27 juli 2011
Economic Outlook and Investment Strategy for Q3 2011

Developed countries are at risk of “Japanisation”

Due to public over-indebtedness, recessionary pressure from ongoing deleveraging could weaken developed countries’ growth for some time, as was the case in Japan after the credit crisis broke out in the early 1990s. Austerity policies implemented or indeed just recommended are intensifying the risk of developed economies “Japanisation”. Faced with long-term deflationary conditions, the return of fiscal discipline is indeed problematic. Premature austerity measures could generate recessionary effects on growth, making it very hard to absorb public deficits.  

European authorities’ indecisiveness is deepening the crisis and creating contagion effects

In Europe, where the risk of a deflationary spiral is particularly high for several member states, the IMF and the eurozone's most virtuous countries are imposing suicidal fiscal austerity on growthless countries while the ECB is adding to their stress by raising its interest rates. The Japanese example demonstrates irrefutably the dangers of this policy. Weakened countries' inability to devalue their currency leaves them no other choice than a restructuring of their debt - as orderly as possible - alongside bold measures to improve economic competitiveness. The markets' repeated attacks make this obvious but with each passing day the ECB's dogmatic resistance makes the future adjustment harder and costlier for peripheral countries. It also presents a formidable risk of contagion to Spain, Italy and maybe one day France.  

Delaying the inevitable restructuring of Greek debt is weighing on European government bonds

For once, the outlook for European interest rates could differ from that across the Atlantic. The economic slowdown in the United States is hitting our economies with its usual 3-to-6-month lag, limiting the potential for long rates to pick up. At the short end of the yield curve, the further weakening of Europe's peripheral countries argues for a less intransigent monetary policy at the European Central Bank, which we think reduces the likelihood of another rate hike this year. In contrast, disastrously putting off the inevitable restructuring of Greek debt will weigh on all European countries' credit. The need to support a growing list of weakened countries, on which the euro's survival depends, will come at a cost to AAA rated sovereign issuers.  

The US economic slowdown will go on longer than the consensus expects

In the United States, the slowdown that began in the second quarter is still generally viewed as a mid-cycle lull caused by destocking, which is usual at this point, and by temporary exogenous factors. Although we think macroeconomic data could improve over the coming months due to lower oil prices and the positive effects on output of the Japanese production chain getting back up to speed, there are at least three reasons why we think the rebound will be short-lived. The first is that leading indicators of US growth have fallen too much in recent months to suggest anything more than a slight, temporary upturn in the cycle. The second is that some current sources of growth are already making their maximum possible contribution. For example, retail sales are unlikely to go on rising by 7.5% a year. The third - and biggest - reason for our scepticism concerns the persistent deflationary effects of deleveraging on the economy, leading companies to take as little risk as possible, the most visible symptom of which is the continued weakness of the US labour market, further reducing the potential for domestic demand and sustaining the slump in the property market.  

Once again, the emerging universe could offer a counterbalance to the problems in the developed world

Although we acknowledge that we were too optimistic in predicting that inflation would ease last quarter, we are convinced that Chinese monetary policy tightening will soon come to an end and that inflation will peak there in the next two months. For global growth, the end of monetary tightening will provide a massive counterbalance to developed economies' foreseeable weakness. The robust growth we are expecting will make it possible to tackle provincial debt, just as it allowed banks' non-performing loans to be dealt with a few years ago. If it proves capable of refocusing growth on domestic consumption, the emerging world may even benefit from persistently slower growth in developed economies whose limited demand for commodities would help alleviate inflationary pressures. These emerging countries, which do not have to overcome major public debt problems, still have very high potential growth and in some cases are about to see inflation stabilise or even fall. Given these conditions, stock market valuations seem particularly attractive with a 2012 P/E of 13x in India and 9x for Chinese equities listed in Hong Kong. We prefer these markets to South Korea and Taiwan, whose economies are more dependent on exports to developed countries.