This year began with such promise. It seemed like the world was righting itself and investors, particularly pension funds, might get some respite from the volatility that they had been facing over the past few years. Europe was on the mend, albeit slowly. The Greek, Portuguese and Irish situations had been dealt with, and while growth was slow in Europe, it appeared that the worst was over. North America and the emerging markets were chugging along. Investors, cheered by all this, eschewed safer, government bonds for equities.
And then came April.
As we are all painfully aware, all was not well with Europe as Spain’s government faced bankruptcy and further bank solvency issues. Italy and France were being scrutinized for their lack of growth and budget deficit plans. Many European countries, including the U.K., Italy, and Spain were in recession, while growth in China and Brazil had slowed to the point that its governments were contemplating stimulus.
Now with so many countries in recession or facing slowing economic activity, it is not surprising that investors are worried.
The U.S. Federal Reserve announced that, given slowing growth and the inability to create jobs, the policy rate would remain at an all-time low for another few years, matched with a new round of quantitative easing (QE3).
Canada, faring marginally better, followed the U.S.’s lead and the Bank of Canada announced continuing low policy rates, though no new quantitative easing initiatives.
Now with so many countries in recession or facing slowing economic activity, it is not surprising that investors are worried. It is anticipated that global growth will recover later in 2012 and continue into 2013. However, there are three main macro-economic risks that bear consideration given their potential negative connotations. These are the continued fragility of the eurozone, China’s path to economic restructuring and slower growth, and the U.S. fiscal cliff and debt ceiling that promises to galvanize investors’ attention later this year.
As already noted, the European economy has weakened, contracting by 0.7% in the second quarter. The strength of the core economies (led by Germany) has been tested as consumers and businesses have respectively reduced spending and investment in the face of the continued uncertainty that their southern neighbours will successfully deleverage their businesses and governments.
In order for Europe to pull itself out of this stupor, the European Central Bank will have to remain accommodative, which should support German growth. This, combined with the acceptance of higher inflation in the core European countries, would allow the southern European countries to slowly restructure. The path will likely be slow and bumpy, with European growth below trend over the short and medium term.
Chinese growth has slowed significantly, estimated at somewhere between 6.5% to 7.6%, which is well below the 9% to 10% growth that it has been experienced for the last decade. Slower growth has been the result of weaker investment and production as higher policy rates have been introduced to dampen the overheated property market. China has also been impacted by slowing European and American demand for its products, though domestic demand has remained robust. Unlike the developed economies, China still has plenty of scope for monetary and fiscal easing, as well as infrastructure spending, some of which has already begun.
The real risk is whether the economic restructuring that is taking place will be successful. China wishes to reduce its reliance on investment and foreign demand, and increase the contribution to growth of private consumption and domestic demand. Longer term, if successful, this will enable China to experience more stable growth, albeit at a lower level of economic activity. Rebalancing the economy will likely lead to spikes (up and down) in the growth rate which could test the new political leaders’ mettle and resolve. With successful rebalancing, China should be able to sustain a 7% to 8% growth rate.
The United States
U.S. growth has rapidly slowed to 1.7%, in the second quarter from 4% in late 2011, as real incomes have failed to keep pace with inflation and weary, nervous consumers have slowed consumption. The recently announced QE3 should provide some economic stimulus by lowering credit costs for sectors with quality balance sheets (both corporates and some households), resulting in increased growth later in 2012. In fact, there are reasons to be optimistic given the potential for shale gas to lower energy costs, and improve trade balances. Excess housing inventory is being reduced and consumer sentiment is rising.
The key threat to the recovery scenario is the fiscal cliff. A combination of spending cuts and tax increases of more than 3% of GDP are scheduled to hit the U.S. economy in early 2013. As well, the U.S. will breach its debt ceiling ($16.4 trillion) in the first quarter 2013.The central expectation is that the U.S. will resolve these issues and the impact to GDP will be less than 1%.
However, with the U.S. presidential election being held in November, it is unlikely government will deal with these issues until after the election is held. The risk is that inactivity and/or poor decisions will derail the U.S. economic recovery.
Given the experience over the last decade, it is not surprising that many investors have become glass-half-full personalities. While the central thesis is for continued improvement, it is safe to say that investors will continue to experience volatility and should organize their investment portfolios accordingly, at least in the near term.