The global economy in H1'2012

A recession in Southern Europe, sluggish growth in the U.K. and much of Northern Europe, near-trend growth in the U.S. and sustained but slower growth in China and other emerging market countries characterized the global economy in H1’2012. During the period, the lagged impact of last year’s monetary tightening in the E.U. -- and in many emerging countries -- and the direct (and indirect) effects of the continuing financial crisis in Southern Europe remained the key constraints to economic growth. In spite of these constraints, economic activity in 2012 started off stronger than I expected with global GDP expanding 2.9% Y-o-Y in Q1’2012[1] -- 10bps higher than Q4’2011 -- as economic data in the U.S. and Asia remained above trend in early Q1’2012, and the European debt crisis appeared reasonably well contained.

With the strength in global economic data, particularly in the U.S. labor market in Q1’2012, global equity markets enjoyed their best rally in several years. In Q1’2012 the Dow Jones Industrial Average gained 8.8%, the S&P 500 Index rose 12.6% and the Nasdaq Composite jumped an impressive 19.0%. The results outside of the U.S. told a similar story, although the magnitude of gains trailed slightly. The MSCI World ex-US Index rose 10.4%, with the DAX up 17.8%, the FTSE up 4.8%, the Nikkei 225 Index up 20.3% and Shanghai Composite advancing 4.7%. Emerging markets as a whole were a bright spot, with the MSCI Emerging Markets Index up 14.1%.

Despite a strong start to 2012, U.S. economic activity took a turn for the worse; with inventories -- which had contributed an outsized 1.8% to Q4’2011 GDP – dropping to a far more sustainable pace of 0.6% compared to 2.2% of GDP growth in the same period in Q1’2012. Also, the strength in consumer spending, which increased by 2.9% in Q1’2012, was offset by tepid core business expenditures which advanced 1.7% and government spending which contracted by 3% -- led by a drop in defense spending. The U.S. manufacturing sector remained a bright spot for economic activity in H1’2012 as the Institute of Supply Management (ISM) Manufacturing Index remained stable and firmly above the expansion/contraction demarcation level of 50%. Additionally, consumption – which represents ~70% of U.S. GDP -- continued to rebound during the period, led by improving automotive sales. Interestingly, U.S. personal consumption expenditures exceeded the growth in personal income during H1’2012, resulting in a drop in the savings rate by 50 bps Y-o-Y to 3.7%. On the other hand, U.S unemployment remained stubbornly high, with the decline to the current level of 8.2%, resulting from a drop in labor participation rate -- as discouraged workers exited the work force.

In Europe, the sovereign debt crisis remained at the forefront of the economic deceleration. In H1’2012, E.U. policymakers came under significant pressure to allay global doubts about the solvency of several Southern European states and their banking systems. This pressure was couponed by the incessant sovereign ratings downgrades across the E.U. which limited member state’s ability to put in place sufficient financial firewalls to moderate the impact of a possible crisis – given the E.U.’s weakening fundamental outlook and a possible Greek exit from the E.U.  In the midst of the deteriorating economic spiral, the European Central Bank (ECB) intervened with a EUR1.01 trillion lending program to European banks in late Q1’2012. The primary goal of this program was to spur on-lending to increasingly constrained Southern European governments. While the ECB’s quantitative easing bode well for financial markets, it did little to stem the fiscal avalanche and even less to promote economic growth in the region. In H1’2012, most European countries remained mired in recession and yet still faced significant fiscal austerity programs.

In Asia, Chinese and Japanese growth held up; with fiscal stimulus and reconstruction efforts combining to support growth in China and Japan respectively, while export demand from Europe waned.  In China, policy makers crafted definitive policy measures to ensure a soft landing – and they succeeded. In H1’2012, the Chinese GDP growth remained at a brisk pace, in spite of a pull back in the manufacturing and exports, and the continued correction in its domestic residential property sector. Overall, China’s real GDP surged 8.1% Y-o-Y in Q1’2012 while inflation remained persistently high around 6.31% in H1’2012 -- compared to 5.6% in the same period last year. In spite of the inflationary pressures, the People’s Bank of China (PBoC) cut its minimum reserve ratio for the first time since 2010.

In Japan, the economy rebounded strongly in Q1’2012, growing 2.7% Y-o-Y, albeit from a low base of -0.2% in Q1’2011 -- when the March 2011 earthquake and tsunami occurred. In H1’2012, private consumption -- which makes up about 60% of economic activity -- rose 1.1%, helped by government subsidies on sales of fuel-efficient cars, even as public investment to cover the post-tsunami rebuilding effort added 0.3% to the expansion. A fall in the yen in H1’2012 compared with Q4’2011 and a mild pick-up in overseas demand late in the period saw exports rise 0.1% to end the period.

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[1] IMF

Outlook for H2’2012 (Developed Markets)

U.S.: Remains likely to outperform

The U.S. economic recovery lost momentum in H1’2012, however with moderate employment gains in recent months and a pick-up in the pace of consumer spending; I expect real GDP growth to increase to trend thorough H2’2012, in spite of the events in the E.U. -- I remain of the view that the transmission mechanism of the European crisis to the U.S. economy are relatively limited. My view on the U.S. economy is further anchored on improving confidence in both businesses and households across the U.S., as well as slower deleveraging, which should allow the saving rates to ease. Housing demand has increased noticeably in 2012, but the overhang of unsold homes and the tide of foreclosures have scuttled a speedy revival in residential investment.

I expect the medley of the aforementioned factors to spur growth in H2’2012, driven by private-sector demand rather than by policy. In fact, I see fiscal consolidation in the U.S. as a possible drag on growth with the risk of excessive fiscal tightening in 2013 still to be addressed. Moreover, long-term fiscal sustainability in the U.S. remains to be achieved, and a credible fiscal plan is needed to ensure it.  Given the still fragile recovery, monetary policy should remain accommodative, but conditional upon other developments. Given the foregoing, I do not expect a moderation in fiscal policy to significantly offset the gains in private sector activity in H2’2012. Furthermore, I have adopted a cautiously optimistic, view of the U.S. equity markets in H2’2012, while being mindful of the risks.

Europe: Outlook remains negative

Activity in the E.U. stagnated in Q2’2012 after contracting at the end of 2011 and Q1’2012. Unemployment has risen consistently through H1’2012 and is set to rise further in H2’2012, owing to weak confidence and difficult financial conditions related to the sovereign debt crisis. Provided that policy actions are sufficient to improve confidence, activity should begin to recover gradually in the H2’2012, notwithstanding fiscal consolidation and private sector deleveraging across the region. However, I am not optimistic that this view will materialize. Rather, I anticipate that E.U. policymakers will muddle through H2’2012 with a series of half measures (the result of a sustained failure to reach consensus) that will prove inadequate to thoroughly resolve the region’s problem. Accordingly, I expect a divergence between moderate growth in creditor countries (particularly Germany and France) and, weaker/delayed recovery in countries with large debt overhang, even as the large margins of spare capacity across the region moderate inflationary pressures. The main risks to this outlook for the region in H2’2012 centre’s on a possible intensification of the debt crisis and the economic effects of high public and private indebtedness. Though recent decisions have significantly increased the capacity of Europe’s firewall to address government funding problems, I remain of the view that it remains insufficient and fraught with regulatory handicaps. With these constraint in view, I expect monetary conditions to ease further in H2’2012 – possibly in the form of a 25 bps cut to the ECB’s prime rate. With the scope for monetary and fiscal stimulus limited, reforms to labor market institutions, product market regulations and the tax system needed to sustain growth and boost jobs, I retain the view that European financial markets are likely to underperform their developed market pairs. 

Global Outlook and Investment Strategy

Global Markets - 2011 Review

Mixed economic data and policy induced uncertainty were major themes in the global economy in 2011. However, the aftermath of the global financial crisis remained the overall determinant of sentiment, as European policy makers struggled to allay doubts about the solvency of several EU states. Of note, the weaker fundamental outlook for the economic zone prompted a loss of investor confidence in Italy and Spain, turning the spotlight on vulnerability in the region’s banking sector.

Across the Atlantic, an unprecedented U.S. sovereign credit rating downgrade following an extended congressional debate on lifting the country’s debt ceiling further magnified uncertainties. Nevertheless, bearish signals from stagnating economies of other developed countries caused investors to seek safety in US treasuries and led to a broad sell-off in risk assets, particularly in Q3’2011. The MSCI All Country World Index fell 16.8% in Q3’2011 alone (its worst quarterly performance since Q4’2009). Also, in 2011, capital flight from emerging and frontier market assets was particularly severe, prompting some governments to intervene in their respective currency markets.

Outlook and Strategy

As I head into 2012, the global caution that prevailed at the end of 2011 is likely to continue -- and for good reasons. In 2012, as Greece continues to totter on the brink of default and the fate of the Eurozone -- and the Euro -- remain unclear, Europe is likely to drift back into recession. Also, as elections loom in the U.S, and China engineers a soft landing, I see 2012 unfolding with a myriad of adjustment risks which need to be surmounted. Accordingly, I also expect 2012 to be another eventful and challenging year for many financial markets, as the political and economic problems of 2011 persist.

In my view, the best opportunities globally are in high quality dividend-paying equities that have global exposure. There is also a stronger case for increased U.S. exposure based on growing signs of an incipient recovery. I also continue to favor strong business franchises in classically defensive sectors such as healthcare, telecoms and non-cyclical consumer areas such as food producers. With commodities and energy, there are strong supply-driven reasons to have exposure to these areas. I expect that, as long as central banks’ accommodative postures persist, gold will continue to provide a hedge against monetary debasement. Finally, in the fixed income space, based on the potential for monetary easing , following a tighter 2011, I continue to favor emerging and frontier market sovereign debt.

A bet on the Naira!

Naira’s strong start to 2012

A turbulent H2’2011 saw the Central Bank of Nigeria (CBN) falter in this efforts to maintain the Naira/US dollar (NGN/USD) exchange rate band (-/+3% of N150/USD) at its Wholesale Dutch Auction System (WDAS), and the adoption of a revised target exchange rate band of -/+3% of N155/USD. However, as I expected, the Naira has begun 2012 on a strong note. At yesterday’s WDAS auction, the Naira appreciated 0.10% to N156.85/USD, as the CBN once again sold US$250 million. While total demand at yesterday’s WDAS was not disclosed, the exchange rate move left the Naira within the N156/USD – N158/USD trading band which the CBN appears to have adopted, after its November, 21st 2011 decision to devalue the Naira.

On the interbank market the Naira closed at N160.05/USD yesterday (a 3-week high against the US dollar), after touching a 2012 high of N159.80/USD during intraday trading. On the parallel market, the Naira also strengthened to N164/USD as traders appeared to benefit from the increased US dollar liquidity from interbank sales of US$100 million, US$66 million and US$10 million, by Royal Dutch Shell, Total and Addax respectively.

Whats up?

In previous a commentary, I highlighted the growing importance of imports and direct remittances (a proxy for non-trade related demand composed largely of financial instrument transfers by non-Nigerian individuals and corporations to their home countries) in shaping the level of “fundamental” demand at the WDAS -- and by extension of the direction of the Naira. To this end, while the CBN has remained tight lipped about the levels of demand at the WDAS thus far in 2012, data from the National Bureau of Statistics (NBS) indicates that imports declined 13.3% YoY by October 2011 (in what appears to be a continuing trend from the previous two quarters). Furthermore, data from the CBN shows that direct remittances as a percentage of WDAS sales declined 50.34% in Q4’2011. With regard to this point,   I do not rule out the role of monetary policy initiatives taken in October and November 2011 to support the Naira/US dollar exchange rate in shifting the direction of currency flows. However, given the tighter regulatory environment, anecdotal evidence in the form of average WDAS/interbank exchange rate differentials, suggests that a positive shift in market dynamics and expectations may have occurred. In all, market participants have remained largely in tune with the CBN’s “apparent” policy trading band of N156/USD – N158/USD thus far in 2012 as is evident from the fact that the average WDAS/interbank exchange rate differential has declined 31 kobo from N4.33 to N4.03 thus far in 2012.

Optimism!!!

On balance, I remain cautious in forming an outlook for the Naira/US dollar exchange rate in 2012, given the multitude of factors and evolving uncertainties that are shaping its direction. While my prognosis for the Naira in 2012 is largely positive, I expect the Naira’s direction to ultimately be determined by the level of external reserves and market expectation.  On the latter point, market data suggests that expectations for sharp Naira declines in 2012 have become more subdued, although I suspect that the recent reversal of the government’s decision to completely eliminate subsidies on petroleum product – as well as moves being considered by the Senate to revise the benchmark price for Bonny Light crude in the 2012 budget could weigh negatively on those expectations.  On the former point, data from the CBN shows that Nigeria’s external reserves are currently at US$33.96 billion (the highest level since October 19th 2011), as the combination of moderating demand and improving accruals have combined to strengthen reserves. On this point also the aforementioned risks are relevant.

Given my expectations that fuel subsidies are likely to require ~N790 billion in additional spending in 2012 (44.4% of the N1.78 trillion used in 2011), I have tempered the impact of these risk on my expectations for the Naira –- assuming that crude oil prices remain stable and no major disruptions to supply occur in H1’2011. Furthermore, I have incorporate the possibility of a positive surprise like proceeds from the disposal of PHCN assets, which was not included in the 2012 revenue forecast in the 2012-2015 Medium Term Fiscal Framework in coming to a largely more positive view of the naira in 2012.