A casual observer could be forgiven for thinking that this is a terrible year for shares. Europe has continued to convulse, the US has seen growth slow to less than 2%, China’s economy has continued to slow as have Brazil and India, and in Australia the mining boom is losing momentum.
And yet the reality has been that shares have so far had a good year, with global shares up 11% led by a 14% gain in the US and Asia, as well as emerging and Australian shares up 6 or 7%. Add on dividends and Australian shares have returned around 11% so far this year. To be sure, there are still lots of worries but shares seem to be, so far at least anyway, climbing the classic wall of worry. So can it be sustained?
2010 and 2011 were interrupted by sharp 15 to 20% corrections in share markets, driven by worries about global growth. This year has been no exception, although the weakness (so far) was focused in May with smaller falls in shares. Europe’s grinding debt crisis, the fragile US recovery and earlier monetary tightening in China and the emerging world have seen the global economy lose momentum. This is clearly evident in a slide in global business conditions indicators (or PMIs) as seen in the next chart.
Source: Bloomberg, AMP Capital
And Australia has not been immune, being impacted by a sharp fall in key commodity prices, which in turn has led to the deferment of projects previously under consideration at a time when the rest of the economy is still struggling.
This is all well-known and factored into markets. Following the experience of the last few years, investors have been quick to see black swans around every corner and quickly moved to price in the tail risk of a return to global recession. However, in recent months the tail risks have started to recede for the global economy. In fact, there is a reasonable chance that we are passing through the weakest phase of the global growth slowdown that’s been underway and that global growth may actually pick up a bit over the year ahead.
Everyone knows Europe is in recession – probably even all the pet shop galahs in Australia! But following recent announcements from the ECB, Europe finally seems to have arrived at a credible and well-articulated plan to bring bond yields back under control in troubled countries.
This involves countries like Spain applying for assistance and agreeing to reforms, with the European bailout funds and the ECB then acting in concert with the bailout funds to buy bonds in order to reduce borrowing costs to more sustainable levels.
The unlimited nature of ECB bond-buying effectively means that worries about the limited firepower of the bailout funds has been addressed. The ECB’s actions, once they commence, should have the effect of repairing the transmission of easy money across Europe, which should take pressure off the Spanish and Italian economies and allow a return to growth next year. All Spain has to do is ask for assistance – which is likely soon as, if they don’t, their borrowing costs will rebound.
Having earlier acted to stop a credit crunch in Europe via cheap three-year loans to eurozone banks, the ECB is now moving to deliver on its commitment to keep the euro together and to remove the tail risk of a much deeper economic slump, say a 5% fall in GDP.
The recession remains in Europe but it is likely to remain “mild”. Interestingly, recent European PMI readings have been flat-lining, consistent with a “mild” recession. This is all consistent with a 1% fall in GDP this year, followed by a return to modest growth next year.
Source: Bloomberg, AMP Capital
The problem in the US is that growth has been too slow to sustainably reduce unemployment. However, the Fed looks to be on to the case and has announced another round of quantitative easing (QE) –on an open ended basis so they can keep it going from meeting to meeting until they get the outcome they want.
All the evidence suggests that the costs of QE are manageable – certainly there’s no sign of the hyperinflation many feared from QE1 and QE2 – and that it has helped boost growth relative to the alternative (just look at the US versus Europe). Much like a drip keeps a person in a coma alive, the Fed has been doing the same for the US economy. Both QE1 in 2009 and QE2 in 2010 were associated with gains in US and global shares (and upwards pressure on bond yields) and there is no reason not to expect a similar positive impact from QE3, albeit it may be a bit smaller as shares are coming from a higher level. See the next chart.
Source: Bloomberg, AMP Capital
Longer term healing in the US is continuing – the housing recovery is looking entrenched, companies are continuing to expand manufacturing operations in the US, private sector debt levels are coming under control, shale oil and gas is a real game changer and the tech boom is still centred on the US. This along with ongoing monetary stimulus is likely to see US growth edge up to 2.5% next year. The “fiscal cliff” next year is a risk but likely to be substantially reduced after the November election.
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