This past month marked the fourth anniversary of the global equity market bottom on March 9, 2009. U.S. stocks have clawed back all of the losses from the Great Recession and are near historical highs. Most other major markets are still well below their 2007 peaks, but have rebounded sharply since last June and look increasingly resilient. However, there is tremendous anxiety about the economic outlook, and many investors fear equities and other risk assets are floating on a sea of liquidity rather than solid fundamentals. We are more constructive and maintain a pro-growth investment stance.There has been a raging battle between the forces of debt deflation and aggressive policy reflation since the start of the Great Recession. Many of the imbalances built over recent decades have come home to roost, causing dramatic deleveraging pressures. At the same time, unprecedented stimulus measures being taken to avoid a depression-like outcome have created new distortions. It is no wonder that many policymakers and market participants have an uneasy feeling about how this issue will be resolved and the consequences that will follow.
Liquidity has played a vital role in boosting risk asset prices and in providing support to the global economy. Central banks now have a virtually open-ended commitment to policy reflation in order to foster economic recovery. Higher prices for risk assets are an objective of policy rather than a by-product. The Fed believes that rising equity and real estate prices will boost both consumer and business confidence and also fortify the banking sector. The Fed’s policies are gradually paying off, and the risks are low that it will prematurely unwind stimulus.
Our view is that growth expectations, rather than liquidity, have been the principal driver of capital markets over the past four years. The prices of equities and other risk assets have fluctuated with perceptions of the global growth outlook, leaving many stuck in broad trading ranges for much of the period. Growth scares developed in each of the past three years, reflecting market skepticism that monetary policy support (i.e., liquidity) would be sufficient to offset underlying headwinds.
It is often difficult to disentangle growth and liquidity as drivers of asset prices, since they are interdependent. Increases in liquidity almost always precede economic inflection points, although the lags are variable. In the current cycle, the lag has been very long because of the headwinds that prevailed at the start of the crisis and those that have developed since then. The strength of these headwinds means that is has taken
exceptionally large and repeated liquidity injections to sustain economic growth across much of the developed world — and it has yet to succeed in some places.
The strong global equity run-up since early June 2012 was triggered in part by stepped-up Euro area policy reflation and reinforced thereafter by rising confidence in the global economic outlook. Capital markets immediately began re- pricing to reflect reduced downside risk, and subsequently markets began to suggest upside potential based on the rising odds that the global economic recovery would eventually get back on track.
On balance, the data has validated the initial market optimism embedded in asset prices. The Organisation for Economic Co-operation and Development (OECD) global leading economic indicator is rising, and the latest manufacturing and non-manufacturing figures for the U.S. from the Institute for Supply Management (ISM) indicate that economic activity is strengthening. U.S. housing continues to revive, employment is trending higher, consumer confidence is rising and capital goods orders have rebounded following last year’s weakness. China’s economic deceleration last year has given way to firmer growth. All told, we expect global growth to gradually pick up and broaden over the balance of the year. Growth will be moderate by historical standards, but confidence in the sustainability of the recovery should slowly improve, and we believe this will have positive implications for equities.
However, important risks remain and merit close attention. U.S. politics are as depressing as ever, but so far developments in Washington have not further dented household or business confidence. Politics are also a risk factor in the Euro area: the post-election situation in Italy is up in the air, and the problems in Cyprus are unresolved. While the Italian election represents a step backward for the European debt crisis, the overall process is still inching forward. Of course, there is also the ever-present risk of a blow-up in the Middle East causing a spike in oil prices.
While a consolidation or correction may be overdue, equities have powerful allies in central banks, an improving earnings outlook and reasonable valuations. Although the long-run absolute return prospects for equities are moderate, the cur- rent backdrop appears promising. Policymakers are gradually making progress in curtailing deflationary tail risks, which is slowly helping to strengthen investor economic confidence. This will encourage investors to extend their investment horizons. Also, with ample slack remaining in labor and product markets, most central banks will stay aggressive and continue to slow the backup in yields (and equity discount rates) in order to support economic growth. There is a possibility of further multiple expansion as investor confidence improves. We advocate focusing on growth-sensitive equities that are levered to the healthier and faster growing parts of the globe. Investors will likely become increasingly selective, seeking stocks that offer the best earnings power in a sustained growth environment.
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