Economic & Market Review - May 2013

by Gavin Graham, Chief Strategy Officer April 30, 2013
Notice: This newsletter is intended as a general financial market outlook, and should not be relied on as investment advice.
This is the first edition of the INTEGRIS Economic & Markets Review, which will be analyzing recent developments in financial markets on a regular basis. It is intended to provide INTEGRIS clients with an overview of what is happening in terms of global economic developments, and their effects on different types of financial assets.

The first conclusion that emerges from looking at the Gross Domestic Product (GDP) growth numbers for the major economies for the first quarter of 2013 is that the recovery from the so-called Great Recession of 2008-09 remains patchy and lacklustre. While the US saw a recovery in its GDP from a small decline (-0.4% p.a.) in the fourth quarter of 2012 to relatively strong growth of 2.5% p.a. in the first quarter, recent data suggests that consumer spending is now being reined in. Consumer spending, which accounts for 70% of economic activity in the US, grew 3.2% in the first quarter, despite the ending of payroll tax cuts at the beginning of 2013, which saw a 2% increase in social security payments. However, retail sales fell by 0.4% in March, and the U$85 billions in mandatory government spending cuts due to the “Sequester” which began in March, saw government spending fall 4.1%, led by an 11.5% decline in defence spending. Canada's GDP is forecast to grow 0.2% in February 2013, the same as in January.

Europe remains mired in recession, with the European Central Bank (ECB) forecasting that the 17 nation Euro-zone countries will see their GDP shrink 0.5% this year, before growing 1% in 2014. The largest European economy, Germany, is forecast to grow 0.6% in 2013, while France and the southern European economies such as Spain and Italy are forecast to continue in recession. The UK, which is not a member of the Euro-zone, escaped falling into a “triple dip” recession when its first quarter 2013 GDP grew 0.3%, after a fall of -0.3% in the fourth quarter of 2012, meaning that the economy grew by 1% over the last 12 months. Meanwhile the Bank of Japan has upgraded its GDP growth forecast for 2013 from 2.3% to 2.9% reflecting its massive monetary stimulus to attempt to defeat deflation. China's GDP has been forecast to grow by 7.5% in 2013, a slower pace than in recent years, owing to the tightening measures introduced last year to cool down overheated property markets.

The common factor between most of the developed markets is the extensive monetary expansion being carried out by central banks, under the name of “Quantitative Easing” (QE). Whether it is the US Federal Reserve under Chairman Ben Bernanke committing to buying U$85 billions a month of government and mortgage backed bonds until unemployment falls to 6.5% and inflation rises to 2.5% or the Bank of England, soon to be run by Canadian Mark Carney, buying Pds 375 billions of gilts (government debt) since 2008, central banks are creating liquidity at a pace never before seen. Even the inflation hawks at the ECB and the Bank of Japan have become converts to this approach, with the ECB's President Mario Draghi committing last summer to do “whatever it takes” to preserve the Euro by engaging in up to E190 billions of Outright Monetary Transactions (OMT) to purchase Spanish, Portuguese and Italian government debt and the Bank of Japan intent on driving inflation up to 1.9% by 2015.

This has resulted in massive amounts of liquidity being created, and while some of it has flowed into supposedly safe government bonds, with the yields on 10 year US Treasury bonds (1.65%) German Bunds (1.2%) and UK gilts (1.6%) falling to 60 year lows, a lot has ended up going into higher yielding equity markets. Thus so far this year to the end of April 2013, the US S&P500 Index is up 11.8% back to its previous all time high reached in 2007, the Morgan Stanley Capital International (MSCI) World Index is up 13% and the MSCI Europe Australasia and Far East Index (EAFE) are up 8.8%, held back by the weaker performance of European markets, with the Eurostoxx 600 Index up only 6.8%. The MSCI Japan Index is up a remarkable 19% year-to-date, with the Topix Index up 61% from mid-November on the promise to defeat deflation by new Prime Minister Shinzo Abe, while the MSCI Asia Pacific Index has hit a 5 year high. In US and Canadian dollar terms this return is reduced by the 22% decline in the Japanese yen from Y77.5=U$1 in September 2012 to Y94.5 at the end of April, as one of the consequences of the liquidity creation by central banks is a fall in their currency's value. However, as virtually all central banks are following the same policy, there is something of a “race to the bottom” in that each is unwilling to have their currency trade too strongly against its trading partners.

Ironically, stock markets such as Canada and the emerging markets, which might have been expected to benefit from the wave of liquidity washing through world equity markets, have actually fallen so far this year. The S&P/TSX 60 Index is down -1.2% and MSCI Emerging markets (Free) Index is off -3.8%, reflecting concerns over higher inflation leading to tightening measures in emerging markets, as seen in China, and also lower commodity prices due to slower Chinese growth. With almost 40% of the capitalization of the S&P/TSX Composite Index comprised of energy and materials stocks, Canada has suffered as worries over slower growth and demand for its exports have led to weakness in commodity shares. This has been especially noticeable amongst gold mining stocks, which comprise over 7% of the index, and which have under-performed gold itself over the last two years, and particularly so far this year. While gold has fallen 12% to U$1425 per oz. year-to-date, the gold mining shares Exchange Traded Fund (ETF) is down 34%. This accounts for some of Canada's under-performance, and its heavy weighting in energy and base metals producers have also contributed.

If the continued liquidity creation by central banks continues, and it appears highly unlikely that there will be any changes in policy with GDP growth remaining so weak, then it would be reasonable to expect that the price of hard assets, such as commodities should eventually benefit from this process. Whether or not inflation increases in the next year to eighteen months is difficult to forecast, but central banks have made it clear they this is what they wish for. The old market saying is “Never fight the Fed (Federal Reserve)”. With Canadian equities having lagged other developed markets by a substantial margin, some catch-up may be expected over the next few months.