A Tumultuous Year for Global Financial Markets December 27, 2011, Bill Witherell, Chief Global Economist
Global equity investors must be welcoming the approaching end of a very difficult year, in contrast to the more contented feeling of fixed-income investors, who have had a good year. Few imagined that financial difficulties in the tiny economy of Greece could be the spark for a year of global markets living under the threat of a meltdown of the European banking system. Added to this were fears of a “hard landing” for the Chinese economy and monetary tightening in a number of important emerging-market economies, including India as well as China.
The global economy has slowed from its 5.1% growth rate in 2010 to an estimated 3.8% this year. For advanced economies the slowdown has been from 3.1% to an estimated 1.6%, a number drawn down by Japan’s 0.8% decline as a result of the tsunami. Emerging-market growth eased from 7.3% in 2010 to an estimated 6.4% this year. Overall, economic growth has moderated to a lower-than-potential pace, but, with the exceptions of Japan and some countries in the Eurozone, has not become the feared “double-dip” recession some predicted. Importantly, there is increasing evidence that the US economy is strengthening and that the slowdown in China is moderate and will be limited in duration. Deleveraging in Europe’s banking system and fiscal austerity are likely to present the greatest headwinds going forward, while monetary inflation by a growing number of central banks should be a positive factor.
Global equity markets, with the notable exception of the United States, have fallen considerably harder than the moderation in economic growth would normally imply. The MSCI equity index for the world is down 5.1% year-to-date (as of December 25), the MSCI equity index for advanced economies ex-North America (EAFE) is down 12.5%, the MSCI equity index for the Eurozone is down 17.4%, while MSCI equity index for the US is up 2.6%. Emerging markets underperformed significantly, with the MSCI equity index for these markets down 17.2%, with China similarly down 16.9%, India tumbling 35.7%, Brazil dropping 20.3% and, in contrast, Indonesia advancing by 6.5%.
The declines in most markets and very high market volatility reflected the fears about the future noted above. Market sentiment swung widely day-to-day from risk-on to risk-off and back. We had suggested the possibility of a market rally in the fourth quarter. Yet every time a rally appeared to be developing, some event, usually in Europe, caused concerns about the future to resurface. The correlations between markets became quite high, a tendency for investors to herd together that often occurs when market confidence is low and fears are strong.
Looking forward to 2012, we anticipate that the year will be a more favorable one for risk assets, despite some continuing concerns. Global growth will continue on a slower than average upward path at about a 3.6% pace. Emerging markets will continue to be the global growth leaders, advancing at a 6+% pace as a group, with China’s growth again approaching 9% and the Asian region’s emerging markets advancing at twice the pace of Latin America and three times that of Central and Eastern Europe. For the advanced economies, North America (US and Canada) and the advanced economies of the Pacific (Japan, Australia, New Zealand, Singapore, and Hong Kong) are expected to outperform those in Europe, where the Eurozone countries as a group are probably now in a recession. For the stronger “core” economies, particularly Germany and Netherlands, economic growth is projected to pick up as the year advances. The weaker periphery economies of Greece, Portugal, and to a lesser extent Spain and Italy, face prolonged depressed activity.
Differences in rates of economic growth do not necessarily translate into differences in the performance of equity markets, since many other factors come into play. Nevertheless, they are an important factor for corporate profits and investor sentiment. The prospects in 2012 for the global economy summarized above suggest that the ongoing Eurozone crisis will continue to present the most important downside risk for equity markets. Recent developments have fortunately been positive. In particular, last week’s provision by the European Central Bank (ECB) of some 489 billion euros in three-year loans to European banks was evidence that the ECB is stepping up its game to ease strains in the financial system. Also, Spain had a surprisingly good bond sale.
We expect Europe to muddle through and avoid a blow-up, with some risk sharing on existing debt and tougher fiscal rules and further economic reforms eventually leading to a stronger euro. However, the process will be lengthy, and there will likely be further episodes of market-disturbing developments. The markets of Germany, Netherlands, and Ireland could continue their recent outperformance; but the Eurozone markets as a group are expected to continue to underperform, at least in the first half. Elsewhere in Europe the non-euro economies will continue to suffer from the recession in the Eurozone. Nevertheless, the equity markets of Sweden and the United Kingdom continue to look relatively attractive.
Outside of Europe the equity markets of the United States and resource-rich Australia and Canada are expected to outperform in 2012, all three benefitting from strong growth in the Asia Pacific region. Japanese equities appear to be oversold. With economic growth there picking up, stimulated by reconstruction spending, there is potential for Japan to outperform. It appears, however, that investors need to be more convinced that Japan will not be hit by a worsening financial crisis in Europe, before increasing their exposure to this market. When such a change in market sentiment will occur is uncertain, probably not before the end of the first quarter, which contains a heavy redemption calendar for Italy.
The underperformance of emerging-market equities that persisted since the third quarter of 2010 ended in the final quarter of this year, and we do not expect it to re-emerge. If we are correct in our expectations that China will avoid a hard landing, the Eurozone will hold together, and central banks will be injecting increased liquidity into markets through monetary accommodation, then emerging markets as a group should be performance leaders in 2012. These stocks typically outperform in the early months of cyclical bull markets. These expectations also imply that commodities will resume their secular upward course and commodity exporters will do well.
The strong economic growth in the Asian region is likely to be reflected in the performance of the region’s equity markets. Chinese equities are already leaving their last several years of underperformance behind them. Korea, Malaysia, Philippines, and Thailand also did better than the emerging-market average in the final quarter of this year. Indonesia, the top emerging-market performer this year, will find it difficult to repeat this in 2012, because its valuations are now quite expensive. Yet with its continued strong growth, low inflation, and energy exports, its equity markets should continue to do relatively well. India, on the other hand, may well repeat in 2012 its significant underperformance in 2011. Taiwanese stocks, which have been underperforming, may be poised for an upswing as the turn in economic polices in China from restraint to stimulation starts to affect the Chinese economy.
Emerging markets in Latin America, and even more so those in Central and Eastern Europe, are more affected by the crisis in the Eurozone. A particular concern for 2012 is the expected deleveraging by European banks, which could lead to a retrenchment of financial flows to Latin America. Brazil, for example, has some US$396 billion in outstanding liabilities to European banks. The Eurozone, which now is likely in recession, also accounts for 21% of Brazil’s exports. This year only Mexico and Columbia did better than the emerging-market average. However, the region is also more closely tied to the US economy. The improving economic situation in the US may be the reason why in the last quarter the region’s emerging markets outperformed both the emerging-market average and the Asian region.
In the coming year, returns from the markets of Peru and Chile markets will depend to an important extent on whether the copper market, and more generally, commodity markets, recover. This will be likely if, as we anticipate, the global market climate moves to “risk-on” in the first half. China again will be the key factor. Continuation of Mexico’s recent outperformance will depend on the US market and could be hampered by the current high valuations.
Outside of the above two regions, both the South African and Russian markets will also depend on the commodity markets. The domestic economy in South Africa continues to suffer from inadequate productive investment. Russia will benefit from the strengthening we anticipate in the global oil market. The current political unrest in Russia is a welcome sign that Russia’s growing middle class is awakening. While the near-term implications are unclear, this is a positive development for the longer-term future of Russia. Aside from Russia, the Central and Eastern Europe markets are likely to remain unattractive due to the Eurozone recession and European bank deleveraging. When these two factors ease, the equity markets of Poland and the Czech Republic are likely to offer the best prospects.
In summary, 2012 is expected to be a year of moderate growth in the global economy, supported by accommodative monetary policies and restrained by fiscal austerity and bank deleveraging in Europe. Prospects are good for the development of a cyclical bull market in equities and a recovery in the commodity markets. Once again the greatest risks in this outlook – upside as well as downside – will be developments in the Eurozone and in China. We will be monitoring both regions very closely.
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