Executive Summary

• Eurozone crisis threatens financial stability

• Global industrial production momentum may be turning back up

• Fiscal policy and sovereign indebtedness is the major medium-term issue

• Monetary policy remains accommodative with emerging countries becoming less restrictive

Economic data in June and early July has continued to indicate a decline in the global economy. However there are now signs that industrial production momentum may be about to turn back up, though this is not yet definitive. Employment prospects remain weak, and consumption at least in the developed world is suffering as a result of higher energy prices and a lack of confidence. The fiscal policy prop to growth is also progressively being removed, but this varies from country to country. Nevertheless current global output growth has even fallen below the weak global demand witnessed in recent months and this should correct in due course. We still believe that a large contributor to this phenomenon was the impact of the Asian natural disasters that occurred in the first quarter which should prove temporary. On the other hand the output weakness has alleviated pressures on commodity prices and the decision by the

International Energy Agency to release reserves of oil should put greater downwards pressure on energy costs (a key component of the softness in demand). This may reverse the impact on consumption seen earlier. In addition headline rates of inflation are already beginning to react favorably and this will reduce any pressure for monetary authorities to consider, or in the case of emerging countries to continue, tightening policy, thus perpetuating the favorable background for financial markets.

Indebtedness continues to be a worry for investors though, not only with regard to personal sector deleveraging (and the concurrent drag on potential growth this has) but most importantly on public sector deficits and the creditworthiness of governments. This is an issue which is unlikely to go away while the effects of the so called “balance-sheet-recession” continue to be felt. The recent attempt by EU authorities to circumvent investor anxiety, via an expanded remit of the European Financial Stability Fund and some level of default by peripheral sovereign countries, is testament to that. The budget deal that has been agreed, if passed, appears to avoid the risk of excessive fiscal tightening. We therefore continue to be sanguine about immediate economic prospects.

The bellwether S&P 500 Index has retraced nearly all of its fall from late April, and although we are optimistic that the market may reach new highs in the final quarter, we believe that it is too soon for that to happen within the remaining summer weeks. We anticipate continued investor anxiety while U.S. budget negotiations endure, and the threat of a credit downgrade prevails. Some degree of skepticism over the latest comprehensive EU package may also linger but this seems less obvious. As a result the 1250 level is still a possible target, but the extreme of 1220 which we identified last month seems more remote. We would advocate that investors start to accumulate risk if the market falls towards this 1250 area.

 

 

Mike Turner

Head of Global Strategy & Asset Allocation

 

 

Economic and monetary policy outlook

The soft patch in the global economy looks like it may be ending, as indicated by the recovery in Japanese manufacturing and the strength of the service sector generally. It also explains why equity markets have been resilient of late, despite so much uncertainty. The global economy is still going to have to look to Asia to lead growth, given the nature of the balance-sheet recession in Europe and the U.S. and the squeeze in disposable incomes. This is why we see potential for stronger Asian currencies. But while U.S. growth could accelerate, there are signs the European economy is beginning to sputter. The Eurozone crisis is far from over, judging by Spain and Italy’s rising borrowing costs.

U.S.

The U.S. seems to be on the cusp of a pickup in activity as supply constraints ease. We are expecting inventory re-stocking and decent capital expenditure. While recent unemployment surveys have been disappointing, idled factory workers should soon be returning to the labor force. We are not expecting a rapid change, but a moderate improvement would at least confirm the U.S. is moving in the right direction. Short-term unemployment is actually below its historical averages as skilled workers are in demand and are not having difficulty finding jobs. Middle-class consumers also appear to be in much better shape than their portrayal by the media. Income has returned to pre-credit crisis levels and household balance sheets have strengthened significantly. Both of these factors have helped improve the ratio of financial obligations to disposable income. As long as the deal on the U.S. debt limit does not prove to be too much of a drag on the economy, falling unemployment could lead to an acceleration in U.S. tax revenues.

Europe

The Eurozone purchasing manager index surveys of business confidence were poor across the board in June. Even Germany, the locomotive of the recovery, is losing steam with the ZEW index now signalling that the business climate will deteriorate. Growth is likely to slow further over the coming quarters and will not be helped by further spending cuts in the peripherals. Economists who have downgraded growth forecasts may be overstating the case though, given that sentiment has been affected by negative headlines about the sovereign bond crisis. The tightening output gap in the core economies could lead the ECB to raise rates much higher than the market expects. Given the ECB maintains a separation principle between extraordinary measures to support the financial system and general monetary policy, the ongoing crisis is unlikely to stay the ECB’s hand.

UK

Britain’s economic recovery remains fragile. The economy expanded by a modest 0.2% in the second quarter – though this was not as bad as feared. Activity may not have been as weak as the headline number suggests. After stripping out the effects of one-off events, GDP would have registered a growth rate of 0.7% for the quarter. The 1.6% rise in the services index in May was the biggest month-on-month increase since July 2002. Output in the manufacturing sector fell by 1.4%, but as this is likely related to supply-chains issues, there is potential for some recovery in the autumn. Retail spending may be subdued, but the UK economy continues to create jobs. As long as the outlook for growth remains muted, the Bank of England is likely to remain on hold. Underlining the UK’s relatively stable situation has been the rally in gilts on safe haven flows.

Japan

Japan is experiencing a V-shaped recovery, which is providing relief to the global industrial sector. Signalling a continued boost to global trade and manufacturing, Japanese export volume made a rapid recovery in June, while the trade surplus returned. Retail sales have also shown a marked improvement. Despite the requirement to reduce peak power usage, manufacturers should be able to maintain output, which is now only slightly below the pre-earthquake level. Japanese carmakers are making a comeback, and earnings which have exceeded expectations should return to more normal levels by next quarter. Unemployment has changed little over the year and is likely to remain unchanged at 4.5%, though this could improve later in the year.

Asia and emerging economies

Inflationary pressures and the contraction in Chinese manufacturing still concern investors. We feel that inflation will abate somewhat towards the end of the year. The threat of a Bank of China rate hike is diminishing, but inflation may remain a problem in countries like India and Brazil. In Brazil, rising interest rates are affecting the availability of cheap lending – a key driver behind the economy’s success. Meanwhile, in Mexico, well anchored inflation expectations leaves it positioned to benefit if the U.S. economy picks up pace in the second half. Australia is having quite a tough time due to a sharp slowdown on the consumer side, and there have been quite a lot of corporate profit warnings. Asia should benefit from a recovery in global growth in the second half of the year, though. Emerging markets still offer better growth prospects than the developed economies.

Equities

U.S. equity markets have found considerable underlying support from the Q2 results season so far, with 80% of S&P 500 companies surpassing analysts’ profits expectations. This is despite the worries over profit margins that we depicted last month. However, there may still be some disappointment from the industrial sector whose vulnerability to higher raw material costs is more prevalent, and indeed the situation in Europe is much weaker with less than half of Europe’s leading companies beating forecasts. At a micro level markets remain on a reasonably sound footing with the corporate sector the most buoyant aspect of the global economy. Reasonable valuations persist with the MSCI World index trading below its long run PE ratio on a reported basis.

Investor risk appetite has declined since late April, but has not yet entered the panic zone usually associated with an uncertain macro environment. Worries over fiscal policy and sovereign downgrades in the U.S. and Europe means that there is still some scope for this to happen in the next few weeks. This is particularly relevant in Europe’s case, where threats to financial stability are still very real. We are mindful though, that global industrial production momentum may be about to turn back up. If policy mistakes are avoided then the combination of reasonable valuation, robust profits and economic rejuvenation could prove a powerful mix to fuel a rally to new highs for markets in the fourth quarter. We would still prefer to see some short term nervousness to make any such rally more convincing. Originally we envisaged the first half of this year being more buoyant than the second half, but the failure to attain our outside targets of 1420 on the S&P 500 during the second quarter shifted our

view on the route that markets might take. Laterally we have likened their path to something similar to 2010 and that is still our base case.

Within geographic regions we are beginning to sense that the relative restrictiveness of emerging market monetary policy is waning, and that the local monetary environment may become more conducive to equity market outperformance. Indeed, if global growth is about to regain greater traction then the dynamic nature of these economies will once more prove a considerable boost to their prospects and that of quoted emerging market companies. Although European economies tend to be a warrant on global growth, there are still tail risks associated with investing in this region. But even though Europe will eventually start to outperform, we would prefer to see the policy environment improve more sustainably, given that the results season has so far indicated some weakness.

Bonds & currencies

The second bail-out of Greece has failed to calm markets. The slump in Italian and Spanish bonds raises doubts whether the deal can prevent them from sinking into self-fulfilling debt spirals. It is questionable whether the bail-out is sufficient enough to allow Greece’s public finances to regain sustainability and whether bond investors are willing to accept the conditions of the restructured bonds. There is also doubt over whether the proposal will be approved by national parliaments. The German government is against a “blank check” for the European Financial Stability Facility to buy bonds of troubled euro members in the secondary market but the €440 billion (approximately U.S. $634 billion) facility looks inadequate unless its size is increased several-fold.

As a consequence, risk aversion continues to boost the Swiss franc alongside gold. At first glance the Australian dollar looks vulnerable to the weaker domestic economy. Despite being about 40% above its real effective exchange rate, the fate of the Australian dollar depends on the outlook for Chinese imports of raw materials. Meanwhile, the U.S. dollar could see some increased strength across the board. Indeed, we are seeing a repositioning in the market as the euro region deteriorates. Yield differentials suggest the euro could weaken against the dollar, though this currency pair should continue to trade within a relatively tight range as sentiment  oscillates between sovereign debt issues, subdued U.S. and European inflationary pressures and bouts of risk aversion.

The historic, bipartisan compromise deal to raise the U.S. government’s borrowing limit will be a big boost to confidence if it is passed. On balance, it appears the deal that is likely to be struck will not jeopardize growth in the run up to the presidential election. The ratings agencies are still making noises about the U.S. losing its AAA rating, but there is little the market does not already  know about America’s creditworthiness. What has not been factored in is the potential for U.S. tax revenues to recover dramatically if the outlook brightens. If Treasury yields do move higher it is likely to be on the back of improving economic data in the third quarter, as they appear overvalued relative to inflation and growth prospects.

Amid all the turmoil in Europe and concerns about the U.S. debt ceiling, emerging market debt has continued to attract strong inflows revealing that risk lies elsewhere. Emerging market debt is supported by more favorable fiscal and debt positions and a better technical backdrop, not to mention more attractive returns. In general, we are cautiously optimistic about credit, as corporate fundamentals and valuations support tighter spreads over the long term – though we favor investment grade debt and emerging market local currency debt, given the scope for further currency appreciation.

Commodities

Tighter monetary policy globally could have a negative impact on commodities. Sharp falls are possible in some commodities, given they are presently dominated by investors rather than physical end users, and because inventory levels are generally high. Prices may be elevated, but the direction of the market largely depends on whether China can engineer a soft-landing and the outlook for global growth generally. That said, Australian exports to China remain below the highs reached around the end of last year, and the prices for both iron ore and coal have been declining since February.

Gold has rallied strongly on safe haven flows. We still think there is scope for further appreciation, but anecdotal evidence suggests that further rises could lead to some profit taking. Even the Eurozone debt crisis and the U.S. debt ceiling stand-off have not triggered any panic buying which could be a sign that appetite for adding to positions in gold is waning. Oil remains highly correlated with the strength of the dollar against the euro, and should trade in a range unless the dollar strengthens dramatically. Some agricultural commodities such as cotton have sold off, but many are supported by supply factors.

Real Estate

Capital values for institutional quality assets have continued to appreciate in the past quarter in most regions, whereas for secondary assets there is little investment interest in view of the halting economic recovery. We don’t expect this pattern of investment demand to change any time soon. Over the next six months, capital values for high quality property should rise further, helped by a combination of a cyclical recovery in occupier markets and a wide premium of property yields over bond yields. Within Europe, we expect a sharp divergence in property market performance, with northern European markets outperforming in the next 12-24 months, whereas southern Europe is set to underperform sharply.

Property market pricing in the advanced economies of the Asia Pacific region do not seem out of line with fundamentals, and we expect capital values to be supported into 2012 by high levels of liquidity. Where we have a greater concern is the pricing of major office markets globally, which are in danger of overheating. At this stage of the cycle, we would favor de-risking office portfolios. In our view, institutional, retail and industrial assets though are fairly underpriced in most advanced economies, and continue to offer stronger prospective returns to medium-term investors.

Index Definitions

The S&P 500 Index is an index of 500 selected common stocks, most of which are listed on the New York Stock Exchange, that is a measure of the U.S. Stock market as a whole.

The U.S. ISM Purchasing Managers Index– Manufacturing is an indicator of the economic health of the manufacturing sector. The index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.

The Morgan Stanley Capital International (MSCI) World Index is a free float-adjusted, market capitalization-weighted index that is designed to measure the performance of global developed market equities.

The ZEW Indicator of Economic Sentiment is ascertained monthly. Up to 350 financial experts take part in the survey. The indicator reflects the difference between the share of analysts that are optimistic and the share of analysts that are pessimistic for the expected economic development in Germany in six months. The survey also asks for the expectations for the Euro-zone, Japan, Great Britain and the U.S.

 

Aberdeen Asset Management (“AAM”) is the marketing name in the U.S. for the following affiliated, registered investment advisers: Aberdeen Asset Management Inc, Aberdeen Asset Management Investment Services Ltd, Aberdeen Asset Management  Ltd and Aberdeen Asset Management Asia Ltd (collectively, the “Aberdeen Advisers”). Each of the Aberdeen Advisers is wholly owned by Aberdeen Asset Management PLC. “Aberdeen” is a U.S. registered service mark of Aberdeen Asset Management PLC. This outlook is for information purposes only and should not be considered as an offer, or solicitation, to deal in any of the investments mentioned herein. AAM does not warrant the accuracy, adequacy or completeness of the information and materials contained in this document and expressly disclaims liability for errors or omissions in such information and materials. Any opinion or estimate contained in this document is made on a general basis and is not to be relied on by the reader as advice. Neither AAM nor any of its agents have given any consideration to nor have they made any investigation of the investment objectives, financial situation or particular need of the reader, any specific person or group of persons. Accordingly, no warranty whatsoever is given and no liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of  the reader, any person or group of persons acting on any information, opinion or estimate contained in this document. AAM reserves the right to make changes and corrections to its opinions expressed in this document at any time, without notice.

 

 

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