The global economy continues to heal and risk appetite around the world appears to be reviving.
Global PMIs have swung higher and leading indicators point to decent economic prospects in the coming months. The U.S. housing crisis is now behind and employment is improving, albeit slowly.
While economic momentum has flattened out in recent weeks and the post-fiscal-cliff rebound in consumer and business confidence has been more subdued than we had hoped, investors appear to be looking past the immediate threats and focusing on the many positive developments that have occurred since the financial crisis, laying a base for sustained, balanced growth in the future.
Headwinds remain and there are still many hurdles to overcome before the global economy is fully stabilized, but significant progress has been made.
Healing Continues
Our basic economic thesis remains unaltered. The global economy is still destined for slower-than-normal growth, but beneath the surface, the beginning of an upward trend may be starting to form. The largest downside risks have arguably shrunk over the past year: the intensity of Europe's crisis has eased, China has engineered a soft landing and U.S. political dysfunction has diminished somewhat. We have adjusted our economic forecasts for 2013. The Eurozone and U.K. outlooks have again shifted lower, reflecting the enduring nature of the weakness in these regions. The U.S., Canadian and emerging-markets basket of forecasts have held firm. Consensus expectations have moved in a broadly similar fashion to our own.
The theme of healing is of central importance around the world, but this is particularly true in Europe. Current-account deficits are shrinking, signalling greater self-sufficiency in Europe's periphery. Many countries have made significant progress in reducing their budget deficits. However, public support for these initiatives has always been fragile, and the inconclusive Italian election demonstrates what can happen when austerity becomes too painful. These events have triggered a renewed sense of uncertainty in Europe. Still, while only in the early stages of rehabilitation, Europe has made measurable progress toward a sustained recovery.
The words "Japan" and "exciting" have not often gone together over the past two decades, despite the country's status as the world's third-largest economy. That could be about to change with the newly elected government leaders making sweeping commitments to spur Japanese growth. These actions should materially boost Japanese economic growth in 2013 and 2014. We have pushed our Japanese outlook significantly higher to reflect this new stimulus.
Inflation remains tame
In a period of slow economic growth, few wage pressures and steady commodity prices, global inflation is unlikely to rise particularly quickly. Economic theory suggests that inflation should begin to edge up over time as economic slack is absorbed. However, we don't think this will have an overwhelming effect in the near-term and inflation will remain subdued over the forecast horizon.
Public debt now in focus
In stark contrast to diminishing global risks and healing economies, global public-debt loads continue to rise in the developed world. Fortunately, policymakers are now turning their attention to serious debt reduction. Governments are beginning to take decisive steps to reduce their debts and this bodes well for long-term economic growth prospects. That said, debt loads will take many years to decline to more reasonable levels, and this makes nations vulnerable to economic shocks along the way.
Dollar bottom is broadening
The cycle of U.S. dollar strength is unfolding as we expected. What started as safe-haven flows into the dollar due to the European crisis a couple of years ago has evolved into support for the U.S. dollar based on an economic recovery and relative monetary policies. There is tentative evidence of a gradual shift towards a positive equity/dollar correlation and it looks like the dollar base is broadening against more currencies. That's the nature of broad currency trends - the bouncing along the bottom for the index happens as individual troughs are established. We continue to work with the base assumption that the rocky bottom will eventually resolve into a meaningful uptrend, and our 12-month forecasts reflect this.
Rise in yields likely to be gradual
Central banks are probably far from tightening, and in some cases even have more stimulus to deliver. The short end of the bond market should thus remain anchored by stimulative central banks. The long end of the yield curve is always more difficult to predict. Yields remain at unsustainably low levels, and as risk appetite increases bond yields should begin to rise. However, there are distinct limits to how high bond yields can rise in the near term. In addition to the obvious constraints of sluggish growth, moderate inflation and low central-bank rates, we must not forget that a key reason for the global recovery is the very existence of ultra-low borrowing costs. Just as rates were managed lower by central banks, we expect they will be managed higher as well.
Stable earnings growth, reasonable valuations
Equities have continued to rally in the first quarter of 2013 and we have seen large equity inflows for the first time in many quarters. It appears that the market has begun to look past the various macroeconomic headwinds and is now focusing on an economic recovery that is gaining traction. Investors are recognizing the stability of the U.S. economy and are no longer reacting solely based on concerns related to other regions. Corporate profit growth has been the main driver of index gains, as companies have proven themselves capable of stretching profit margins ever wider, even in a tough operating environment. But in an era of sluggish economic growth, further stock-market gains are now more likely to come from shifting investor behaviour than surging earnings. As the economy continues to heal, we expect valuations to gradually move higher, pulling the equity market up with it.
This article was supplied by Colin MacAskill CFP, CIM, a Vice-President and an Investment Advisor with RBC Dominion Securities Inc., the wealth management arm of the Royal Bank. Member CIPF. Colin welcomes your calls on his direct line (604) 257-7455
