Global Strategic Outlook

Transcription

1 Allianz Global Investors Global Strategic Outlook 1st Quarter 2013 Understand. Act.

2 ContentQui leno suspicor Amor quibus mido Consido noster luvabrum 5 Section one: Strategy summary 9 Section two: Thematic piece 15 Section three: Equities outlook 23 Section four: Fixed income outlook 28 Section five: Multi asset outlook 30 Section six: Sustainability Research - long term trends 32 Section seven: Economic forecast and valuation review 35 Section eight: Global Policy Council biographies 2

3 The world is overloaded with information but to have value it needs to be understood. Once information is understood, we then need to act. At Allianz Global Investors we follow a two word philosophy. Understand. Act. Andreas Utermann Global Chief Investment Officer, Allianz Global Investors 2013: The beginning of the end of the great financial crisis? Although risks remain and volatility will continue, Andreas Utermann is more positive about the world in 2013 than at any point since US growth could surprise on the upside and markets could see the beginning of the end of the great financial crisis. Key Takeaways: There are signs of green shoots in the eurozone periphery, China s robust growth should continue and a turnaround in the US housing market could lead to an upside surprise Global central banks will continue their ultra-loose monetary policies until economic growth is firmly established With nominal bond yields at record-low levels, we do not expect their returns to match inflation over the next 10 years We expect equities to continue outperforming bonds; although it is likely there will be continued volatility, any significant weakness should be used to establish longer-term positions Emerging market assets should continue performing well 3

4 Economic outlook and the eurozone What we predicted for 2012: We do not expect most developed economies to fall into recession and we expect emerging markets growth to remain solid. However, growth risks are increasing particularly in Europe, where a recession in the core eurozone economies is now almost certain. Our medium-term outlook remains unchanged: in times of high public sector debts, and private and public sector de-leveraging, trend growth will be lower than before the bubble burst. This period is likely to last for several years. Our current view: While remaining positive, global growth did remain below trend again in 2012, as expected. This was primarily driven by a sharp growth slowdown in Japan, a continued near-recessionary environment in Europe, slowing emerging market growth and a continued below-par recovery in the United States. The key macroeconomic factors contributing to this continue to be excessive private-sector debt in many economies, rising public-sector debt in almost all economies, the continued stressed bank financial sector in Europe and the political problems surrounding the eurozone. Owing to the decisive action by the European Central Bank (ECB) in the summer of 2012, followed by a reinvigorated political process in Europe, it is possible to envision a more benign middle-term scenario for the eurozone for the first time in a number of years. While growth is still expected to remain in near-recessionary territory for most of 2013, there are tentative signs of green shoots in the eurozone periphery, notably the elimination of current account deficits and Greece remaining in the eurozone. Encouragingly, Ireland the first country to receive a eurozone bailout may regain access to capital markets in the course of Problems remain, though, including elections in Italy and a French programme of economic reforms that may exacerbate rather than remediate France s structural problems. Fears about China s hard economic landing and political uncertainty have not materialised, and we are likely to see continued robust growth in China in Most encouragingly, the United States could surprise on the upside in This is primarily based on our conviction that the US housing market has turned, and that there is a broad base housing market recovery underway that will increase consumer confidence and also possibly encourage corporations to spend some of their large liquidity surpluses. Budget deficits and central bank policy What we predicted for 2012: A quick fix is unlikely. Realistic political actions take a long time to be implemented and even longer to be effective most likely too long for financial markets. The longer the debt crisis looms, the bigger the political risk. As recent developments in Greece show, there is a real threat of a break-up of the eurozone if political processes get out of control. Debt monetisation is already on the agenda in the US and the UK but not in the European Monetary Union (EMU), even though the ECB has become more Fed-like. Medium-term, we think a more active and aggressive role for the ECB is likely. Our current view: The fiscal situation in most economies has continued to deteriorate in 2012, as expected. As a result of this, central banks have continued with their ultra-loose monetary policies. In many cases such as in Japan, the US, the eurozone and the UK those policies have been reconfirmed and reinforced. Most importantly, and as we had hoped, the ECB made a decisive step in the summer of 2012 toward becoming a more credible lender of last resort, which led to a broad-based rally in risk assets in the final part of

5 Should growth surprise on the upside in 2013 as expected, the rate of increase in government debt globally should slow. Nevertheless, we predict a continued ultra-loose monetary policy regime for OECD economies for 2013 and beyond. This should continue until such time as trend or above-trend economic growth is firmly established. Inflation What we predicted for 2012: We believe the cyclical moderation will trigger a moderation in inflation rates again. Given the low level of real interest rates, ongoing central bank balance sheet expansion and our expectations of continued solid growth in Asia, we do not expect a return of deflationary fears, despite weakening growth. On the other hand, with demand for money strong in the current period of de-leveraging, inflation is unlikely to be a threat in the foreseeable future. Our current view: As expected, neither inflation nor deflation concerned markets significantly in For 2013, we do not expect either one to be a major topic of market concern. While global growth remains below trend and private sector debt levels stay elevated, inflation is unlikely to be a major issue while aggressive quantitative easing policies will keep deflation at bay. Interest rates and bonds What we predicted for 2012: We expect rates to come down further in the eurozone and emerging markets. In the US, the UK and Japan, we expect the policy of extremely low interest rates to continue. The downside to bond prices in the UK and US clearly is limited. As long as political uncertainty persists and economic data remain weak, we expect risk aversion to prevail. Bunds are likely to remain safe haven assets for the time being. A risk-on trade within the European bond markets is only likely once economic data start to improve or the ECB takes a more active role in solving the debt crisis. Longer term, we remain cautious on sovereign bonds at current yields. Even if nominal returns may turn out to be positive, we expect real inflation-adjusted returns to be disappointing. Our current view: EMU bond markets continued to be driven by political events in the first half of As predicted, a risk-on trade in European peripherals kicked in once the ECB had emphatically stated it was not going to let the EMU fail statements that were then later confirmed by European policymakers. We expect aggressive quantitative easing policies to continue through 2013 and thus limit the downside; however, with nominal bond yields throughout the yield curve now at record low levels, we do not expect nominal returns to match inflation over the next 10 years. Benchmark bond yields (Japanese government bonds, US treasuries, German bunds and UK gilts) appear overvalued. For 2013, we continue to favour selective corporate and high-yield issuers, other spread products and, notably, selected emerging market global currency debt. Equities What we predicted for 2012: With economic activity slowing globally and with moderate equity returns, we prefer stocks with relatively high dividends and payout ratios. Dividend payments should offer investors some protection in the current environment. A lasting rebound in equity markets is expected only if markets can start to price in a credible solution to the EMU debt crisis and/or when economic data point toward a stabilisation in economic activity. Political tensions or sovereign debt fears would be another buying opportunity for those who want to establish longer-term positions. Our current view: For the first seven months of 2012, equity markets were very volatile with dividend stocks performing particularly well as we anticipated. Also, as expected, equity markets rebounded following decisive action by the ECB, with most major equity markets ending the year in double-digit territory. In local currency terms, as of 27th December 5

6 2012, German equities had performed best with a near-30% return, followed by Asian markets at around 20% and the S&P 500 at approximately 15%. For 2013, we expect equities to continue to outperform bonds with overall returns in the region of 8% 10% possible. There will be continued volatility and any significant weakness should again be used to establish longer-term positions. Currencies What we predicted for 2012: Strategically, we will hold on to our expectation of appreciating emerging market currencies due to superior growth and productivity gains. We are waiting for an attractive entry point to re-enter this asset class. We expect some appreciation of the US dollar due to the still-unsolved eurozone debt crisis. In addition, the US dollar looks somewhat undervalued relative to the euro. Our current view: For the major currencies the euro, US dollar and sterling the year brought much volatility but, as expected, no major changes in their relative values. As expected, the renminbi has continued to appreciate against both the US dollar and the euro, and the yen appears to have started its long-anticipated relative decline. For 2013, we expect a very similar picture. Emerging Markets What we predicted for 2012: Emerging markets remain strategically important and the slowdown in economic activity will end, in our opinion, in a soft rather than hard landing. The reasons for our relative optimism are negative real interest rates, a rather low level of total indebtedness and strong underlying demand. Our positive view on emerging markets leads us to a strategically positive view on emerging market assets whether equities, bonds or currencies. Our current view: Most emerging market assets have, as expected, outperformed in 2012; in a relatively benign market environment they should continue to perform well in Conclusion What we predicted for 2012: We expect 2012 to be similar to 2011: bouts of risk aversion followed by increases in risk appetite, all against a background of relatively low growth and great political uncertainties in all regions. Countercyclical and long-term orientated investment behaviour will be imperative for market participants. Our current view: 2013 could well be the year when growth in the US surprises on the upside and markets begin to anticipate the beginning of the end of the great financial crisis. Clearly, many risks remain and continued volatility in risk assets is certain to be a defining feature. However, overall we are feeling more positive about the world at the start of the 2013 than at any point in the last five years. Let s hope this turns out to be correct. Our upcoming Investment Forum in mid-january will delve into some of these themes in more detail notably the question of asset-class valuations, China s growth story and the medium- to long-term inflation outlook. We will bring you more on these themes in the coming weeks. 6

7 1. Strategy summary Our market expectations for Q have turned out to be very much correct. Equity markets globally have been trending sideways, confirming our neutral equity allocation, after a strong run in Q The only market that has showed a strong performance, much to our surprise, has been Japan. Sovereign bonds issued by the US, Germany, UK and Japan have continued to show positive albeit very low returns. Spread products, whether corporate bonds or EMU periphery bonds, outperformed. Emerging market assets, both bonds and equities, also outperformed developed market assets. How can we explain this pattern and what is our outlook going forward? It is a combination of better economic data and ongoing efforts to solve the EMU debt crisis on one hand, as well as still-prevailing political risks, especially in the US regarding the fiscal cliff, on the other hand, which have been driving capital markets. Going forward, we think that positive news could ultimately gain the upper hand. We reiterate our constructive view on risky assets provided that risks, mainly political, do not materialise. Three months ago, we observed a gap between economic surprise indices and hard economic data. Surprise indices measure the difference between reported data and expectations as expressed by consensus. Surprise indices for global developed markets had already started to improve in June 2012, indicating that economic data released were not as bad as negative consensus expectations. However, this was not enough for equity markets to rise for more than just a few weeks: data actually needed to turn up. Most high frequency data, though, continued to deteriorate until late summer. The gap between surprise indicators and actual data releases only started to close during late autumn, when many leading indicators started to turn up once more. In the US, we take particular comfort from the fact that the labour market continues to improve and that house prices have also started to stabilise. Both markets are, in our opinion, crucial to a lasting recovery in the US economy. The most recent deterioration in some high frequency data, notably the Institute for Supply Management Manufacturing Index and the NFIB Small Business Confidence Indicator, are in our opinion explained by super storm Sandy, which caused massive damages on the US East Coast in late October. The biggest risk for the US economy going forward and probably the biggest risk for the global economy is a failure to solve the fiscal cliff. In a worst case scenario, US fiscal policy would drag down US growth by $607 billion (Congressional Budget Office, as at 22nd May 2012). In the event that the fiscal multiplier in the US turns out to be larger than 1, which can t be ruled out in an environment of close to zero interest rates, the damage inflicted on the US economy could be substantial. At the time of writing, a temporary solution has been found, including higher taxes for the very rich and an end to the Bush payroll tax cuts. The fiscal cliff has been averted for now. However, Democrats and Republicans have only postponed a decision on cutting government expenditures for two months. After an agreement at the turn of the year on tax incomes, an agreement on expenditure seems likely. Nevertheless, there is no guarantee. European data, too, are showing first signs of improvement. PMIs are off their 2012 lows, albeit still at recession levels for most countries. Our proprietary leading indicators, though, suggest that growth in the eurozone could turn out to be marginally positive, while consensus estimates are in negative territory. Two factors could actually explain why growth in the eurozone may actually surprise on the upside; both illustrate that economic policy decisions can be key in stabilising or even improving confidence in an economy. First, continued progress in the solution of the debt crisis is likely to have positive spillover effects on the real economy. As outlined in previous Global Strategic Outlook (GSO) documents, the willingness of policy makers to move ahead with a banking union as well as the European Central Bank (ECB) becoming effectively a lender of last resort for sovereigns in well-defined circumstances are key to a lasting solution of the EMU Stefan Hofrichter, CFA Head of Global Economics and Strategy Group 7

8 debt crisis, as both developments address the original weaknesses of the EMU financial architecture. In December, eurozone finance ministers agreed on the design of the new single supervisory mechanism (SSM). Accordingly, the ECB will take over direct supervision of around 200 EMU based banks the largest in absolute terms in the respective member countries and will oversee the national supervision of all other banks within the eurozone. An agreement has been found on the supervision of banks based in the EU but outside the eurozone. The SSM is supposed to be operational from March 2014 onwards. From this date, failing banks will be rescued by ESM funds directly. Also the introduction of the Outright Monetary Transactions plan (OMT) can be interpreted as a seachange in ECB s policy as the central bank is now effectively providing unlimited funds to governments with liquidity problems, provided they accept a memorandum of understanding and implement fiscal austerity and/or structural reforms. The pure announcement of the OMT has already been sufficient to soothe market concerns: even though the ECB has not yet invested a single cent in bonds issued by EMU sovereigns, EMU periphery bond spreads have already tightened substantially. What matters is the ECB s commitment to provide unlimited amounts and the expectation of market participants that, if spreads started to widen too much, any country could apply for ESM funds one pre-condition to benefit from the OMT. We are convinced that both measures in combination with ongoing structural reforms in EMU periphery countries as well as the increased harmonisation of EMU fiscal policy have significantly reduced the EMU break-up risk, as is also reflected in the tightening of EMU periphery spreads. Less stress in the financial system should also bode well for the growth outlook, as our research shows. There is a second positive effect for EMU growth coming from fiscal policy. To be precise, fiscal policy will be less of a drag on growth compared to previous years. Firstly, austerity measures in the EMU periphery have been very much front-end loaded, i.e. most of the measures have already been implemented. In addition, the Troika has stopped responding with demands for more fiscal austerity measures when a deficit target has been missed. This is quite important as it helps to reduce the head wind to growth stemming from fiscal austerity. In an environment of near zero interest rates, the fiscal multiplier tends to be high. We think that during the past three years, the fiscal multiplier in EMU has increased to more than 1.5, confirming IMF estimates. The reduction of tail risks in the EMU is likely to have positive effects not only in the region, but also in the rest of the world, as one major source of uncertainty has been reduced. Clearly, political risks remain within the EMU, as we can t rule out that electorates, whether in core countries or in the periphery, decide to stop supporting the process of a tighter monetary union. The decision by Mario Monti to step down as head of the technocrat government in Italy as a consequence of losing support from the parliament (from Silvio Berlusconi s party, to be precise), leading to irritations in both equity and eurozone periphery sovereign bond markets, was just a reminder that capital markets remain vulnerable to political turbulences in the region. In Japan, where nominal GDP has just contracted on a yearly basis for the eighth time since the bubble burst in late 1989, the new government of Shinzo Abe from the conservative Liberal Democratic Party (LDP) will try to push for more fiscal and, if possible, monetary easing. As things stand, it is still uncertain how far monetary policy can be eased in reality, as long as the Bank of Japan (BoJ) is independent from the government and as long as the LDP needs approval for the nomination of the new BoJ Governor in April 2013 from other parties. In addition, achieving an inflation target of 2%, as proposed by Abe, is much easier said than done, as inflation expectations are unlikely to change near term. Nevertheless, we are likely to get a positive growth impulse again in Japan in the course of In emerging markets, data have started to improve, notably in China. We have been expecting this for quite some time, as pointed out in the two previous GSO editions. The yield curve, as well as money supply (adjusted for inflation), have again proven to be reliable indicators with a long lead time. The positive news flow is not restricted to China, but can be seen in various countries in the Asia region, such as Korea and Taiwan. Overall, global cyclical data show signs of improvement while political risks, although still 8

9 prevailing, have slimmed down significantly. As a consequence, we think that the backdrop for risky assets is likely to be rather constructive, generally speaking. Whenever political risks mount again though, markets are likely to face a setback. Immediately following its election in early November, the US is a perfect example: even though the economy showed signs of relative strength, at least compared to other regions, US equities underperformed because of fears that policy makers would fail to find an agreement on the fiscal cliff. As of the day of writing, we recommend using market setbacks to add to risky assets. We are not, however, changing our long-term expectations of low trend growth in the developed world as we remain in a multi-year period of deleveraging of both the private and the public sector. A simple buy-and-hold strategy is not warranted in such a scenario. Investors need to react quickly to cyclical swings and changes in the political landscape; tactical allocation becomes ever more important. In such an environment, we also think that going for current yield as an important driver of total returns, as opposed to expecting superior price increases, is what investors should target. Similarly, we also think that alternatives with rather stable cash flows, notably in infrastructure, can offer interesting investment alternatives. Our thematic research note sheds some more light on this topic. Within equities, we retain our preference for emerging market equities, which do not seem expensive on our numbers. In addition, improving cyclical data in Asia, especially in China, should bode well for this asset class. We turned neutral on Japanese equities in November in expectation of the LDP winning the elections in December. We think that the market will expect further yen weakening as a consequence of potential economic stimulus packages as well as a potential policy of ultra-easy monetary policy in Japan. With the Topix again negatively correlated with the yen, Japanese equities could do well in local currency terms. Given Japan s structural problems an exploding debt burden, weak demographics and uncertainty with respect to a timely implementation of LDP s policy measures we are not currently willing to go long Japan s equities. We have also started to warm up to eurozone equities. With tail risks having diminished significantly and the region very much moving in line with sovereign spreads, the tighter spreads are, the higher the chance of outperformance of regional equities. On valuation grounds, eurozone equities look attractively priced. We therefore added to European equities in December. US equities, which we preferred during autumn, have been reduced in preparation for a more risk-loving environment. Regarding sectors, we have kept the balanced portfolio structure between cyclical and defensive sectors. By overweighting the materials sector at the expense of IT, we have moderately increased cyclicality. The materials sector combines reasonable valuation, the chance of improving commodities demand following a Chinese reacceleration and a bottoming out of earnings revisions momentum, especially in the mining segment. Within the cyclical space we also like industrials, which should profit from better order momentum in capital goods and a generally improving macro environment, which we foresee for the coming months. In the more defensive areas, we are sticking to our preference for consumer staples and health care over telecoms and utilities, which again negatively surprised investors with dividend cuts. Despite their bounce, we remain cautious on financials for structural reasons like regulation, however in the short term, improvements in financial conditions, the decline of global tail risk factors and the revival of the US housing market may support the sector a bit further. Against the backdrop of moderately improving cyclical data and, as our base case scenario, lower (political) tail risks as opposed to earlier in 2012, we continue to like spread products in the fixed income area. This includes corporate bonds, both investment grade and high yield, which are still reasonably priced even after several quarters of outperformance, as well as emerging markets bonds. Admittedly, spreads for hard currency bonds issued by emerging market sovereigns are tight in a historical comparison. However, fundamentals have improved substantially: sovereign debt ratios have fallen, while they have risen in the developed world. Credit risk, consequently, has come down. On our valuation measures, emerging market hard currency bonds are still attractively priced and bonds in local currencies offer attractive yields. We reiterate our long-term positive stance on Asian emerging market currencies. As outlined in our thematic note published in the Q GSO 9

10 document, we particularly like the renminbi. Our longterm cautious stance on the yen has started to pay off. Following the announcements of Abe before the elections in Japan, the yen has weakened to an 18-month high against the US dollar. We are holding on to this position. Our euro/us dollar position is currently neutral. Falling tail risks are supportive to the euro, while valuations and the relative growth outlook warrant a neutral position. Sector Allocation - Virtual GPC Portfolio Global Sectors Consumer Discr. Consumer Staples Energy Financials Health Care Industrials IT Materials Telecom Services Utilities Active Weight -1.0% 0.5% 1.0% -1.0% 1.5% 0.5% 0.0% 1.0% -1.5% -1.0% BMK Weight 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% 10.0% Legend: Position added Position reduced Asset Allocation - Virtual GPC Portfolio* Global TAA MSCI World Citi Global BIG DJ UBS TR Euribor 1M Active Weight 0.0% 0.0% 0.0% 0.0% BMK Weight 60.0% 30.0% 5.0% 5.0% Equity Regions MSCI USA MSCI EMU MSCI UK MSCI Japan MSCI EM China A Shares Active Weight 1.0% -1.0% -1.0% 0.0% 0.0% 1.0% BMK Weight 35.0% 25.0% 10.0% 15.0% 15.0% 0.0% USA EMU UK Japan Cash EM FI Regions JPM USA ML US Corp HY Bonds JPM EMU ML EMU Corp HY Bonds JPM UK JPM Japan Euribor 1M JPM EMBI Active Weight -1.0% 2.0% 0.5% -1.0% 0.5% 0.5% -0.5% -2.0% 0.0% 1.0% BMK Weight 20.0% 15.0% 0.0% 20.0% 15.0% 0.0% 10.0% 10.0% 10.0% 0.0% Global FX EUR GBP JPY CHF AUD Emerging RMB Active Weight 0.0% 0.0% -5.0% 0.0% 0.0% 0.0% 5.0% BMK Weight 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% *Emerging markets are not included within the benchmark. The hypothetical or virtual portfolio has some inherent limitations. The asset allocation for a portfolio actually managed by Allianz Global Investors or its affiliates will differ from those presented here, due in part to a portfolio s investment objective and guidelines and market and economic conditions that would impact the decision-making when managing actual portfolios. There is no guarantee that these investment strategies will work under all market conditions. Each sector of the bond market entails risk. The guarantee of Treasury and Government Bonds is the timely repayment of interest, and does not eliminate market risk. Mortgagebacked securities & Corporate Bonds may be sensitive to interest rates. When interest rates rise the value of fixed-income securities generally declines. There is no assurance that private guarantors or insurers will meet their obligations. An investment in high-yield securities generally involves greater risk to principal than an investment in higher-rated bonds. Equity investing is subject to the basic stock market risk that a particular security or securities, in general, may decrease in value. Investing in foreign securities may entail risk due to foreign economic and political developments and may be increased when investing in emerging markets. The securities of emerging markets may be less liquid and subject to the risks of currency fluctuations and political developments. 10

11 2. Thematic piece: Infrastructure The Backbone of the Global Economy In many places, global demographic change is creating the need for investment in infrastructure. This need is particularly great in the emerging countries, but investment is also required in the industrial countries to ensure quality of life and economic growth. November 2006: a breakdown in the German power grid leaves about 10 million people in Europe in the dark September 2011: a massive power outage leaves five million people without electricity, paralysing large sections of the south-western US and Mexico July 2012: India is hit by one of the largest power outages in more than 10 years. More than 600 million people are affected These examples show that electricity blackouts don t just happen in developing countries, they can also occur in the industrial countries of Europe and in the US. Why? The answer is globalisation. The global population is growing. People are increasingly mobile, demand for goods and services is increasing and energy consumption is on the rise. It is clear that the infrastructure in place cannot meet the challenge of these developments. Governments need to invest millions in new streets, bridges, clinics, airports and social services to meet these requirements. Globalisation: global trade as growth driver According to United Nations statistics, the world population was around 2.5 billion in 1950; it has now risen to more than 7 billion and is expected to exceed 9 billion by Global population growth continues inexorably, with five babies born every two seconds. Growth in the industrial countries is much less dynamic than in the emerging economies. The UN estimates that the share of the world population of the industrial countries will decline from almost 19% in 2005 to 14% in The share of the emerging countries will remain virtually unchanged at about 67%, while the developing countries share will rise from just under 12% to 19%. The increasing world population and growing globalisation are driving global trade. A steadily growing and increasingly prosperous society is demanding more goods and services. This can be seen in the fact that global trade has risen twice as fast as world economic growth since According to the World Bank, low-income countries will grow twice as fast as high-income countries in the coming decades. The future belongs to the city In 1980, 39% of the world s population lived in cities; now, more than half live in major cities and this figure is expected to rise to 67% by 2050, according to a United Nations forecast. The trend is clear: the future belongs to the city. The result of this urbanisation is the rise of megacities, a trend that now seems to be irreversible. While just five cities had a population of at least 10 million in 1975 (New York, which is the oldest megacity, Mexico City, Sao Paulo, Tokyo and Shanghai), the UN expects there to be 22 by 2015, 17 of which will be in developing countries. Asia is already home to seven of the world s ten largest megacities. The industrial and service metropolises will see a particular need for replacement investment in infrastructure facilities in the coming years. The emerging and developing countries, in contrast, are faced with severe congestion, environmental and socioeconomic problems, as well as an extreme infrastructure deficit. To counteract these developments, a wide range of investment is needed in utilities, construction, telecommunications, transport and social infrastructure. The example of China makes this especially clear. One billion people will be living in Chinese cities in 2030, according to McKinsey. By that time, there will be 221 Chinese cities with a population of more than a million people (in Europe the figure now is just 35). In the next 20 years, 40 billion square metres of living and working space will be created in 5 million buildings, 50,000 of which Stefan Scheurer Global Capital Markets & Thematic Research 11

12 will be skyscrapers (this corresponds to 10 times the volume in New York City) 1. Enormous need for infrastructure investment worldwide The OECD estimates average worldwide investment volume for new infrastructure, or for maintenance of existing infrastructure, to be around USD 1.8 trillion annually from 2010 to 2030: The water sector is expected to see the highest expenditure (USD 900 billion per year) Around USD 270 billion will be spent on road construction per year About USD 210 billion annually will go to the power supply Whether it s the energy supply, the improvement of utilities and transport infrastructure or telecommunications a country s infrastructure requires constant maintenance and renewal. Globalisation, coupled with worldwide demographic change, will make enormous infrastructure investments necessary in the coming decades in both the industrial countries and the growth countries. 1 Source: McKinsey Global Institute: Preparing for China s Urban Billion, Figure 1: Expected global expenditure on infrastructure per year in billion US dollar, USD bn Road Rail Telecoms Electricity Water Source: OECD (2006), Allianz Global Investors Capital Markets & Thematic Research 12

13 3. Equities outlook - US US equity markets produced solid returns in 2012, with the S&P 500 advancing just over 13% for the full year. The fact that US equity prices were able to deliver an above average gain, despite a notable slowdown in S&P operating earning growth to 3.3% year-on-year (YoY) (through Q3 2012), a continued shift in portfolio preferences of individual investors away from equities and virtually no change in the size of the Federal Reserve s balance sheet, suggests the nearly $230 billion (annualised, through Q3) reduction in shares outstanding played an unusually large role in supporting US equity prices. This year should produce more favourable fundamentals and demand conditions for the US equity market. Under our base case, earnings growth and Fed liquidity creation are both due to improve in 2013, while individual investors may be pulled back into the equity market. Yields in the debt market continue to remain historically low relative to inflation and also relative to returns that households require to achieve their targets. With the US economy showing the most signs of reacceleration of all the developed nations, foreign investor purchases of US equities may also gain momentum in Regarding earnings growth, US companies were able to hold profit margins near historical highs during the course of The deceleration in S&P 500 operating earnings growth was primarily the result of slower revenue growth, not profit margin decay. US total business sales growth peaked in the middle of 2011 at nearly 13% and shifted down to 3.1% by October 2012 about the same pace as earning growth through the end of Q3. With existing home prices up just over 10%, and double-digit returns in the equity market, US consumer spending has begun to mildly reaccelerate despite the labour market remaining lukewarm. More importantly, there are preliminary signs that capital spending has begun reviving. This, along with a $10 billion per month improvement in the trade balance since January, should support better top line growth for US based companies than in In addition, unlike in the eurozone, there are initial signs of a revival in labour productivity growth in the US. Business sector productivity is on the rebound, lifting from a low of 0.1% YoY growth in Q3 2011, to 1.6% YoY growth as of Q This in turn has led to a slowdown in unit labour cost growth for the business sector (see Figure 1). Indeed, labour cost deflation is likely to have returned to the US as of Q With pricing power holding steady, lower unit labour costs make profit margin expansion more likely in We are also finding an improved tone to capital spending indicators in the US. Institute for Supply Management new orders have moved back above the 50 level, marking expanding order books, while new orders for non-defence capital goods excluding aircraft have also begun to turn back up again after peaking in level terms back in the spring (see Figure 2). This development suggests that capital spending slowed with a delayed response to slower profit growth and that the fiscal cliff issue has not been the main factor holding back capital spending. Otherwise, had the fiscal cliff been foremost in the minds of managers, we would have observed a more rapid rate of decay in new orders for capital goods coming into the end of the year, not a rebound. Stronger capital spending not only improves the revenue growth for capital equipment producers, but should add more thrust to the labour productivity revival, while also supporting further improvements in the US trade balance. With a price-trailing operating earnings multiple close to 14, which is close to the lower bound of the range during the past 25 years, and a dividend yield above the 10 year US treasury yield, valuation remains reasonably cheap for the S&P 500. In addition, we know the Fed has committed to expanding its balance sheet by nearly a third in Sellers of treasury bonds and mortgage-backed securities to the Fed are unlikely to turn around and plough the proceeds back into asset classes offering historically low nominal yields. Riskier asset classes especially those offering Rob Parenteau, CFA Economist, External Advisor 13

14 a claim on a tangible asset are likely to once again find support from such large-scale balance sheet expansion by a major central bank. While no doubt some of this increased liquidity will be reallocated to emerging equity markets, it would be surprising if the US equity market does not benefit as well. The main risk to our US base case is that the tax hikes and expenditure cuts implemented in the 2013 fiscal consolidation prove to be too large a burden on household incomes and business revenue and profit streams, thereby slowing consumer and capital spending. As of the time of writing, with the last minute tax deal, the initial $607 billion of pre-planned fiscal contraction for 2013 has been reduced to an upper bound of $309 billion in fiscal drag. That assumes a worst case scenario, where negotiations break down in March, and all of the $109 billion in planned sequestration is implemented. More likely, another last minute compromise will be reached late in March, with more moderate reductions in both entitlement commitments and military spending, leaving the total fiscal drag in the $200-$225 billion range. Then the issue shifts to downgrades by rating agencies, since the trajectory of the public debt to GDP ratio will not look like it is flattening or even reversing soon enough for their preferences. However, since the Fed will be expanding its balance sheet by one third (roughly $1 trillion dollars) in 2013, the risk of an interest rate surge in the government and mortgage backed securities markets is quite mitigated. The second major risk to our US base case is a sharp decline in foreign growth. To date, both China and Germany are showing signs of a mild reacceleration, which should help to lift Asian and eurozone prospects. Commodity prices are also showing traction, so emerging market producers like Brazil and Indonesia should also begin to experience improved revenue streams. While both of these risks deserve to be monitored closely as the year unfolds, we believe the prospects of an earnings reacceleration, large Fed liquidity injections and favourable valuation metrics should all support very good results for US equities in Figure 1: US labour productivity reaccelerating Mar 92 Mar 93 Mar 94 Mar 95 Mar 96 Mar 97 Mar 98 Mar 99 Mar 00 Mar 01 Mar 02 Mar 03 Mar 04 Mar 05 Mar 06 Mar 07 Mar 08 Mar 09 Mar 10 Mar 11 Mar 12 Business Sector: Real Output Per Hour of All Persons % Change - Year to Year SA, 2005=100 (LHS) Business Sector: Unit Labour Cost % Change - Year to Year SA, 2005=100 (RHS) Source: Bureau of Labor Statistics/Haver Analytics 14

15 Figure 2: US capital goods orders reviving Nov 07 Jan 08 Mar 08 May 08 Jul 08 Sep 08 Nov 08 Jan 09 Mar 09 May 09 Jul 09 Sep 09 Nov 09 Jan 10 Mar 10 May 10 Jul 10 Sep 10 Nov 10 Jan 11 Mar 11 May 11 Jul 11 Sep 11 Nov 11 Jan 12 Mar 12 May 12 Jul 12 Sep 12 Nov Mfrs' New Orders: Nondefense Capital Goods ex Aircraft 3-month Moving Average SA, Mil.$ (LHS) ISM Mfg: New Orders Index 3-month MovingAverage SA, 50+ = Econ Expand (RHS) Source: Census Bureau, Institute for Supply Management /Haver Analytics 15

16 Equities outlook - Europe Neil Dwane Chief Investment Officer Equities Europe Markets have made dull progress since the autumn reflecting a challenging constellation of issues. Firstly, there are the politics of the EU regionally and domestically. At a European level, the EU is struggling to find accords that cover not only its next seven-year budget, where disagreements centre on the EU share rising during local austerity, but also on the banking union where it is increasingly clear that Germany will not pay nor transfer to solve the insolvency of many peripheral countries banks. Accordingly we have seen growing frustration from the IMF, who do not endorse the recent Greek III solution through a bond buy-back and cancellation, which leaves the EU isolated again from international investment flows. Importantly, the banking union is a key step to embracing a closer European union but involves over 30 trillion of deposits and is thus more of a political rather than financial decision. Breaking the sovereign and bank loop is crucial in calming markets further and sustainably. More immediately, Q will see the Italians return to elections after the withdrawal of support for the Monti technocrats, which may well unsettle investors even if Italians themselves expect little to change. Most importantly, it is now increasingly clear to us that all big decisions in the EU will be postponed until after the German elections in September, so we should expect little policy of any note until Secondly, there is the positioning of investors towards Europe. Across markets in general, it must be said that in the last few years, Europe has not tried to attract international capital as it has forced losses onto Greek bond holders and also certain bank debt holders. However Europe badly needs to attract this pool of capital so that there is more than just Germany capable of doing the heavy lifting. With EU suspicion of international banks still high and with rising taxes on international investment, as well as open hostility to large multi-nationals (as recently seen in France), this tide may take some time to turn. Nevertheless this is indeed the opportunity as both local and international investors are very underweight Europe, in spite of the relative strength of the euro which has been buoyed by de-leveraging and repatriation of banking assets. This positioning has still left Europe looking attractive on both longer term valuation metrics as well dividend yields. Thirdly, there is the tightening grip of European austerity, which is pushing more and more of the economy into recession. As we look into 2013, it is likely that much of Europe is entering recession and that, as the IMF have now proved, the negative feedback loops of austerity are much more serious than anticipated. This then is already in the mix for Europe and is being exacerbated by the financial repression, which is encouraging banks to fund their sovereigns rather than the real economy a credit crunch is underway that will impair investment and employment. While a measure of austerity is probably appropriate, it is clear that Europe needs to address some of its structural challenges in a more dynamic and thoughtful way such as the growing and unacceptable levels of youth unemployment that could have lasting effects on economic potential. Given the demographics challenge Europe already faces, it desperately needs to address this issue (see Figure 1). Lastly, we face the global challenges left unresolved by the global financial crisis that will have a dramatic impact on equities and their prospects. Banks in Europe remain less capitalised than their UK and US competitors and will suffer both from global banking regulations like Basel III as well as local changes to regulation that will afford more protection on a national level, such as the need to hold sufficient capital in the USA to be a US bank. This, combined with Swiss and UK separate ordinances to hold high and liquid levels of assets, will also challenge both the 16

17 returns banks are able to make as well as what they can lend within the economy. European economic growth badly needs the banks to be able to fund real economic activity as much as sovereigns but for now Europe is seeing the private sector squeezed out, which is undermining investment, employment and confidence. Elections will weigh heavy through the year and the effects of implementing agreed EU policies will add further additional volatility. Figure 1: Eurozone unemployment for those aged < Dec 02 Jun 03 Dec 03 Jun 04 Dec 04 Jun 05 Dec 05 Jun 06 Dec 06 Jun 07 Dec 07 Jun 08 Dec 08 Jun 09 Dec 09 Jun 10 Dec 10 Jun 11 Dec 11 Jun 12 % of Workforce Source: Bloomberg, as at 31 October

18 Equities outlook - Asia-Pacific Raymond Chan, CFA Chief Investment Officer, Asia-Pacific A better 2013? Amidst the relatively weak, but seemingly not as bad, global economic environment, we expect Asia to have experienced a trough in growth through Q3 and Q and a slight uptick in activity as we enter The appearance of a clearer path toward structural resolution in Europe and political resolution in the US, combined with consistent easing monetary policies by developed market central banks, should at least help to place a floor on the pace of global economic growth. Reflationary tactics deployed by developed markets could potentially constrict the policy options available in Asia, but we expect asset markets in Asia will continue to benefit from liquidity inflows. As inflation in the region is still trending down, partly because the economies are still operating at below capacity, Asian economies may very well be poised to head into a Goldilocks environment, characterised by the ideal balance of stabilised growth and relatively benign inflation expectations, in the first half of China The 18th Party Congress was held on 8 November and ended on 15 November The composition of Standing Committee Members of the Politburo was unveiled with seven members, rather than the nine members making up previous committees. For the time being, details on the reform agenda have been rather limited. The new Standing Committee of Politburo (SCP) is generally considered politically conservative but economically liberal. It is anticipated that economic reforms should be much easier than political change for the new leadership as all eyes will be on the messages conveyed regarding the upcoming reforms. Financial liberalisation and pricing deregulation will likely be at the top of the economic reform agenda. A crackdown on state monopolies, or even privatisation, may also be on the agenda, albeit more challenging to implement. Securing economic growth and improving living standards will likely continue to be the Chinese government s near-term focus. A majority of the new SCP members have experience in heading fast growing coastal cities or provinces in the past. Many of them also held key positions in the Jiang Zemin s regime, during which some key economic reforms, such as China s access to the World Trade Organisation (WTO), banking reforms, privatisation of state-owned assets and managed floating rate system of the renminbi, were introduced. In the next five years, we expect further progress in economic and social development, especially capital market reform, private sector/sme development, urbanisation and health care reform. As for political reforms and economic rebalancing that involve redistribution of interest among different parties, the new leaders may adopt a more conservative approach of negotiation and compromise. Policy priorities of the new administration will become clearer after the Central Economic Work Conference in December 2012 and the National People s Congress and Chinese People s Political Consultative Conference meetings in March We are comfortable with our expectation that the economy has troughed and is likely to deliver stable growth in the near- to medium-term, as our view is that the current recovery represents a cyclical rebound driven by growth in fixed asset investment and, hence, a normalisation of economic growth. However, while economic data points to China having reached a cyclical bottom, it is unclear whether we are on another structural uptrend quite yet. Economic growth is unlikely to pick up significantly and on a sustainable basis unless the government starts introducing significant reform measures. However, we are not sure whether the government has the courage to deal with some of the structural issues on the political side. And time may not be on their side as we see increasing levels of public discontent. With respect to the renminbi, the market has been focusing on the sustainability of its appreciation, especially after the currency s strong performance during recent months. From our perspective, recent strength in the renminbi has been largely driven by technical factors with inflated demand from short 18

19 covering activities, especially from exporters who accumulated US dollars in early 2012 when the renminbi depreciated. We believe fluctuations in the spot market would not lead to any significant change in China s exchange rate policy towards the US dollar. In addition, we see limited fundamental changes to support the appreciation story going forward. On the other hand, with the renminbi s trading band widening in April 2012, we believe the currency should have entered into a new regime with increasing twoway volatility driven by market demand and capital flows, instead of the predictable one-sided appreciation. Looking into the longer term, the internationalisation of renminbi should continue to support the currency, however, we expect the pace of appreciation will be slower than the market has previously experienced. India While concerns about slowing growth and the end of the investment cycle in India have persisted since late 2010, the government has finally started to take action to address these issues. Following the change in the finance ministry during the latter half of 2012, the government has now targeted a reduction in subsidies as well as a revival of the investment cycle. The aim would be to reduce the deficit while reviving GDP growth back to the levels India saw for most of the last decade. The finance minister has shown a serious intention to reduce the deficit by controlling the subsidy bill. He aims to reduce this by 0.5% of GDP every year for the next few years. The government has started with a fuel price hike in diesel and reduced the subsidised liquefied petroleum gas cap to six cylinders per year, per household. The budgeted fiscal deficit for the financial year of 2013 is 5.1% of GDP, but this is likely to slip past 5.5% by the end of the fiscal year. To help catalyse a revival of the investment cycle and market reforms, several important decisions have been implemented, including an increase on the limits on foreign direct investment (FDI) into multibrand retail, broadcasting services, insurance and pensions, power exchanges and the aviation industry. In addition, there are several projects in the pipeline awaiting approval (Figure 1). The government has formed a Cabinet Committee on Investments (CCI), which will be presided over by the prime minister and will comprise all respective ministers from the infra space. CCI will fast track all projects over $200 million that are awaiting clearance from ministries. From a monetary perspective, the Reserve Bank of India (RBI) has mentioned that they would start the easing rates cycle from Q amidst signs growth is slowing down. Therefore an easing rate cycle and a clear focus on investment and infrastructure, with the policies to back them up, should provide solid support for the revival of the investment cycle in Japan Following the recent election, Japan may very well be reaching a necessary inflection point toward turning the economy around. The election in December saw a landslide victory for the Liberal Democratic Party (LDP), which gives the Prime Minister Shinzo Abe the tools to rapidly implement campaign promises to boost growth. The Bank of Japan (BoJ) finally became a full member of the QE club and will increase the size of its balance sheet with an additional 25 trillion next year. All of this is positive for Japanese equities. However, it remains to be seen whether the BoJ s aggressive move will finally weaken the currency on a sustainable basis and help end deflation. We will pay attention to the BoJ in case it starts to explore inflation targets or other forms of less orthodox policy in upcoming meetings. While we would like to see Japan embrace more aggressive structural economic reforms, we would see near-term fiscal and monetary policy support as also being conducive to at least nearterm economic growth in Japan. ASEAN ASEAN economies have been at an economic sweetspot for some time now with the right balance of demographic and economic forces driving a number of structural developments. Strong investment and resilient consumption has been a key driver of a de facto decoupling of the ASEAN economies from the rest of the global economic stress. However, we are now reaching some stress points to the otherwise flawless story as the dependence on FDI flows and current account erosion are becoming increasingly apparent across much of the region. Indonesia is a good example. We still expect these economies to perform well; however, we would not expect the ASEAN story to remain quite as robust as it has the past few years. 19

20 Australia Although commodity prices have rallied recently on hopes of a resurgence in Chinese demand, the Australian economy is showing signs of slowing and we expect interest rates will be under pressure as we go into The near term buoyancy of the Australian dollar is a result of further diversification of their reserves by the global central banks. As we enter 2013 We are constructive on Asia Pacific stock markets for the next 12 months. The bottoming out of Asian economic growth, in particular, China, should set a stage for marginal positive economic momentum. The developed central banks continue to pursue a put option for investors to take risk. We believe a combination of modest earnings growth and some multiple expansions can set a scene for positive return for investors investing in the region. Figure 1: India Projects Announced vs. Projects Stalled (Rupees bn) INR bn 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000-25,000 20,000 15,000 10,000 5,000 - FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 Financial Year (FY) FY07 FY08 FY09 FY10 FY11 FY12 1HFY13 Projects stalled (LHS) New projects announced (RHS) Source: CMIE, Citi Research, AllianzGI Research as at 30 September