As the summer draws to a close, elected officials and policymakers focus on getting back to work. And it would appear that between the extraordinary policy measures that investors expect from global central bankers and the festering political problems that voters in Europe and the United States are pressing elected officials to address, there is plenty of work to be done. We look for the relatively placid and constructive conditions that have persisted for the past few weeks to give way to a choppier and less directional market environment as we head into the election season in the United States and legislative sessions across Europe, noting that investors will need to continue to balance elevated risk premiums, subdued sentiment and dampened volatility.
On the positive side, the U.S. economy has shown signs of stabilizing following yet another soft patch amid the ongoing recovery within the housing sector, some improvement in labor market conditions and an unexpected rebound in retail sales. Meanwhile, monetary policymakers continue to provide ample support, with each of the major central banks around the world pursuing an openly accommodative policy stance.
Keep in mind, however, that the sharp rebound in equity markets since June — coupled with a more challenging earnings environment during the second half of the year — suggests the upside for stocks from here is more limited. We know that September and October are historically poor performers and much more volatile than average, so caution is valued.
Halting and uneven recovery
The global economic recovery continues, albeit haltingly. The eurozone has weakened further, with region-wide GDP having contracted. Renewed funding pressure on Italy and Spain, coupled with rising concerns of a Greek exit from the euro, have begun to take a toll on the core countries, as reflected by the recent deceleration in German activity. Emerging market economies also appear to have been greatly affected by the crisis. China’s export data for July were dismal and clearly reflect the contraction within the eurozone. Domestic demand, on the other hand, appears to be improving as evidenced by the rebound in PMIs last month. Given the scope for further easing of policy in the months ahead, we look for the Chinese economy to gradually accelerate through 2012.
The U.S. economy has shown signs of stabilizing, and UBS’ U.S. Growth Surprise Index has been rising for the past few weeks. The housing sector has been one of the few bright spots, with the recovery spilling over into the broader economy. Labor markets have also shown some signs of improvement, although the data here remain mixed. Overall, the United States appears on track for real GDP growth of annualized 1.5 percent and 1.8 percent in the third and fourth quarters, respectively. Similarly, second-quarter corporate earnings trends painted a mixed picture, but overall the profit picture should remain generally supportive for equities. Indeed, we believe the probability of a Greek exit from the eurozone in 2012 has increased and may be even more likely in 2013.
Easy does it?
Chairman Ben Bernanke made it clear the Federal Reserve is ready to provide additional monetary policy with the recent announcement of the so-called QE3. Bernanke announced that the Fed will continue to buy mortgage-backed bonds (Fannie Mae and Freddie Mac bonds) until the unemployment rate falls below 7 percent. That could be six months or six years. This is an open-ended program, very different than previous quantitative easing programs. But even as the Fed engages in further quantitative easing (QE), it’s unlikely to materially alter the macro outlook or drive stocks sharply higher. Global equity markets have already rallied, at least in part in anticipation of an easier policy stance. Also, evidence suggests central bankers now face the prospect of diminishing returns on these efforts. Each Fed move has yielded increasingly more muted market reactions in terms of magnitude and duration of the impact. Further, U.S. equity market valuations are much higher than at the onset of prior QE measures, suggesting the market impact may be even more muted with additional QE.
European Central Bank President Mario Draghi caught many by surprise on July 26 when he announced the bank was “... ready to do whatever it takes to preserve the euro.” Draghi was forced to act when the spreads on Italian and Spanish debt moved to new highs and threatened to rekindle stresses in the financial system. The perception that he was willing to take decisive action to address the debt crisis was enough to drive peripheral spreads sharply lower and provide fresh legs to the summer-long rally.
His stance has effectively reduced the tail risks and given the region a temporary respite. Both U.S. and European stocks bottomed out after the spring sell-off. While the recovery was fairly uniform through late July, their fortunes diverged sharply following Draghi’s London speech, with European equities outperforming U.S. stocks. So if elected officials fail to follow Draghi’s lead or ECB actions fall short of market expectations, European markets are likely to come under renewed pressure. The euro currency would also be likely to drop in this scenario, magnifying losses for USD-based investors. Keep in mind, however, that with “the Draghi put” having removed much of the tail risk, the downside also has a limit, and eurozone equities still trade at a discount to other developed markets.
Let’s talk about it
The above was condensed from Wealth Management Research’s investment strategy guide, “Back to Work,” August 24, 2012. For more information or a copy of the report, contact me at andrew.hart@ubs.com.
Andrew Hart is a financial advisor in The Bluegrass Wealth Management Group, UBS Financial Services, Inc. in Lexington.