At this point in time, we think the prudent way to manage the near-term risks related to the growth outlook and Greece justifies some moderation in our risk-taking, but not a change in our overall risk-tilt. Our medium-term thinking has not changed.
Eurozone still far removed from equilibrium
US and emerging markets drag down global growth in Q1
Global growth fell considerably from its annual trend of about 3% in the past few years to just above 1% in the first quarter (Q1) of this year. The two traditional laggards in developed market (DM) space, the Eurozone and Japan, did quite well while the disappointments were concentrated in the US and emerging markets (EM).
In the US, the big question is to what extent the disappointing Q1 growth figure was driven by transitory factors and seasonal adjustment problems. The general story here is that the corporate headwinds stemming from lower oil prices and a stronger dollar are somewhat bigger and more frontloaded than expected at the start of the year. Meanwhile, the response of the consumer has been relatively muted so far. In general, confidence indicators remain around the highest levels seen since the crisis, which suggests underlying domestic demand momentum should remain strong. We therefore expect US growth momentum to pick up to an above-potential pace in the second half of this year and beyond, as the US recovery should be firmly supported by a positive feedback loop between consumer and corporate appetite for spending.
The EM slowdown is to a considerable extent part of a structural trend driven by private sector deleveraging and low corporate profit margins. These will weigh on EM domestic demand growth going forward. Still, in this region there could also be some transitory factors at work (ripple effects of Chinese New Year, US port strikes, temporary lull in global goods demand).
Eurozone economy firing on all cylinders
The Eurozone is definitely the region where the contrast with last year is huge. For the first time since the crisis, almost all factors are pointing in the direction of a stronger growth momentum. The region is characterized by solid rises in business and especially consumer confidence over the past few months. On top of this, private sector credit is starting to flow more vigorously and financial conditions have turned substantially more supportive. The ECB’s QE program has probably significantly enhanced these trends and is likely to act as a strong support for financial conditions and credit flows in the near future. What’s more, fiscal policy is set to remain broadly neutral and the labour market displays a strong positive response to the growth upturn, i.e., it does not take much growth to increase employment and push the unemployment rate lower.
In view of all this, it is not too surprising that European data bucked the global trend in many areas in Q1. Not only GDP but also trends in industrial production, retail sales and even exports have been more robust than in other parts of DM space. Also, the trend in car registrations has picked up significantly, suggesting that we could be at the start of an upswing in the consumer durables cycle. After seven years of very low durable goods sales there could be a lot of pent-up demand here.
The recent Bund sell-off and euro appreciation of course implied a pretty significant tightening of financial conditions, but from a very accommodative level. This is not yet reason to change our base case for the economy, as consumers and businesses react to longer-term trends in financial conditions rather than short-term movements. Having said that, we doubt that the ECB will be very pleased and in this respect we would not be surprised to hear some increased verbal intervention in support of looser financial conditions.
We should not get too excited about the Eurozone yet
Before we get all too excited about the Eurozone, we should not forget that in level terms the region is still far removed from what could be called a normal equilibrium. The unemployment rate is still well above pre-crisis levels and its descent may well slow down at some point due to rising labour supply and productivity growth. Also, core inflation and short-term inflation expectations remain well below target. As a result we believe that the ECB will need to continue with its QE program for a long time to come.
Time is running out for Greece
On top of that, developments in Greece add some downside risk to the equation. We are still not too concerned about the long-term outlook, even if Greece were to default on its debt, as policy tools and political willingness to contain contagion in the Eurozone are much stronger than in previous years. However, we do think that markets are a bit complacent about the near-term risks surrounding a deal over the next two weeks in the run-up to the payments that Greece has to make to the IMF in June. If no agreement is reached — which would allow for the remaining EUR 7 billion of the current program to be disbursed — it is very likely that Greece will miss a payment to the IMF.
We have always felt that this scenario could be avoided. Greece could have put a stop to additional austerity if only it had been more willing to push through reforms. Unfortunately, the Greek government did not seize this opportunity. The crucial question is now how its behaviour will change now that time is really very close to running out. Our base case still is that the pressure will force them to deliver on the structural reform front.
Some moderation in risk-taking in the near term
At this point in time, we think the prudent way to manage the near-term risks related to the growth outlook and Greece justifies some moderation in our risk-taking, but not a change in our overall risk-tilt. The behavioural dynamics at this point in time do not give reason for additional concern. Investors’ cash levels are high compared with historical levels, most crowded trades have been largely unwound and investor sentiment is already on the low side (which is a contrarian indicator), while resilience in momentum of flows and returns is evident.
Our medium-term thinking has not changed and we continue to prefer risky assets over government bonds. The current adaptation therefore is a moderation in the size of our overweight in equities (from medium to small), while simultaneously reducing the underweight in government bonds from medium to small. At the same time we keep a small overweight in real estate. More change will certainly come at some point, but this will more likely than not be in the direction of adding risk rather than lowering it further.