Uncertainty remains despite EU, US central banks steps

Jan Amrit Poser, Head of Research and Chief Economist
Although the decisions taken by the European and US central banks have helped to stabilise the markets, there are still many uncertainties regarding the future direction of the economy, according to the latest Global View published by Bank Sarasin.

It predicts additional, far-reaching political measures for the fourth quarter of 2012. After the late summer rally, equities only offer limited upside potential and a setback are likely. The yields on government bonds are likely to trend sideways and will only start to rise significantly as the global economy starts to pick up again in 1Q13. The additional dollar liquidity is likely to weaken the greenback during the fourth quarter. Corporate bonds remain attractive.

Recent announcements by central banks have managed to stabilise economic sentiment, albeit at a fairly low level. But getting the economy back on its feet requires far-reaching political measures which could possibly be forced by renewed turbulence in financial markets during the fourth quarter of 2012. Given this backdrop, the uncertainty regarding the future direction of the economy is likely to persist until at least the end of this year. In the longer term, investors should prepare themselves not for hyperinflation or a global debt haircut, but for a scenario of “financial repression”. The purpose of this is to reduce the level of indebtedness over time, by keeping interest rates below the nominal rate of growth. However one side-effect of this is a creeping transfer of wealth from creditors to debtors, from savers to mortgage borrowers and from future to current pensioners.

“The forthcoming quarter will not be an easy one in macroeconomic or political terms. We think the decision-makers in the world’s major economic powers will be forced to take far-reaching measures in order to kick-start economic growth. This reduction of debt and the need to save mean that any growth speculation can be ruled out,” Jan Amrit Poser, Head of Research and Chief Economist at Bank Sarasin, said.

“We expect earnings forecasts for 2013 to be downgraded further during the fourth quarter. Many companies will probably have to revise their forecasts when they publish the next quarterly results, because the global economy is not picking up speed as quickly as central banks had hoped for,” Philipp E. Baertschi, Chief Strategist at Bank Sarasin, added.

The third quarter of 2012 was dominated by the decisions taken by the ECB and US Fed. While in the Eurozone the concessions made by the ECB in the form of a new bond purchasing program helped to alleviate the fear of the break-up of the currency union, the trigger for the Fed’s decision to launch another programme of quantitative easing (QE) was the high unemployment figures. Although the US Fed did not judge the situation to be any worse than in June, it still launched a third QE package. Unlike previous packages, there is no upper limit on the maximum amount of bonds that can be purchased under QE3. Even so, things do not look particularly rosy in the USA. Unless the current policy is changed, there will be automatic tax increases and spending cuts of USD 607 billion in the next tax year. This “fiscal cliff” would drag down the economy with a GDP reduction of around 5%. Even the “Middle Kingdom” has not been spared from the slowdown of the global economy. Official GDP data do in fact signal a soft landing in Q2 2012 above the government’s growth target of 7.5%. But the figures for electricity production actually signal GDP growth of just fewer than 5%.

The determined intervention of central banks has triggered a rally on equity markets. But the latest surge has already factored in much of the good news. Assuming that there is hardly any upside potential left in terms of valuation, the future development of equity markets depends heavily on corporate profits. It is likely that earnings estimates for 2013 will have to be revised downwards once again in the fourth quarter, as the global economy is not picking up as much speed as central banks had hoped. A defensive positioning is therefore advisable in terms of regions as well. Caution is advised for the emerging markets, and the more defensive markets of Europe should be preferred. Although US equities are supported by strong demand, company profits have the most potential for providing negative surprises in the USA. In the mid-term, preference should be given the sectors with high levels of debt, strong cash flows and stable dividend yields. Here the biggest winners are likely to be the real estate, consumer goods and healthcare sectors. Share prices are likely to head downwards before the end of the year, however. The environment will only become more positive once the economy starts to pick up again in 2013.

The ECB’s announcement was greeted with euphoria by the capital markets and led to a sharp drop in Spanish and Italian yields. Despite the ECB’s willingness to intervene, we do not expect a selloff in Europe’s “safer havens”. Yields on Swiss or German government bonds will not climb any further in Q4 2012, but will trend mostly sideways. Only in 2013, when the Fed’s monetary easing is accompanied by an improvement in the global economy, is a clear uptrend in yields expected. But the uptrend in yields in 2013 will not mark the beginning of a bear market in government bonds. In the coming years, central banks and governments will attempt to keep yields artificially low to facilitate deleveraging. By contrast, corporate bonds will still be attractive during the fourth quarter. In the Eurozone the focus will be on the core countries. Setbacks are likely in the peripheral economies because the central-bank-driven rally could run out of steam soon.

The US Fed has initiated a third round of quantitative easing (QE3) and set the course for the US dollar’s future performance. The additional US dollar liquidity will dampen the greenback’s performance. High-yield currencies such as the Swedish krona and the Australian dollar stand to profit the most from the USA’s expansive monetary policy. But QE3 is not the only measure that has buoyed the EUR/USD exchange rate. The ECB’s announcement that it would purchase the bonds of crisis countries has dramatically reduced the risk of a national bankruptcy for Spain and Italy. The Swiss National Bank (SNB) can relax for the time being in the wake of the Fed and the ECB’s measures. After the SNB was forced in previous months to purchase up to CHF 60 billion in foreign currencies every month to defend the euro lower limit at 1.20, the EUR/CHF exchange rate climbed above the floor in September without any assistance from the central bank. But the Swiss currency is still clearly overvalued. According to the bank’s internal calculations, the fair value of the EUR/CHF exchange rate based on purchasing power parity is at CHF 1.32 per euro. The EUR/CHF exchange rate is not going to be able to break free from the SNB’s lower limit before the end of the year.

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