Beginning in late 2012, mutual fund and ETF flows indicate that investors have dramatically increased equity purchases. This signals a reversal of the trend favoring safe bonds over equities that has been firmly in place since the 2009 market crash.
World growth will remain low on average but negative in the UK and Europe; price inflation will remain sufficiently subdued for a while longer so as to impose no constraint on monetary expansion; central banks will sustain a regime of negative real interest rates and rapid monetary expansion; the risk of a eurozone collapse is off the table for now; finally, stock markets should continue to perform better than expected, even though the four-year old cyclical bull market is long by historical standards.
Macro Themes for 2013.
1. Tail risks are receding: the eurozone is holding together, Greece recently got an S&P upgrade, China has executed a soft landing and the U.S., despite its dysfunctional politics, has a number of things working in its favor.
2. Global growth will remain weak: leading indicators are not providing any evidence of an imminent return to trend growth rates in emerging or developed nations.
3. Central banks will likely step up the flood of liquidity and low interest rates will remain in place, as key central banks are set to drop inflation targets in favor of nominal GDP and labor market outcomes.
4. While excess capacity and labor market slack imply that the short-term inflation outlook is benign, shifting central bank policy and stepped-up government intervention may result in a pickup in inflationary expectations in the coming year.
The current economic data around the world is mixed and conflicting, making the outlook for the year ahead very uncertain. Employment prospects are poor in virtually all countries. The massive numbers of unemployed, taken together with the underemployed and those withdrawn from the labor force, continue to scare policy makers and politicians, putting pressure on central banks to do much more to stimulate demand.
Almost two years ago we wrote a special report entitled “Why the Secular Bears Are Wrong” (January 17, 2011). We received an enormous amount of feedback and virtually all of it was critical. Needless to say this made us feel more comfortable that our hypothesis had some merit. With widespread negativity on the future still palpable, it is appropriate to review our thesis in light of the passage of almost two years. Readers should keep in mind that we are talking about very long-term trends, not the outlook over the short term.
The huge relation efforts of the past three years--quantitative easing (QE) combined with fiscal deficits--as indicated in Table 1 below, have done their job of not only aborting a potential depression in the world at large, but actually generating recoveries in most countries, albeit weak and hesitant.
Investors should use the summer rally to take an increasingly cautious stance. The S&P 500 is near a cyclical high, while earnings growth and profit margins almost certainly have peaked. Meanwhile, the euro crisis is far from resolved, as evidenced by recent extreme social and political stress in Portugal, Greece and Spain. U.S.
The summer rally has taken the S&P 500 up 9.5% from the low of last June. Most other equity markets have also moved smartly higher as “risk on” sentiment became dominant. Bonds have reacted similarly with strong rallies in the troubled debt markets (e.g. Italy and Spain) and sell-offs in safe haven markets (e.g.
U.S. corporations have performed extremely well during the recovery from the 2008 financial crisis. Profit margins and earnings growth have remained at record levels, despite weak global growth and a number of other macro threats.
The quickening pace of the euro crisis indicates events are continuing to outrun the ability and willingness of policy makers to control it.
In our Special Report of July 13, 2012 entitled A “Two Euro Solution” to a Terminal Illness, we suggested that the euro should be split into two─a hard euro and a soft euro. More than ever we are convinced that this will happen, one way or another. The important question is whether it will be managed rationally before a market disintegration or whether a crisis will first be needed to force policy makers to throw in the towel. Unfortunately, there is precious little evidence that policy makers will ever get out in front of the crisis.