Despite another episode of intense but fleeting euphoria earlier in the year, at mid-year the global economy is in roughly the same position as it was six months ago-an anemic recovery threatened by a European crisis. Coming into 2012, our view was that there was an approximately two-thirds probability that the global economy would continue to expand, albeit at a below-trend pace, and a one-third probability that Europe would be the catalyst for another crisis. As of early June, we would stick with those odds.
Investors can take some comfort in the fact that the United States is on marginally firmer footing and that emerging market growth should begin to stabilize in the second half of the year as the impact of 2011's monetary tightening wanes. That said, a number of risks have the potential to cause a global double-dip recession:
- Europe remains the major risk. While it appears that a Greek exit is not as imminent as some had feared back in May, the election results do not change the underlying fundamentals. Even if Greece remains in the euro, a bolder plan for tighter fiscal integration is proving frustratingly elusive.
- The need to recapitalize the Spanish banking system. This is now probably a bigger threat to the European enterprise than whether or not Greece decides to remain in the euro.
- The potential "fiscal cliff" facing the United States in six months, which investors may be underestimating. Not surprisingly, there has been no progress to date on addressing either the long-term fiscal imbalances or the massive, pending fiscal drag facing the United States in January. Given the soft recovery, if current policy is not altered, the risk of a U.S. double-dip recession rises. As of this writing, while the subject is much debated, investor behavior suggests that this risk is not currently discounted into asset prices.
In light of these realities, we believe investors are in for a rocky road and volatility will remain elevated. We would still continue to advocate for a relatively conservative portfolio composed of high-dividend paying stocks-including in emerging markets-and U.S. spread products, such as investment grade and municipal bonds.
A specter is haunting Europe …
Marx was referring to communism, not the dissolution of the European Union, but the language could apply in the current environment. At the end of our 2012 outlook piece (see January Market Perspectives), we suggested that this was likely to be another year in which financial market fortunes would be largely driven by the effectiveness, or lack thereof, of policy makers. As of the end of May, the jury is still out as to whether the European Union can summon the necessary political will to address the euro's structural flaws.
Despite positive growth in the United States and a few tentative signs of a soft landing in China, Europe continues to represent a significant threat to the global economy. As was the case in 2010 and 2011, marginal improvements in the global economy have been overshadowed by the threat of a disorderly Greek default and broader fears regarding the solvency and longevity of the entire European Economic and Monetary Union.
While the early months of 2012 looked better than expected and recent ones worse, so far 2012 has played broadly to the scenarios we laid out in our 2012 outlook. The U.S. and global economies have chugged along at a positive, but uninspiring rate. Europe has, as was expected, been a drag on global growth-with the weakness disproportionately evident in the south. Inflation has remained muted, and while rates hit a new low in early June, they have spent most of the first half of the year stuck in the same range that has broadly defined the bond market since last September.
In terms of financial markets, our expectation for 2012 was for a decent but uninspiring year for stocks, which we expected to at least outperform bonds. Within equities, we favored dividend-paying mega capitalization stocks (mega caps), smaller developed countries and emerging markets. In fixed income, we expected interest rates to remain contained, but for municipal and investment grade bonds to outperform.
On the whole, performance year-to-date has generally conformed to that view, with the notable exception of emerging markets. Equities are narrowly beating bonds and mega caps have outperformed both small and large caps. The one call which has not had much of an impact to date is our preference for emerging markets. Year-to-date, EM equities have performed in line with those in developed markets.
On the bond side, we started the year with a particular focus on U.S. investment grade debt and a continued preference for high grade municipals. So far, performance has been broadly in line with our comments, with both investment grade and municipals outperforming broader bond indices.
What is interesting is how narrow the differences among asset classes have been year-to-date: most are close to where they started the year, with few producing better than mid-single digit returns.
While the general economic and market environments have been broadly in line with our outlook, we have made at least one mid-course correction. The ever-present threat in Europe, coupled with what looked like investor complacency-no amount of rationalization justified the VIX Index in the mid-teens as recently as early May-caused U.S. to adopt a more defensive posture in mid-April. At the time, we suggested that financial volatility was likely to rise, and equity markets were facing a correction.
Against that backdrop, with the market already experiencing a 10% correction, what are our expectations for the remainder of the year?
Economic Outlook: 2% Growth Ad Infinitum?
Absent a crisis in Europe, we would continue to expect economic growth in the second half of 2012 to be broadly in line with the first quarter-positive but subpar. In the United States that suggests growth of around 2%, while global growth should be roughly 3% to 3.5%.
In the United States, our preferred measure of economic activity -- the Chicago Fed National Activity Index (CFNAI) -- remains in the same range that has defined it since 2009. The CFNAI has been an exceptionally reliable indicator, historically explaining roughly 45% of the variation in next quarter's GDP. It has kept U.S. relatively measured in our expectations for economic growth through both the pathos of last summer and the premature euphoria of earlier this year. Despite all the gyrations in sentiment, the CFNAI continues to oscillate somewhere around zero, which is consistent with GDP growth of 2% or slightly better (see Figure 1). In the absence of an exogenous shock-Europe being the most likely, but not the only candidate-we would continue to expect the United States to grow at around 2% for the remainder of 2012 and into 2013.
Similar to the CFNAI, we find that the Global Purchasing Managers Index (PMI) provides a reasonably accurate read of near-term global economic activity. Here we see the same picture as in the United States with the indicator suggesting that global growth is unlikely to collapse or accelerate in the near term. The Global PMI ended April at 52.2, well above its levels in 2008, early 2009 and last summer and indicative of growth, but down from the more robust levels of earlier in the year (see Figure 2). Absent a collapse in Europe, the global economy should be able to limp along for the remainder of the year.
Even in China, the picture remains remarkably similar. Growth disappointed in the first quarter and is likely to be soft again in the second quarter; however, Chinese leading indicators suggest slow growth, but no meaningful deceleration.
While the data out of China has been decidedly mixed and difficult to interpret, our best guess is that China engineers a soft landing in the back half of the year, with growth settling at around 8%. After all, China has both the motivation and the means to do so. The motivation is the pending leadership transition in the fall, for which we believe Chinese officials will take whatever steps necessary to ensure a reasonably smooth transition, including keeping growth at a respectable rate. And as is the case with other emerging market countries-notably Brazil-China has the fiscal and monetary flexibility to provide further stimulus. In the run-up to the transition, we would expect additional steps, such as cuts in the reserve requirement and targeted stimulus aimed at consumption, to ensure a soft landing.
The ongoing global economic sluggishness begs a question: why is growth so weak nearly three years after the end of such a brutal recession, and how long is it likely to remain stuck in first gear? Leaving aside the risk associated with the European chaos, the U.S. fiscal drag or higher oil prices, the answer is that the same headwinds that have inhibited the recovery since 2009 remain broadly in place. Debt levels in the developed world are still too high and the deleveraging process is likely to continue to exert a headwind for the foreseeable future. In the United States, in particular, consumer debt levels, while lower, are still extremely high by historical standards, and are unlikely to return to a more sustainable level until probably 2014.
In addition, consumers are also struggling with stagnant wage growth, which for hourly workers is at a record low, and negative in real terms. Even for the broader working population, income growth is barely keeping pace with inflation. One little-noticed development is that personal income growth has decelerated sharply over the past 12 months. Part of the reason for this is the slowdown in government transfer payments-direct payments such as unemployment benefits-which are no longer supporting personal income growth to the extent they were in 2009 and 2010. In the absence of ever-increasing largess from Washington, personal income growth has decelerated from 6% year-over-year in early 2011 to barely 3% today (see Figure 3).
In the first quarter, consumption was supported by a decline in the savings rate, which fell from 4.7% at the end of 2011 to 3.8% in March (see Figure 4). This drop in the savings rate helped to propel real personal consumption to a five-quarter high in the first quarter. Given the already low level of personal savings in the United States, we would not expect this tailwind to continue, and believe personal consumption is likely to be slower for the remainder of the year.
Will the United States Plunge Over the Fiscal Cliff?
A major threat to the above scenario of slow but positive growth is, of course, Europe. Before addressing Europe, it is worth reiterating that the United States also poses a significant, though less imminent, threat to the global recovery.
As has been well reported over the past several months, the United States is potentially facing the largest fiscal drag in decades. At the end of 2012, several tax hikes and spending cuts are scheduled to hit simultaneously. The cumulative impact will be more than $600 billion in fiscal drag, or the equivalent of roughly 4% of GDP (see Figure 5). Given our view that under the current deleveraging trend growth in the United States is unlikely to be better than 2%, if the fiscal drag were to occur, we believe a double-dip recession becomes much more likely. This view has recently been echoed by the Congressional Budget Office, which now forecasts a contraction of more than 1% in the first half of next year unless current policy is amended.
The odds still favor an eleventh-hour compromise that is likely to delay part or all of the fiscal drag, but this is by no means assured. After all, despite widespread views that a compromise would be reached last year, Washington failed to reach a consensus on the U.S. spending cuts, resulting in the sequester scheduled to take effect next year. Given that the upcoming election is likely to be highly bitter, and may very well increase the partisanship in both the House and Senate, a compromise is not certain. As of this writing, despite all the headlines, we believe that investors are placing a very low probability on the fiscal drag actually occurring. This is partly evidenced by the fact that 2013 growth forecasts have remained remarkably stable over the past nine months, despite the pending fiscal drag.
If in the run-up to the election a continuation of divided government starts to appear more likely, we believe that the market will come under pressure. At the very least, absent a clear consensus coming out of the election, November and December are likely to be marked by heightened volatility as investors grapple with the odds of a last-minute compromise.
In Europe: Greek Rage, Spanish Banks and German Politics
While investors enjoyed a temporary lull in early 2012, courtesy of the European Central Bank's (ECB's) massive injection of liquidity, the focus is once again on Europe. The deepening of the Spanish banking crisis and the uncertainty surrounding Greek solvency are just the latest manifestations of Europe's lingering structural problems. While the second Greek election appears to have resulted in a more market-friendly outcome, the country's fundamentals continue to deteriorate: the economy continues to shrink, banks are still bleeding deposits, and Greece's debt burden still appears unsustainable.
Going forward, there are three critical developments we'll be watching. First are events in Greece. Despite New Democracy's win on June 17 there are still uncertainties regarding Greece's ability to fulfill its obligations under the March agreement. The coalition government is likely to attempt to renegotiate the terms of the bailout. Given this scenario, there is still a significant tail risk that Greece may eventually decide to exit the euro. Should that occur while Europe's banking issues remain unresolved, this will raise the likelihood of a full-blown banking crisis. Even if an agreement can be reached between Greece and the troika it is important to watch the outflows from Greek banks. If the Greek banks continue to bleed deposits, the ECB will need to provide more emergency assistance to prevent a collapse of the Greek banking system.
Second, and an even larger threat to Europe, are the Spanish banks. Spain needs to recapitalize its banking system, which is likely to cost at least €50 billion and perhaps much more. To date, there is no credible plan; investors are still looking for the government to articulate the mechanism by which the banks would be recapitalized as well as the source of the funds.
The final development to watch in Europe is how the political winds blow in Europe's ultimate creditor-Germany. The Germans are coming under increasing pressure to accept some scheme for mutualizing European debt. To date, Chancellor Merkel has been in strict opposition to this development. However, if the political climate in Germany veers toward a grand coalition between Chancellor Merkel's Christian Democrats and the opposition Socialists, she may be more inclined to entertain pooling at least some of Europe's debt obligations. Any development in this direction would be a positive for the markets.
The net result of this uncertainty is likely to be continued stress in the financial system. Credit spreads have been widening in recent weeks. The pressure on the global financial system is also evident in the Global Financial Stress Index, produced by Bank of America Merrill Lynch. The indicator recently rose to its highest level since early January (see Figure 6).
One of the consequences of the current environment is investors should expect more volatility in the second half of the year. Europe's lingering fiscal dilemma and the pending drama of the U.S. budget all suggest that markets can advance in the second half of the year, but the ascent is unlikely to be smooth. Since the early spring, we've been expecting more equity market volatility. We believe that markets are likely to remain on edge throughout the remainder of 2012.
One potential solution to the present volatility is the equity dividend play. In addition to the yield story, dividend stocks are generally less volatile than the broader market. Since the correction began, dividend-focused indices have generally outperformed the broader averages.
Recent performance is consistent with the historical pattern. In general, dividend stocks and funds tend to be less volatile than the broader averages. The beta (a measure of the tendency of securities to move with the market at large) of the Dow Jones U.S. Select Dividend Index to the S&P 500 Index has historically been around 0.8, meaning that for every 1% the market moves this index typically moves around 80 basis points. Even in emerging markets-typically a more volatile sector of the market-dividend stocks do tend to cushion the downside. The Dow Jones Emerging Markets Select Dividend Index has a beta of roughly 0.8 to the broader MSCI Emerging Markets Index. In general, dividend stocks and funds have demonstrated muted volatility when compared to broader indices.
In addition, many segments of this style are actually trading at a significant discount to the broader global market, particularly outside of the United States. The Dow Jones EPAC Select Dividend Index, covering Europe and Asia, is currently trading for less than 12x earnings versus a multiple of around 13.5x for the MSCI World Index. This trend is also evident in emerging markets. The Dow Jones Emerging Markets Select Dividend Index trades at less than 10x earnings versus around 11x for the broader MSCI Emerging Markets Index.
Emerging Market Stocks
Our other main view on the equity side balances out the defensive tilt implicit in our preference for dividends. As we've advocated since late last year, we would look to overweight emerging markets. While this has not produced positive relative returns year-to-date, we're sticking with the call.
The argument rests on a number of factors: a longer-term trend toward less volatility, stronger economic growth, falling inflation and more compelling valuations. Focusing on the last two, it is worth highlighting that emerging market inflation continues to fall, with the notable exception of India where we remain underweight. Most of the larger emerging markets have witnessed a significant deceleration in inflation over the past six months. In China, inflation has fallen from 6.5% in July 2011 to 3.4% in April 2012. In Brazil, a country with a history of struggling with high inflation, inflation has decelerated by more than 2% since September 2011 (see Figure 7).
As we've discussed in the past, lower inflation in emerging markets is particularly critical as equity valuations are very sensitive to inflation. As inflation falls, multiples in emerging markets typically rise at a faster rate than for a similar drop in developed markets.
The potential for multiple expansion is arguably greater given that emerging market valuations are currently low by most measures. In late May, the MSCI Emerging Markets Index was trading for less than 11x earnings, the bottom quintile of its historical range. Valuations appear even more compelling when compared to developed markets. Emerging markets are currently trading at a 20% discount to developed markets. In late 2010, emerging market stocks were trading at less than a 10% discount (see Figure 8). Historically, emerging markets have tended to outperform over a one-year horizon whenever the relative valuation is at a 20% or greater discount to developed markets. We would therefore view current levels as an attractive opportunity to add positions, particularly in Latin America, China and Taiwan. As discussed above, we would also have a preference for gaining our emerging market exposure through high-dividend stocks and instruments.
Sticking with Investment Grade
In the fixed income space, we've had a preference for municipal bonds since late 2010. This asset class has continued to do well. With municipal yields still at a significant premium to comparable Treasuries, and with little evidence of the feared meltdown in municipal finances, we would stick with this call.
The final theme we would emphasize would be our continued preference for U.S. corporate bonds, particularly investment grades. One of the many ironies of the last several years is, despite the ongoing fiscal deterioration in the U.S. balance sheet and the continued improvement in corporate profitability, credit spreads remain high by historical standards. This is particularly true of much of the U.S. investment grade space, which largely sat out the risk-driven rally earlier in the year. As a result, while investment grade bonds have narrowly outperformed the Barclays U.S. Aggregate Index year-to-date, spreads still appear wide by any measure.
Currently, the yield spread between Moody's Baa index and the 10-year Treasury note is approximately 340 basis points. While spreads were much wider during the height of the financial crisis, current levels look exceptionally wide when compared to the 20-year average of around 230 basis points and even more so against the long-term average of around 185 basis points (see Figure 9).
It is true that we would expect spreads to be somewhat wider given the sluggish nature of the recovery. However, current levels look extreme unless you believe the United States is headed back toward another recession. Spreads also look exaggerated when you consider the ongoing profitability of the U.S. corporate sector, as well as the continued strengthening of balance sheets, particularly for large cap companies. As such, we would continue to advocate that investors trade duration for credit risk, with U.S. credit being an attractive place to start.
Give me control of a nation's money and I care not who makes her laws.
Mayer Amschel Rothschild
Over the coming weeks, months and years, Mayer Rothschild's axiom is likely to be put to the test. While Germany continues to ultimately control Europe's checkbook, this may be insufficient in the presence of rising anger in much of the periphery. If politicians cannot adopt a complement of pro-growth policies and address Europe's fragile banking system, a broader European crisis becomes inevitable.
Actions by the ECB at the end of last year and again in February were a powerful palliative, but did nothing to resolve longer-term questions over Greek solvency, Spanish banks, longer-term growth or fiscal integration. Based on the market's recent performance, outside of some modest reforms in Spain and Italy, 2012 has been little better.
That said, a European crisis is not preordained. Economic solutions do exist, although whether they are politically viable is still an open question. Nevertheless, in some respects -- a growing awareness of the need for growth and tentative signs that Germany may accept eurobonds -- Europe is stumbling toward a consensus. The big question is whether they will get there in time.
In the meantime, we expect volatility to remain elevated, partly due to Europe and partly due to the uncertainty surrounding U.S. fiscal policy. In this environment, while equity markets can move higher, we would expect that move to be accompanied by a reasonable amount of volatility, certainly more than we experienced in the first quarter and early second quarter. Given that scenario, we would prefer the relatively low beta of high dividend stocks-both in developed and emerging markets-and to use any market weakness as an opportunity to add to longer-term positions in emerging markets. On the fixed income side, while high yield was the flavor of the month in the first quarter, we believe historically high spreads and less risk favor investment grade in the coming months.
 Source: Bloomberg 4/30/12.
 Source: Bloomberg 4/30/12.
 Source: Bloomberg 4/30/12.