Accelerating growth points to earnings over yield

A more confident view emerges of 2014 as investors seek to exploit a growth phase which may be muted by historical standards.

Summary: Europe’s exit from recession and the strong economic performance in Japan are good signs for the global economy, while recovery in US and UK is accelerating, but likely to remain weak by historical standards. Financial conditions should remain highly supportive of developed country demand, however the outlook for emerging markets is more uncertain.
Key take-out: Capital outflows will receive some uplift from accelerating global industrial activity, but the widespread need to unwind imbalances will leave global growth a little below trend in 2013 and 2014.
Key beneficiaries: General investors. Category: Economics and strategy.

Earlier today (Friday October 4) UK-based global fund manager Standard Life released its global outlook … and the message is clear. The recession is over and the recovery is ‘on’. Crucially, there are some areas growing faster than expected – the UK for example – and other areas where there are particular fears, such as emerging markets.

However, if you read the ‘helicopter view’ from chief economist Jeremy Lawson and then finish with the extract from Standard Life’s head of global strategy, Andrew Milligan, the conclusion for the active private investor is clear. The switch from yield to growth stocks in up and running in offshore developed markets; it may not have hit Australia yet, but it’s on its way.

Managing Editor, James Kirby

The anticipated upswing in global business activity has finally arrived. This is most evident in the near-universal rise in business sentiment indicators in recent months, but also in the harder industrial production and export data. While sentiment indicators are probably overstating the underlying improvement, the combination of healthy new orders and low inventories (Chart 1) will be a powerful stimulus for global production and investment in the second half of the year. For now, the improvement in economic conditions is most evident in the developed countries as monetary policy remains highly accommodative and the headwinds from financial deleveraging and austerity are fading. Emerging markets are also benefiting from the uplift in developed countries, although widespread structural imbalances will attenuate the recovery.

The US remains the leader

The US economy continued to expand at a below-trend pace in the first half of the year. Nevertheless, it was enough to bring about sufficient employment growth to generate a decline in unemployment. I remain cautiously optimistic that the recovery will strengthen as the year progresses. The economy has been resilient in the face of a significant fiscal tightening this year; activity would likely have grown at an above-trend pace in the absence of austerity.

Another factor supporting growth is that financial conditions are likely to remain supportive even as the Fed gradually exits its current asset purchase programme. So, although long-term bond yields and mortgage rates have increased sharply, they remain well below historical norms. I also do not expect the Fed to be in any rush to raise policy rates. House prices are underpinning rising wealth, and bank lending standards are continuing to ease. Moreover, forward-looking non-financial indicators appear healthier. The new orders components of PMIs and survey measures of firms’ capital spending plans have turned up solidly in recent months.

The biggest downside risks to the US outlook over the next 12 months are political. A fractious Congress has to reach an agreement to raise the debt ceiling to fund the government in 2014. A government shutdown or temporary default would swiftly dent economic sentiment. Any airstrikes on Syria could also be destabilising, particularly if the conflict escalates and oil prices spike. Meanwhile, the Fed’s eventual exit from its unconventional policies will be complicated by the simultaneous transition to a new Fed chair. Political risk has diminished since the summer of 2011, but it has not disappeared.

A recovery of sorts in Europe

After six quarters of falling output, Euro-zone GDP finally increased in the second quarter. That the improvement in activity was broadly based across countries and sectors was particularly positive. Germany is still the best performer but France expanded modestly for the first time since Q3 2012, and the Spanish and Italian economies contracted at a much slower pace. Private consumption, business investment and net trade all made positive contributions in the quarter, with only inventories weighing on growth. This bodes well for activity in the second half of the year since inventories are at historically low levels and are therefore due for a rebuild.

There have been three key pillars to the improvement in the Euro-zone outlook. The ECB’s OMT announcement was much more successful in bringing down peripheral bond spreads than expected, with both Spain and Italy retaining access to market financing. While Euro-zone credit is still contracting, lending standards are tightening at a slower pace and rates are coming down in the periphery. After countries undertook very sharp fiscal adjustments in 2012, there has been a slowing in the pace of consolidation in 2013. Finally, Europe is benefiting from the upturn in the global business cycle.

Despite these positives, I still anticipate an anaemic recovery with risks tilted to the downside. The European banking system remains undercapitalised, which will continue to weigh on lending growth. On the fiscal front, public spending cuts will not drag on growth as much as in 2012, but there is still a large debt overhang and further debt write-downs cannot be ruled out. Meanwhile, although there has been some progress on addressing internal European imbalances, most notably in Ireland and Spain, structural reform has ground to a halt in Italy and France, both of which still have large competitiveness gaps vis-à-vis Germany. Further political upheaval related to the social costs of economic adjustments is also possible.

The UK motors ahead

Perhaps the biggest surprise of the summer was the pace of improvement in the UK. Not only did the economy grow solidly in the second quarter but business and consumer sentiment surveys are pointing to even more robust growth ahead. A strengthening Euro-zone has been supportive, given the strong trade linkages between the two economies. Monetary policy also appears to be gaining more traction, in part because the authorities have made more progress repairing bank balance sheets. However, the economy seems headed down a familiar path. Stronger consumption is being facilitated by declining saving rates rather than real income growth (Chart 2), with the auto sector the most obvious beneficiary. Government policy also seems aimed at generating another cycle of house price increases. I would feel more comfortable about the sustainability of the improved outlook if it were better balanced.

Abe’s first two arrows hit their mark

Japan’s stellar economic performance in the first half of the year has revealed the first phases of Abenomics to be a success. Higher equity markets, the lower exchange rate and improved business and consumer confidence have combined to produce an acceleration in growth that is likely to continue into the second half of the year. Inflation is also moving in the right direction, suggesting that a decade of entrenched deflation may be coming to an end. Important risks remain, however. The first two arrows in Abe’s bow address Japan’s demand shortfall but will not do anything to lift the economy’s potential growth rate. That requires structural reforms. Abe has promised a detailed agenda before the end of the year but until then I remain cautious. I also note that long-term fiscal consolidation remains as distant a prospect as ever. (Also see Japan's ETF jackpot in today's edition).

Running the emerging market gauntlet

Although emerging markets will benefit from strengthening demand in the developed world, growth is likely to remain well below its average over the past decade. In China, economic indicators have improved since the early-summer liquidity shock but internal imbalances still loom large as the investment ratio is far too high and credit growth too rapid.

Fortunately, China does not have any external financing constraints, which buys the government time to make the necessary structural adjustments.

In other emerging countries, the near-term outlook is more concerning (Chart 3). India, Brazil, Indonesia, South Africa and Turkey are all running sizeable current account deficits. Their currencies have come under significant pressure as capital inflows have gone into reverse during the march towards Fed tapering. Current account deficits may be reduced over time but this will almost certainly be accompanied by sluggish domestic demand, creating difficult trade-offs for policymakers.

Financial risks have increased elsewhere too. Although countries like Singapore, Malaysia, Hong Kong and Korea are not running current account deficits, there has been a significant increase in private sector leverage since the crisis, that will have to be unwound over time. Then there are the large commodity exporters that will have to adjust to lower growth now that the commodity price super-cycle appears to be over. In summary, I think that fears of an emerging market financial crisis are overblown given that balance sheets and policy-setting institutions look more robust than before historical crisis episodes. However, emerging markets are unlikely to perform as well they have in previous upswings of the developed country business cycle.


Europe’s exit from recession and the strong economic performance in Japan are good signs for the global economy, although both still face significant structural barriers to growth. I have more faith in US and UK economic fundamentals but even there the recovery is likely to remain weak by historical standards. Despite the significant steepening of yield curves in recent months, financial conditions should remain highly supportive of developed country demand. However, the outlook for emerging markets is more uncertain. Global interest rates returning to the normal levels that existed prior to Fed extraordinary monetary measures are creating difficult trade-offs for local policymakers. Furthermore, capital outflows are acting as a financial decelerator. They will receive some uplift from accelerating global industrial activity but the widespread need to unwind imbalances will render the next phase of economic activity muted by historical standards. This will likely leave global growth a little below trend in 2013 and 2014, although somewhat better than in 2012.

Sustainable earnings

Meanwhile, Standard Life’s head of global strategy, Andrew Milligan, adds:

In broad terms, our portfolios are slowly becoming more cyclical. Sustainable yield is being replaced by sustainable earnings within the House View, although the process is gradual. There are still yield opportunities which should be sought in a world of low interest rates – after all, both the ECB and MPC have announced forward guidance in an attempt to keep official rates low for several years to come. Hence, investors should look carefully at equity income and real estate yielding opportunities. Nevertheless, the economic cycle is expected to be more positive into 2014, despite some downside risks related to policy errors or geopolitical events. An inventory cycle is leading to a revival in business sentiment; the next step will need to be an upturn in hiring intentions and capital spending. As ever, a key issue is the ability of firms to drive forward positive earnings growth into 2014 as top-line sales improve. Equity market returns in 2014 need not be as robust as those seen in 2013, but this is set against the backdrop of a revival in profits so shares should outperform the returns from most fixed income assets.

Jeremy Lawson is chief economist of Standard Life Investments.

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