Champagne moment? Capital Economics' key forecasts
A little more upbeat
Capital Economics' senior analyst John Higgins has reviewed his key market forecasts. While he still expect government bond yields in the major developed economies to remain very low during our forecast window, he has become a little more upbeat about the prospects for equities. He also no longer expects the euro to fall so far this year.
For Higgins four key developments have helped to push the prices of most risky assets higher in recent months. First, the Fed launched and expanded a third round of quantitative easing. Second, the full effects of the fiscal cliff in the US have been avoided. Third, there have been tentative signs of recovery in the global economy. And fourth, concerns about the future of the euro-zone have eased further.
Higgins takes us a on a journey across developed markets as he outlines his key calls.
Accommodative monetary policy
'We think the accommodative stance of monetary policy in the US (and elsewhere in the developed economies) will exert further upward pressure on the prices of risky assets over the next couple of years. After all, the Fed has suggested that it will only take away the punchbowl once the US unemployment rate falls to (or below) 6.5%, which might not be before mid-2015.
US debt crisis
By contrast, fiscal policy in the US is likely to have the opposite effect. A battle in Congress over the size of spending cuts and extending the debt ceiling should dull investors’ appetite for risk, especially if other rating agencies join S&P in stripping the US of its AAA credit rating or S&P itself lowers further its rating – which was cut to AA+ in August 2011.
Investors may even start to worry about the government defaulting on its debt, although such an outcome is extremely unlikely. Sentiment is likely to be most affected in the first half of this year. But since a divided Congress may only come up with a half-baked solution to the problem, the crisis may rumble on and on until a new President is eventually in office.
When it comes to the prospects for the global economy, we think it is too early to crack open the champagne. That being said, the outlook is probably neither sufficiently bad to trigger a large increase in investors’ aversion to risk, nor sufficiently good to jeopardise continued loose monetary policy.
Admittedly, much of Europe, and Japan, is likely to remain in or close to recession. But the fundamentals in the US look better than they have in a long time, and growth in China has picked up. The fall in the price of Brent crude that we forecast (to $90 by the end of 2014) would also underpin growth.
Eurozone flare up
We do not think the ECB’s pledge to do “whatever it takes” to solve the crisis in the region has significantly reduced the likelihood of monetary union fragmenting during our forecast window.
But the average investor does appear to have formed this opinion. According to the betting exchange, Intrade, the probability that any country will abandon the euro by the end of 2014 has more than halved in the past two months, and is now only around one in four. Nonetheless, we still think the crisis in the eurozone is likely to flare up again at some point.
Even if the ECB puts its money where its mouth is, the central bank can only continue to address a symptom of the crisis in troubled countries – higher bond yields – not one of its main causes – a growth-sapping lack of competitiveness.
Admittedly, competitiveness has been partially restored in recent years. But this has occurred through painful “internal” devaluation, involving a sharp reduction in wages. This has compounded economic weakness in the short run and angered voters.
If it continues – and we expect eurozone GDP to shrink by 2% this year – some countries may decide to throw in the towel and seek further adjustment outside the euro-zone, especially if the euro itself rises further in the near term. Meanwhile, there is evidence that the ongoing weakness in the economies of troubled countries is now affecting their stronger neighbours, such as Germany. As the economies of these strong countries come under pressure, they may be less willing to pay a high price to bind monetary union together.
It is impossible to pinpoint the precise trigger for a re-escalation of the crisis, although there are several obvious candidates. These include renewed concerns about the health of Spain’s public finances and regional politics, general elections in Italy next month and in Germany in September, and a potential unravelling of Greece’s bail-out.
We now assume in our market forecasts that the flare up will occur in the second half of this year, although it could easily take place at any time.
Our central expectation is that policymakers would pull out all the stops to prevent a full-blown break-up of monetary union that involved the departure of large countries like Spain and Italy. But we still think it is more likely than not that at least one small country will leave within the next couple of years.
So how do these views feed into our market forecasts? As far as currencies are concerned, we now expect the euro to climb further against the dollar (to $1.40) in the first half of 2013 as tension in the euro-zone continues to ease, the Fed expands its balance sheet further, and political brinkmanship in the US increases.
But we expect the euro to fall in the second half (to $1.25) as the euro-zone crisis intensifies, the region’s economy shrinks, and Congress kicks the US fiscal can down the road. Next year, we forecast a renewed rally in the euro (to $1.35) as the darkest clouds over Europe begin to clear.
Cable may get caught in the crossfire as usual – we now forecast that the dollar/sterling exchange rate will end 2013 and 2014 at 1.55 and 1.60, respectively. Otherwise, the fortunes of the yen should continue to be closely tied to investors’ appetite for risk – and the situation in Europe in particular.
We forecast the exchange rate against the dollar to climb to a peak of 95 in the first half of the year before falling back to 80 by the end of 2013. We have pencilled in a renewed fall in the yen for 2014.
An increase in appetite for risk alongside concerns over the spat in Congress could act as a drag on the prices of government bonds in the first half of this year – our end-Q2 forecast for the 10-year US Treasury yield is 2%. But bonds should continue to benefit from accommodative monetary policy. And as the crisis in the euro-zone worsens, the demand for safe havens should strengthen.
Our end-2013 yield forecast is 1.5%. Next year, we expect the yield to climb a little again – but only to 2%. Elsewhere, monetary policy should also keep yields firmly anchored at low levels. In addition, we now anticipate less upward pressure on the yield of 10-year German Bunds to result from the potential pooling of eurozone credit risk and/or capital flight out of the euro-zone during a re-escalation of the region’s crisis.
Stretched US equity values
We think the outlook for equities is mixed. In the US, further Fed-fuelled gains in stock prices in H1 2013 should be constrained by sabre-rattling in Congress. Although investors’ worst fears over US fiscal policy may have eased by the time H2 rolls around, they may simply be replaced by fresh concerns about growing tensions in Europe.
The valuation of the US stock market is also now quite stretched from a historical perspective and margins are stretched. The upshot is that we expect the S&P 500 to trend sideways in 2013, ending the year at 1,500. We forecast a rise to 1,600 in 2014.
European equity outperforms while Japan underwhelms
Our expectation is that equities in the euro-zone will continue to rally in the first half of this year, as the region’s crisis continues to abate. But we expect renewed underperformance in the second half of 2013 as tensions resurface.
Finally, the relative performance of Japan’s stock market should continue to be influenced heavily by changes in the value of the yen. We expect the Nikkei 225 to underperform the S&P 500 in 2013, but outperform significantly in 2014.