Global economic outlook and investment implications in 2013

Highlight:

• Despite improved financial market sentiment, the global growth outlook remains subdued. This masks, however, significant divergences between regions. Economic growth should be the strongest in Asia.
• This slow growth outlook will be compounded by ongoing fiscal policy tightening and an already aggressive monetary policy stance in many developed economies, as well as a continuation of the deliverable process.
• Structurally, aggressive monetary policy, through quantitative easing, is forcing down real yields and driving a hunt for yield and income.
• As a result there will likely be three major implications for investors.
• Firstly, given a continued slower growth environment, it is likely that returns on traditional asset classes in the years ahead may be much lower than has been the case for the decade prior to the global financial crisis.
• Secondly, the need for portfolio diversification is likely to become even greater. Portfolios will need to be able to withstand periods of increased volatility, continual reassessment of the macroeconomic outlook and increased political risk in 2013.
• Thirdly, the need to invest in the structural changes flowing through the global economy. It will be increasingly important to invest in countries and companies ‘facing’ the world’s growth.

What has driven improved market sentiment and returns?

• 2012 delivered a considerably better financial market environment than most commentators and investors were expecting. Financial markets have been supported by extremely aggressive central banks, particularly the US Federal Reserve, and reduced tail risk fears in Europe. Combined, this saw better returns in equity markets over 2012, as low yields in bond markets encouraged investors to seek higher returns and income opportunities in other asset classes.
• In Europe, financial markets begun to price in the reduced likelihood of a tail risk event post European Central Bank President, Mario Draghi’s comments that within their mandate, the ECB would do ‘whatever it takes to preserve the euro’. His comments drew a line in the sand, reassuring investment markets that the ECB would do everything in its power to prevent another crisis developing.
• The US economic recovery also appeared on a firmer footing, supported by the US Federal Reserve and clear signs of an improvement in the housing market.
• In China, economic growth stabilized and the leadership transition was smooth and relatively uneventful. For the rest of Asia, the economic growth performance in 2012 was relatively subdued, but the outlook has improved markedly.
• As a result, especially in the later stages of 2012, risk assets performed well. This saw capital reallocation's beginning to return to equity markets: out of safe haven assets, in particular cash markets.
• While this was a positive development, there remain some concerns over the ability of these improved investment market returns to continue given the still challenging macroeconomic environment.

The global economic outlook

• The International Monetary Fund, on 23 January 2013, forecasts world economic growth in 2013 at 3.5%1.This represented a more gradual recovery than forecast in October 2012. A delayed recovery in Europe, a recession in Japan and continued fiscal contraction amongst the major developed economies continue to add to the malaise. More positively, however, growth in China and the rest of Asia is expected to accelerate in 2013.
• The expected global economic growth rate for 2013 remains lower than the average growth rate of 4.2% experienced from 2000 to 2007. While, in isolation the forecast for growth in 2013 of 3.5% is reasonable; the challenges continue to lie in the sources of this growth and the ongoing rebalance of growth towards Asia from the developed world.
• Looking at more detail within the IMF forecasts, we see that emerging market and developing economies are forecast to grow by 5.5% in 2013 and 5.9% in 2014.
• In contrast, developed economies are forecast to grow by just 1.4% in 2013 and 2.2% in 2014. It is this divergence in growth that financial markets continue to grapple with.
• Developed economies will continue to be weighed down by moderate growth in industrial production and global trade.
• In the US, while there is a recovery in the housing sector, fiscal contraction and subdued business investment are expected to weigh on the US economy in 2013, keeping growth for the year to just 2.0%. See chart below.

IMF World Growth Forecasts (%)

• In Europe, while tail risks have been mitigated, fiscal consolidation and the delayed effects of the crisis in 2012 are continuing to hamper growth in 2013. As a result, the Euro-Area as a whole is expected to remain in recession in 2013.
• In Japan, while there is increased talk of aggressive policy by the Bank of Japan, the impact on the real economy is expected to flow through only over time, while the demographic challenge remains a key negative. As a result, economic growth in Japan is forecast at just over 1% in 2013.
• Growth in emerging market and developing economies is expected to rebound in 2013, but will still be below the highs recorded in 2010 and 2011, which was boosted by stimulus efforts. As noted, however, growth across the emerging and developing nations, especially in Asia, is expected to be significantly more robust than the developed world.
• In China, economic growth is forecast at 8.2% this year, up from 7.8% in 2012. The pace of growth in India is also expected to accelerate, up to 5.9% in 2013 from 4.5% last year.
• The “newly industrialised” Asian nations (Korea, Singapore, HK and Taiwan) are expected to grow by 3.9% in 2013, up from 3.2% in 2012. Meanwhile, the ASEAN nations (Indonesia, Malaysia, Philippines, Thailand and Vietnam) are expected to enjoy solid growth of 5.7% this year, up from 5.5% in 2012. Finally, ‘developing’ Asian nations are forecast to grow by 7.5% in 2013, from 7.1% in 2012.
• However, despite some improvements in the global economy and improved financial market sentiment, considerable uncertainty continues to persist.
• Much of this is driven by political uncertainty, such as the recent Italian elections and upcoming elections in countries such as Germany and Australia later this year and India in early 2014. All of which could bring volatility. In the US, the Sequestration, debt ceiling and Budget negotiations all present an economic headwind.
• The good news is that inflation pressures have, at this stage, remained contained. This is largely due to the significant output gaps that still exist in developed economies -despite aggressive monetary policy. The IMF forecasts inflation of just 1.6% for the developed economies in 2013.
• In emerging market and developing economies earlier efforts to contain inflation in 2010 and 2011 have remained successful. The IMF, however, forecasts inflation of 6.1% for emerging and developing economies for 2013. China’s inflation rate is expected to remain relatively low around 3.0%, but with higher rates of inflation across countries such as India, Indonesia, the Philippines and Vietnam.

Investment conclusions

• The diverging global economic growth outlook and political uncertainty is likely to have a significant impact on the source of asset price growth over both 2013 and into the medium term.
• Asset performance will also likely be highly dependent on the ability of emerging economies to continue to grow in the face of low economic growth from the developed world.
• The potential flow-on from this slower economic growth outlook and the limited ability of governments to stimulate their economies is likely to be, therefore, a period of lower returns on investment in financial asset than experienced in pre-Global Financial Crisis markets. The absence of leverage is likely to compound this.
• If the economic outlook for the major developed nations is as moderate as expected over the medium-term there would appear to be three key lessons for investors.
• Firstly, a slower macro-economic growth rate (ie. lower nominal GDP growth) would imply a period of lower returns on traditional assets classes than many investors have come to expect, especially given the returns experienced over the decade prior to the financial crisis.
• Despite stronger gains in financial markets in 2012, investors may still need to adjust downwards their expectations for future returns in markets.
• Secondly, investment portfolios will likely need to be diversified in such a way as to be able to cope with periods of reduced expectations for economic growth, increased financial market volatility, elevated political risk, greater regulation by governments and a reduced ability for governments to support growth through either fiscal or monetary policy.
• Thirdly, exposure to the large structural forces underway in the global economy will become more important in providing growth in a portfolio.
• The centre of growth in the global economy continues to change and investors must be aware that divergent economic growth patterns are likely to continue for a prolonged period of time.
• It seems clear that the majority of the world’s economic growth will either come from Asian countries in the years ahead and/or those countries that can export goods and services to the fast growing Asian region.
• Cyclical trends will be important to understand, therefore, but investing for the structural change in a diversified manner should continue to be a focus for investors.
• Investors should, therefore, focus on countries and companies ‘facing’ the world’s growth.
• In an environment where the macro-economic outlook looks set to be muted and provide challenging circumstances for traditional asset classes, looking at alternative investments will also remain a focus.
• This could include asset classes such as infrastructure and property, where income growth is linked to inflation and/or determined by government regulation.
• Investments that are leveraged to the positive structural changes in the global economy, compared to the subdued cyclical environment, should also perform better.