Brewin Dolphin Holdings plc : 2012 bad but not all bad

5 January 2012 Brightness in darkness

With one important exception economic prospects for 2012 appear lacking in promise. In addition the balance of risks to the outlook appears stacked to the downside. This is not wholly because of the crisis in the eurozone. In looking elsewhere, such as to the developing world, the loss of economic momentum that is underway has only partly to do with the eurozone.    

Yet the eurozone remains central to the outlook. This is not just because of doubt about whether its leaders are credibly applying themselves in tackling the crisis. The doubt is also about whether the eurozone's difficulties, the financial crisis and the issue of sovereign debt sustainability behind it, can be credibly resolved at all. The pressure in eurozone sovereign debt markets and the stress in funding markets for the banks reflect this sentiment.     

Over the past months, consensus forecasts for GDP growth and corporate earnings for the year ahead have been revised steadily downward. This revision of expectations is likely to continue and equity markets are discounting some of this already. However, they are still likely to grapple, as they have, with the valuations that apply in an environment of great uncertainty for earnings growth and this begs the question whether the degree of volatility seen during the latter half of 2011 will be repeated in 2012. This point is addressed later. But first, the bright spot!

Against a discouraging backdrop, particularly for Europe, the US economy is regaining momentum after a disappointing first half for 2011. America enters the New Year with continued support from the Federal Reserve and its commitment to keeping interest rates where they are until the middle of 2013. That is besides other things, such as Operation Twist (the substitution of longer for shorter dated Treasuries in the Fed's balance sheet) and the Fed's reinvestment of principal payments from its holdings of agency debt and agency mortgage-backed securities in more of the same through purchases in the secondary market.

The US economy also enters 2012 with several encouraging developments including steady albeit modest job creation which is helping to boost consumer confidence, rising capacity utilisation indicative of a likely pick up in investment activity and a recovery in bank lending to non-financial companies. 

While the odds of the US relapsing into recession are not of a trivial order of magnitude, neither are they judged to be the one-in-three chance thought likely several months ago. With that in mind, the Fed is unlikely to adopt a still easier monetary policy. Also, we see Congress extending both the employee payroll tax cut and the emergency unemployment benefit scheme beyond the two months concession granted already. In both cases an extension to the end of 2012 is likely. We rate the chances of the US relapsing into recession at no more than one in five, if that, and, if anything, suspect that the economy will grow faster in 2012 than in 2011.

This is partly because the US economy has two things going for it. First, productivity has shot up rapidly since the recovery from the financial crisis, more so than in Europe, as the following chart shows. This has not only helped to contain unit labour cost growth but it has also been a factor behind the surprising strength of US corporate profitability in the recovery to date. Second, as measured on a trade-weighted basis, the dollar has been on a steadily weakening trend since the financial crisis, at least until recently. Both developments have helped the US economy acquire an internationally competitive edge at a time when global trade is set for a further slowdown in 2012. This should help the economy retain market share, if not gain it, and help also to shift consumption towards domestic output instead of foreign goods and services.

However, even though the share of exports in GDP has grown over time, the US is still a relatively closed economy and less exposed than others, notably Europe, to the ebb and flow of international trade. As the following chart shows, the share of exports in GDP is about a third of what it is for the European Union, meaning the economy remains largely driven by domestic demand - even more so than in the case of Japan.

With US employment growing and Fed policy committed to supporting the economy, domestic demand can be expected to continue strengthening in 2012, thus helping corporate sector revenue. Meanwhile, the modest growth in unit labour cost that can be expected from modest wage growth and still favourable productivity trends should help profit-margins. At present, expectations for global earnings growth and profitability in 2012 are being revised downward but if there is any major economy that offers the potential to surprise on the upside, it is likely to be the US.   

Recent productivity trends have not been vastly different between the US and Japan. Leaving aside the trauma of Japan's earthquake last March and the recovery that is underway, a big difference today lies with exchange rates. As the following chart shows, the yen is the strongest of the major currencies. Thus, while Japan can claim productivity to its credit, it lacks a competitive exchange rate. Sterling may have a competitive exchange rate but it lacks Japan's productivity. Not so for the US, which has both.

Japan to fare better in 2012

Japan is expected to leave recession behind following the devastating earthquake so, in contrast to 2011 the economy should make a small but positive contribution to global growth in 2012. Housing investment is expected to pick up and, while employment may not rise by much from current levels, both personal consumption and business investment are expected to grow modestly. The bottom line is that Japan and the US, collectively a third of the global economy, are expected not only to contribute positively to global growth in 2012 but to make a greater contribution than they did in 2011.

Developing world shifts policy from tightening to demand stimulus

For the third of the global economy that is the developing world, the risk to the outlook is a further loss of momentum for 2012. The expected slowdown is in large part the legacy now of past policies geared towards restraint and considering that central banks were still raising interest rates up until a few months ago, this could have some way to go. The slowing is also the result of rising inflation which has eroded real income growth and private spending. Brazil is a good example of where the combination has induced a rapid deceleration in growth. As the following chart (overleaf) shows, growth in India is decelerating too and for similar reasons. 

India's slowdown combined with the deteriorating trade and fiscal deficits are also part of what lies behind the capital flight that has been weakening the rupee. Interest rates are expected to come down sharply in 2012 and, indeed, unless they do, the economy will hit the buffers with yet more weakness in the rupee.     

When it comes to China, we are talking about an economy that has contributed the lion's share of global growth in recent years. When the numbers are finally in for 2011, global growth will likely have been a little less than 3 percent and of this, China will have contributed around 30 percent, at least.

Global trade will not only suffer from the eurozone's sovereign debt crisis in 2012 but also from a slowdown in China, as this will affect commodity demand, much of which is supplied by the emerging economies themselves. A hard landing would be seriously bad news for the global economy and with China's housing market under what has been 'policy-induced' pressure to cool it, a hard landing is clearly a risk. 

However, as the authorities micro manage as well as macro manage the Chinese economy we suspect they will ably steer it through the global slowdown. The recent reduction in reserve requirement ratios at commercial banks is an example of both that aims to alleviate the liquidity squeeze on small and medium sized companies.

China's economy is also not reliant on foreign inflows for its growth. Debt-to-income ratios for the public and private sectors are comparatively low. Both features augur in favour of a soft rather than hard landing.

Importantly, while the authorities recognize that the economy is unable to sustain rapid growth without forcing up inflation, they have scaled back their own aspirations for what can be achieved but their objective of balancing growth with inflation still means that a soft landing is the more likely outcome. The current 5-year plan sets out a target growth rate for GDP of 7.5 percent. This, at the very least, is what the economy can be expected to deliver in 2012.

As for how the loss of momentum in the developing economies will be affected by the eurozone's sovereign debt crisis, there are two considerations. Not only will the impact be felt through global trade but it is likely to register in terms of bank lending. On the former, emerging Europe, and notably the central European economies, will feel the immediate impact of recession in the eurozone. As for bank lending, a good example comes from the Spanish banks which are big lenders throughout Latin America. The risk is that lending activities are greatly curtailed.

Collectively, there is plenty of scope for policy makers in the developing world to stimulate demand. Brazil has been leading the way among the BRICS by cutting interest rates. China is beginning to relax monetary policy but by means other than reducing interest rates. Russia has just cut interest rates. In general, we are likely to see the central banks of the developing world bring down interest rates rapidly in 2012 and we expect the loss of momentum to be arrested in the final stages of the year.  

Europe under siege

Not so for Europe where recession, or something close to it, lies ahead. For Greece, Portugal and Ireland this will be nothing new. For Italy, Spain and possibly France, recession is the likely prospect for 2012. It will be border-line elsewhere in Europe as to whether recession in the 'technical' sense of two consecutive quarters of negative growth is avoided but this is academic. Europe faces a year of depressed economic activity.  

And this includes the UK, where little more than paltry growth, if that, can be expected. The consolation is that inflation is expected to decelerate sharply over the course of the year. The adverse influence of sterling's depreciation on inflation, the impact of higher energy prices, the increase in VAT at the start of 2011 and increases in utility prices all lie behind.

As the following chart indicates inflation is peaking. As the Bank of England sees it, the key downside risk to inflation stems from demand being 'insufficient to absorb the margin of spare capacity'. It is a view we share. Inflation is now expected to fall rapidly throughout the course of 2012, thus partially reversing what was the squeeze on real wage growth when inflation was rising. So much for the good news!   

The bad news, as the following chart shows, is that the numbers of full-time employees are turning downwards again while the unemployment rate is turning upwards. Not only is the Bank rate likely to stay put for 2012 but more quantitative easing is also likely to be on the way.

ECB action speaks louder than words

As for the eurozone, it was Fitch, the credit rating agency, that recently summed it up when it said, in announcing that a number of the eurozone economies including France and Italy were on watch for potential downgrades; '... a comprehensive solution to the eurozone crisis was technically and politically beyond reach'.

In the same breath, it was also critical of the European Central Bank (ECB). In referring to an absence of a credible financial backstop for the crisis it made the point that part of the backstop required a 'more active and explicit commitment from the ECB to mitigate the risk of self-fulfilling liquidity crisis …'

The ECB would be sure to dispute this and rightly so since the argument has more to do with its minimalist intervention in distressed bond markets via its Securities Market Programme (SMP). Although the ECB remains under pressure to use the SMP more aggressively as a backstop or firewall in limiting contagion, it is unlikely to give way on what it sees as the sole purpose for the vehicle, namely, for operating in the secondary markets where distressed debt puts at risk the channels through which monetary policy takes effect. Little else is intended, as suggested by its attempt to sterilize the liquidity provided through the SMP.

Yet, despite the conservative nature associated with its public profile, the ECB has been busy expanding its balance sheet as the following chart shows. To date this has been principally via the SMP. However, the ECB has introduced for the first time a three-year Long-Term Refinancing Operation (LTRO) intended to help banks with their funding requirements. These could include meeting redemptions on bonds or stemming the pressure to cut lending to the private sector in view of the need to boost capital requirements or sourcing funds for asset purchases, notably sovereign debt with substantial carry trade opportunities, or whatever.

Whether any of this will subdue the financial crisis as it relates to funding sovereign debt and the banks remains to be seen but the three-year LTRO initiative is welcome and we expect it to help. As an ECB Governing Council member put it, it represents a 'bridging loan' for banks. What matters though is how the eurozone leaders progress their 'fiscal compact'.

Resolving the fundamental issue of sovereign debt sustainability and with this eliminating its destabilising influence for the banks may not happen in 2012 but the 'reinforced Stability and Growth Pact' has now come into force for all of the European Union. The 'enforcement mechanism' that forms part of the Pact applies only to members of the eurozone, whose leaders signed up to it this past December. The issue now is implementation, which is where the risks lie for equity markets.

Volatility in 2012 - a case for less of it

To the question, is the volatility of 2011 likely to be repeated in 2012, there can be only guess work. The EU framework for fiscal governance with its rules for economic and fiscal surveillance will not lessen the risk of a sovereign default. For Europe, the reality is that the economics are repressive.

Not only is fiscal austerity inhibiting growth, thus making fiscal imbalances more difficult to correct, but so too is the stiffer regulatory regime of higher capital requirements for the banks. Despite the easy monetary policy, including now a weakening exchange rate, the combination is easily one that could be setting up the contractionary forces of deflation in Europe. That is reason enough to expect more volatility.

But this may also account for the bolder line the ECB is now taking with its refinancing operations. Against that potentially deflationary backdrop and the hundreds of billions of both sovereign and bank debt up for refinancing in 2012, a good part of which needs to be refinanced between now and April, a more cooperative ECB may provide less reason for equity markets to exhibit the kind of volatility in 2012 they exhibited in 2011.

Another three-year Long-Term Refinancing Operation is scheduled for the end of February. The ECB may be reluctant to engage in quantitative easing but it cannot be faulted for holding back on the provision of liquidity to the banking system. This bold and more accommodating behaviour could thus influence for the better the sentiment that drives the risk-on/risk-off trade.

Valuation favours equity markets 

Valuation could be another reason for expecting less volatility. Yields on gilts, bunds and US Treasuries are at levels neither we nor previous generations have seen. They are historically low for a reason but even so and allowing for the prospect of earnings downgrades, earnings yields on equities are discounting plenty of risk. As the following chart shows, bond-equity earnings yield ratios for the developed and developing markets are actually lower now than at their lows near the end of 2008. Relative valuations strongly favour equity markets.

Markets are quick to judge and unforgiving. Their verdict is likely to be that while eurozone leaders have made progress towards resolving the issue of sovereign debt sustainability, their business has been left unfinished. A recession will not help matters so the pressure in debt markets is likely to be sustained and the stress in funding markets for the banks not easily dissipated. But it need not worsen and, on the face of it, the policy effort on the part of the ECB and eurozone governments now seems directed to ensuring this and holding the euro together. We suspect it will survive another year, at least.     

FTSE 100 - modest gain for 2012 

Our initial glimpse into 2012 is one of caution and our expectation of how well the equity markets will do is limited. However, we are still hopeful that the FTSE 100, to take an example, will end the year at around 5850 or thereabouts. We expect equity markets to gain support from a more encouraging outlook for the US economy. Also, in view of the scope for conventional policy stimulus in the developing economies, we remain optimistic about the contribution they, and notably China, will make to the global economy in the latter part of the year and beyond.

And while the ECB may not wish to be seen in anything other than its conservative cloak, it is doing what it must and with a sense of commitment to ensuring financial stability. In contrast to the Fed, which believes that what matters is the message and not just what it does, the ECB believes that action is what counts. For the ECB action speaks louder than words and we think equity markets could take heart from this as the year progresses.

IMPORTANT NOTES
The information contained in this report represents an impartial assessment of the value or prospects of the subject matter. Graphs, performance data etc are as at the close of business on the day preceding the date of the note. The information contained in this report has been taken from sources disclosed in this presentation and is believed to be reliable and accurate but, without further investigation, cannot be warranted as to accuracy or completeness. The opinions expressed in this document are not the views held throughout Brewin Dolphin Ltd. No Director, representative or employee of Brewin Dolphin Ltd. accepts liability for any direct or consequential loss arising from the use of this document or its contents. We or a connected person may have positions in, or options on, the securities mentioned herein or may buy, sell or offer to make a purchase or sale of such securities from time to time. In addition, we reserve the right to act as principal or agent with regard to the sale or purchase of any security mentioned in this document. For further information, please refer to our conflicts policy, which is available on request or can be accessed via our website at www.brewindolphin.co.uk. The value of your investment or any income from it may fall and you may get back less than you invested. Past performance is not a guide to future performance. If you are in any doubt concerning the suitability of these investments for your portfolio you should seek the advice of a qualified investment adviser. Brewin Dolphin Ltd, a member of the London Stock Exchange, authorised and regulated by the Financial Services Authority. Registered office: 12 Smithfield Street London EC1A 9BD. Registered in England and Wales no 2135876.