Headwinds to a normal, self-sustaining economic cycle are diminishing. U.S. residential real estate - the financial crisis' epicentre - is now fundamentally rebalanced, and prices are stable or advancing. Credit channels are functioning more smoothly with the supply and demand for loans of all types moving in a constructive direction.
Four years of debt reduction has arguably created more flexibility for U.S. consumers than at any time since the Carter administration. Corporations, now including U.S. banks, are in sound financial condition and sitting on mountains of uncommitted cash. And in the emerging world, local and global easing of monetary conditions through 2012 is helping to improve investor's confidence.
Still, problems persist. The fiscal cliff looms as the U.S. sorts its options for the retrenchment of government finance. Europe is stuck in mild recession, still facing profound questions and without an effective structure for decision-making. A soft landing for China is still in our forecast, but with growth and inflation both slowing; an easing of monetary conditions is timely and increasingly necessary.
As the healing continues, we look for modest growth and inflation through the forecast horizon, with the exception of Europe, where conditions are moribund, and the emerging world, where growth should perk up to the 6% level. However, where the balance of forecast risks have been to the downside for the past several years, the potential for positive surprise is now apparent.
Even as the headwinds calm, monetary conditions, whether delivered through interest rates or other policies, will continue to contribute massive support through the forecast horizon. As long as confidence remains fragile, the global economy will be especially vulnerable to shocks, and central banks will err on the side of massive ease.
Progress toward a normal, balanced and self-sustaining economic cycle creates considerable risk for fixed income markets, especially sovereign bonds where real (after-inflation) rates of interest have sunk below zero in many regions including the U.S. As the need for quantitative easing and other unorthodox monetary policies ultimately passes, and as risk aversion turns more broadly to return seeking, bond yields could experience a very long period of upward pressure, enough perhaps to entirely eliminate total returns. Corporate credit markets offer higher coupons and positive leverage to economic conditions; although, here too, falling yields and narrowing spreads to sovereign yields through the past four years present challenges and limit the scope for future returns.
Stocks have rallied strongly since the summer as near-term threats to the global economy diminished somewhat and as corporate earnings proved resilient. Still, in a sluggish global environment and where margins are already firm, stocks are increasingly hostage to valuations as the source of returns. In all major regions, price/earnings ratios range from reasonable to historically attractive, so improving confidence holds the potential for compelling returns from equities. In the absence of that improvement, progress in stock prices will be laboured. And, consistent with trading conditions through the past half-decade, plenty of threats to the recent calm exist through the near and intermediate term.
This article was provided by Colin MacAskill CFP, CIM, a Vice-President and an Investment Advisor with RBC Dominion Securities Inc. Member CIPF. He can be reached on his direct line at 604-257-7455.
