12 February 2013
- We think investors should stay the course and resist the temptation to take profits
- Despite their run, equities have plenty of valuation headroom to fill
- We maintain our equity overweight
- Sequestration cuts are moving from the bear case to the base case, but the market remains resilient
- Investors are heartened by the strength of the US economy
- We don’t think the eurozone is fixed but it is probably not an issue again yet
- China’s growth will be slower but better quality, this year and next
After a strong end to 2012 and a strong start to 2013, investors might be tempted to reduce their equity exposure. After all, they are facing some fairly clear economic headwinds: namely the impact of spending cuts and tax rises in the US and a potential destabilising political scene in the Eurozone (particularly Italy).
Secularly Sequestrated
The start of a structural programme of spending cuts known as sequestration totalling some $110bn per annum are due to begin on 1st March 2013. There are further fiscal obstacles in the foreground too: the continuing resolution that has funded the government since last September expires at the end of March; and the federal debt ceiling, which was suspended last month, will be reinstated in May.
The committee discussed the implications of the sequestration debate, specifically focussing on the chances of a further deal being done. It was noted that, unlike previous deadlines which would have led to default or tax increases, those in March, relate to spending cuts. Republicans would abhor default or tax hikes, but they crave spending cuts (although not to defence which comprises half of the sequestration cuts). Public support for spending cuts is meaningful and previous debt debacles have resulted in the Republicans appearing intransigent whereas the Democrats are much more complicit in any failure in this instance.
With little progress evident on negotiations for a better deal the full impact of sequestration is increasingly moving towards the market’s base case. This would be a drag on the economy and a further indictment of US political process but, with a more confident mood in the US, and growth forecasts rising, the economy’s ability to tolerate such a drag has tangibly improved.
Elections in Rome
The committee discussed Berlusconi’s rise in the Italian opinion polls but, on balance felt that it was very unlikely his centre-right coalition would win the popular vote. That would leave the centre-left party of Bersani to be automatically rounded-up to a 55% share of the seats under the system Italy uses to ensure a majority.
The Senate, however, may well be hung. The likelihood of the centre-left failing to win the Senate has encouraged analysts to predict a coalition-of-coalitions encompassing the centre left and Mario Monti’s centrists, or even a grand coalition including Berlusconi’s centre-right as well. Some predict that Monti would head such a coalition as a compromise but, with his campaign sinking to fourth in the polls, such an arrangement would appear to lack democratic legitimacy. Partisan factions within either the centre left or centre right parties may well be an obstacle to the much-needed reform process even within a coalition and so Italian political stability may become a headwind as the year progresses.
Back to reality
Outside of the dysfunctional world of politics, the committee sought solace in a discussion of the general economic backdrop. Of particular note in this regard was the continuation of themes which have underpinned the post-financial crisis recovery.
Some degree of global economic rebalancing is continuing and can be seen with the rapid diminution of the Spanish and Greek current account deficits and the less dramatic diminution of the Chinese current account surplus. The equal and opposite reaction to this is the decline in the US trade deficit. The committee have discussed in many previous meetings that the US has been gaining competitiveness against China by virtue of a number of factors.
The sudden acceleration of Chinese labour costs, with wage inflation running comfortably in double digits, contrasts sharply with that of the US where wage costs have been extremely benign. This is magnified by the rise of the managed appreciation of the renminbi relative to the dollar. The currency has been allowed to float as part of a means to rebalance the Chinese economy away from low cost manufacturing and towards more value-added production and suppress inflationary pressure.
We also noted that fuel costs increasing fivefold since 2000 serve as a further tax on the centralised manufacture and distribute model of low cost producers like China and instead encourage a shift towards end-market manufacturing, known as on shoring.
The structurally higher energy price and improvements in technology now add the US shale gas revolution to this embarrassment of US manufacturing riches. Low gas prices make the US the new favourable location for the manufacture of technology and energy intensive goods – a point exemplified by the location of new plants by a wide range of different manufacturers. Airbus are building a plant in Alabama, Samsung are manufacturing in Texas and Apple have announced they will shift some manufacturing of Macs to the US. The advantages they seek in terms of rich sources of natural resources and non-unionised, competitively priced labour, have rendered the southern states of America as the newest and most promising emerging market for foreign direct investment – with the added advantage of the largest internal market in the world.
The prospects for China were discussed in the context of seemingly pronounced acceleration of the environmental problems which have haunted the region. This, together with attempts to control the growth of the shadow banking system and the accumulation of non performing loans on state bank balance sheets, leads us to conclude that headline growth rates for China may disappoint. That said the quality of growth, relying less on non-productive fixed asset investment and more on consumption or simply more productive investment, is important for China’s stability.
On balance…
Whilst there are clearly some meaningful events on the horizon, the market should have reasonable capacity to absorb these given the stronger state of growth and reduction in tail risks. The disappointing fourth quarter US GDP estimate will almost certainly be revised higher given the improved trade data which has been reported since. But it is the increased drag of inventory depletion on the fourth quarter of last year which bodes well for the start of 2013. Rebuilding inventories during the current quarter, sharply higher payroll growth and the wealth effect of the rising US housing market are starting to make the sequester cuts appear digestible. Once the political impact of the sequester headline has been recorded, its provisions may, of course, be supplanted by a more measured cost reduction plan.
European political instability, meanwhile, may become more troubling, but we would expect the election to provide a modicum of reassurance before tensions resume in the summer.
Our below consensus view of Chinese growth does not conflict with our overweight to Asia given that Asian exporters are among those befitting from the changing competitive landscape by relocating facilities to the southern states of the US and will see their bottom lines benefiting from the move. That includes Toyota who, after a history of steadfastly building their cars on the structurally uncompetitive mainland, are now locating a facility in Kentucky, a contrarian indicator for the yen if ever there was one!
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Guy Foster Press Office
Head of Porfolio Strategy Brewin Dolphin
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