dichotomy between Asian and Emerging Markets, which remain extremely attractive, and developed market valuations, which look fair. Several explanations were offered for the underperformance of the emerging markets. Most notably the bull case for US manufacturing must necessarily be echoed by the bear case for the workshop economies whose lack of cheap energy now places them at a disadvantage to the developed markets. Other potential explanations included the higher cost of debt and increased share issuance (compared to a trend of buybacks for the cashflow-positive mature markets).

Asian markets, however, where Brewin Dolphin maintains an overweight, saw their momentum checked. While data emanating from Asia has been somewhat soft, the Committee noted that generally higher purchasing managers indices provided hope for a stronger performance in the second quarter of 2012.

Guy Foster
Head of Portfolio Strategy

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