Enjoy the good times while it lasts, says investment chief
Emirates NBD’s investment chief Gary Dugan takes a positive tactical view of equities but remains wary of political risk in the Euro zone. He shares his thoughts on gold, government bonds and the US economy.
March 21, 2012 3:18 by kippreport
The ongoing good news from the global economy plus short term fixes on the Euro zone problems have prompted us to buy some equities in our portfolios. However we live in fear.
The Euro zone problems are not solved just put off and while the US economy is enjoying good times at present they have still to resolve their debt problems. In the very near term we believe the equity markets could breakout to the upside.
Among risk assets our preference remains for the emerging equity markets, agricultural produce and gold (on weakness) amongst commodities and US high yield and selective emerging debt markets. We would stress that our purchases of equities are very much a tactical call and we remain skeptical whether a rally can be sustained through the whole of 2012.
A driver of increased optimism in the markets has been the better than expected data from the United States. Latest news shows that US retail sales have been far stronger than expected.
Latest numbers show strong retail sales growth in February and data was revised up for previous months. The manufacturing sector is sparkling- US factory output in February is running at a 10 percent annualized gain in the first quarter close to the strongest gains in five decades. This week brings more updates on the housing markets with data due for housing starts and home sales. It is unlikely the housing sector will show any of the vibrancy of the rest of the economy.
It is of course not all good news. The new worry for the markets is the rise in the US government bond yields. The US 10 year government yield has risen from 1.95 percent on March 6 to trade at close to 2.3 percent. Such a move equates to a loss of capital for investors of around three percent in just 10 days, quite painful when you consider you would have to wait all year for your two percent interest payment. The reason that the levels of US government bond yields are important in that many other fixed income markets price-off US bond yields. As losses mount in US bonds other bond markets could potentially also suffer similar or greater losses. So far many of the bond markets have absorbed the sell-off of the US government bond market.
Spreads (the difference between the yield of the non-government bond and the government bond) in many markets have narrowed hence non-government bonds have not suffered the same losses as US government bonds. Higher bond yields can also signal problems for the equity markets however to date equities have continued to make gains. Investors are taking the view that better news on US growth should mean higher profits for US corporates and by implication ongoing good news for the equity market.
However we do not envisage a sustained rise in bond yields. The global economy is still facing its challenges, that means global inflation and interest rates will probably be anchored at low levels for some time to come. The US economy is enjoying a strong 2012 but in 2013 growth will be constrained by a need to rein in the budget deficit and reduce overall government debt.
The Euro zone needs to go through a multi-year adjustment to bring government deficits down to a sustainable level. We do not quite envisage Japan like conditions in the major countries of the world but it would be a surprise to see US government bond yields rising to the 3 percent mark from just over 2 percent today – a level that would start to spook investors.
As long as investors don’t give up entirely on US government bonds the US dollar is likely to benefit from the rise in US government bond yields. Indeed the extra yield on US bonds is likely to lead to further potential inflows of capital into the US lifting the dollar. The extra interest rate differential versus low yielding currencies such as the Yen and the Euro will be supportive of the dollar.
We would look to buy gold below $1600 per ounce. Gold at the current level of $1660 has tracked back a good way from the recent highs of $1784, however from a technical perspective the current price is in no-man’s land and probably needs to slip below $1600 before we see any sustained buying support. We still believe that central banks will be buyers of gold particularly those in the emerging markets.
Long term investors using exchange trade funds remain strong holders of their positions. Gold has risen 6 percent since the start of 2012, a stellar performance considering all the good macroeconomic news and the strong rally in equity markets.
However our main reason for encouraging investors to continue to accumulate more gold is that we doubt that the problems of governments overspending and accumulating debt are not behind us. Remember that Greece even with all the austerity measures is expected to have a debt to GDP ratio of 180 percent even in 2020.
While we remain positive about the emerging markets, India remains our least favoured equity market. The latest Indian budget shows only a modest improvement in the budget deficit from 5.9 percent of GDP to 5.1 percent even on what seem like aggressive government targets for asset sales.
The government’s lack of progress in cutting government spending is likely to impact the pace at which the Central Bank can cut interest rates. Some commentators are suggesting that there will only by a further 25 basis points cut in interest, insufficient to excite the markets. Indian equities look likely to mark time through 2012.
The Euro zone may have put good quality sticking plaster on its near term problems however political change could bring significant challenges in the coming months. In late April and early May, we will see a presidential election in France and a likely general election in Greece. In Germany the failure to pass the state budget in North Rhine-Westphalia on the 14th March is likely to lead to a snap-election in the state in early May (6th /13th).
Current polling suggests the result will be a wipeout for Chancellor Merkel’s coalition partners, the FDP. Mrs. Merkel’s coalition could weaken to such an extent that ultimately Chancellor Merkel will be forced into an early election. Europe could be facing a major shift in political leadership and philosophy at just a point where it needs stability. Nicolas Sarkozy the current French president trails socialist Francois Hollande in the polls.
A shift to the left in the politics of the leading Euro zone countries is likely to lead to a much less focus on collectively solving the problems of the Euro zone and more focus on the domestic challenges in each country.
Gary Dugan, Chief Investment Officer, Private Banking, Emirates NBD