The following is an excerpt from the global monthly market commentary by the Global Investment Committee at Morgan Stanley Smith Barney for September.
For the last several months, the markets have been behaving as though the global economy were about to slip into a double-dip recession. That has never been our belief, and indeed, recent economic data point to the upside. In the US, shoppers responded to back-to-school discounts and tax holidays, which led to increased retail sales in July and August. In the US and China, the world's two biggest economies, the manufacturing Purchasing Managers Indexes (PMI) unexpectedly rose in August after falling three months in a row. To underscore that point, the National Bureau of Economic Research announced on Sept. 20 that the Great Recession, an 18-month slump that was the longest and deepest since the Great Depression, ended in June 2009. What's more, job growth continues throughout most of Asia, Europe and Latin America. In the US, private sector jobs have now grown eight months in a row. In addition, world trade has reached an all-time high.
POLICY MATTERS. Still, it's too soon to sound the all-clear signal, especially in the developed economies. Locally, more than a year into its recovery, US unemployment remains high and credit spreads are still wide enough to signal some stress in financial conditions. All of this is factored into a model developed by Robert Barbera of Mount Lucas Management Corporation, who is a consultant to the Global Investment Committee. The model arrives at a recommended federal funds rate for achieving economic growth consistent with an acceptable unemployment level alongside benign inflation. The model combines the work of Hyman Minsky, who focused on credit conditions, with that of John Taylor, who developed a formula for balancing the Federal Reserve's goals of sustainable economic growth with tame inflation based on how far away each goal is from its target. The bottom line: Barbera's model calls for a negative federal funds rate to achieve policy objectives. Since nominal interest rates cannot be negative, extraordinary policies such as Quantitative Ease (QE) are needed to allow the recovery to become an expansion. Accordingly, we see no exit from QE until the Fed is comfortable that the economy is on firm footing.
Fortunately, not only in the US but also globally, monetary, fiscal and trade policies are is broadly supportive of economic expansion. For example in Japan, the world's third-largest economy, the Bank of Japan (BOJ) intervened in the foreign exchange market on Sept. 15 after the yen surged to a 15-year high against the US dollar. With data showing Japan's recovery losing momentum, policymakers intervened to avoid a slowdown in exports. The intervention was conducted in a manner that allowed the funds to remain in the banking system, effectively instituting massive QE and thereby improving the outlook for Japanese GDP growth.
Global central bank policy remains supportive of growth. A good way to gauge that is by the real policy interest rate, or the nominal yield less the inflation rate, weighted by the size of each major economy. The weighted policy interest corresponding rate is now below the rate of inflation, a condition known as a negative real interest rate (see Chart 2). To us, negative real policy rates are the magic ingredient in any effective central bank policy initiative: negative real yields always revive economic growth by creating an incentive for households to invest in assets other than cash and/or to spend money rather than allow purchasing power to erode. Similarly, negative real yields prompt firms to seek out better returns by expanding their business through capital spending and hiring, mergers and acquisitions or by returning excess cash to shareholders through share buybacks or dividends.
Locally, recent Fed action has spurred mortgage refinancing activity to its highest level since May 2009. Lower borrowing rates reduce the share of household income necessary to service debt and lease payments, leaving more disposable income for savings, investment or other expenditures. The US debt service and financial obligation ratios to disposable income have returned to levels that were common prior to the excesses of the last business cycle, indicating that household balance-sheet repair is far along. Despite the widespread concern that a deleveraging consumer would cut back on spending, nominal US consumer spending is higher now than before the Great Recession.
Also due in part to the Fed's efforts, the US Treasury long bond yield is less than 4%; the real yield, which takes inflation into account, is less than 3%. Since 1950, such low numbers have historically resulted in returns in the following year on risk assets such as equities that are more than twice those of government bonds and more than four times those of cash for the same time period.
US-CHINA TIES. Perhaps the most important relationship of the current business cycle is that between the US and China. The bilateral relationship moved in a positive direction in June when China relaxed its currency peg to the US dollar; the Chinese renminbi has risen only 1% since. At the margin, this revaluation and any others going forward will make it easier for China to work toward its long-term goal of rebalancing its economy in the direction of more domestic demand and away from exports, in our view. In turn, that makes for more balanced global growth.
HOW MANY JOBS? One place to look for evidence that the US economy is recovering is in jobs data, for which there are two primary measures. The US Labor Department's Household Survey questions labor market participants directly, while its Establishment Survey covers new hires of existing businesses and includes an estimate of the jobs created by new firms, which tends to lag at turning points in the cycle. Consequently, the degree to which new businesses hire is generally better reflected in the Household Survey early in a recovery. Year to date through August, the Household Survey estimates new job creation at 1.5 million, while the Establishment Survey counts only 723,000.
MODEST GROWTH. Morgan Stanley and Citi economists continue to forecast modest but sustained global growth for 2010 and 2011, in the 3%-to-4.5% range. They forecast that the emerging market economies will grow at about 6%, with developed economies' growth at 2%. Put differently, emerging economies will account for two-thirds of the global GDP expansion this year. This economic activity should be conducive to continued corporate profits growth. Morgan Stanley and Citi strategists, as well as the analyst community, are looking for profit growth to exceed 30% in 2010, followed by more normalized profit growth in 2011.
ATTRACTIVE VALUATION. US and global equities are trading at forward price/earnings multiples near 12, at the low end of their range during the past 20 years. What's more, global dividend yields are attractive relative to the low yields in cash and sovereign debt. Likewise, corporate bonds offer above-average spreads over sovereign debt and should see more credit ratings being upgraded than downgraded as the profits recovery continues.
MIDTERMS, TAXES AND DEFICITS. We believe that Republicans will gain a majority in the House of Representatives in the November midterm elections but the Senate will maintain its Democratic majority—albeit a smaller one. Considerable uncertainty should diminish once the election results are known. Since 1950, the 12-month period starting just prior to US midterm elections has been especially friendly for equities, with the S&P 500 Index rising an average of 27% in the year starting on Sept. 30, just prior to the midterm elections. The last 15 instances all produced positive returns (see Chart 4). Of course, past performance is no guarantee of future results.
An important issue facing investors is the fate of the Bush-era tax cuts, set to expire on Jan. 1, 2011. We believe that Congress will likely address this issue after the Nov. 2 elections. In that eventuality, the odds would favor an extension of the tax cuts, including the two top marginal federal income tax rates. Dividend and capital gains tax rates will likely rise to 20% or higher but stay well below the 39.6% rate that would prevail if no tax bill passes. While we maintain this outlook, tax policy uncertainty will likely hang over the markets until December.
FAVORING RISK ASSETS. As the global recovery matures, we have been continuously assessing whether to reduce our risk exposure. Our current analysis suggests that risk assets—equities, corporate and emerging market bonds, REITs and commodities—remain attractive relative to safe-haven assets such as cash, sovereign debt and inflation-linked securities. As a result, our asset allocation models remain positioned for a global expansion by overweighting global equities and alternative/absolute return investments while underweighting government bonds and cash.
Within global equities, our models are tactically overweight to emerging markets. The rationale for this positioning is that emerging markets have robust growth characteristics with the potential for currency appreciation. We are also overweight commodity-sensitive regional equity markets, specifically Canada and Asia Pacific ex Japan; the former has more exposure to energy, while the latter, which includes Australia, has more exposure to mining and raw materials. We remain underweight to developed-market large-cap equities in the US, Europe and Japan. Within the US, we favor growth stocks over value stocks.
TILTING TOWARD CREDIT. Within global fixed income, our portfolios favor high-grade and high yield corporate debt, which continue to offer attractive yields relative to developed-market government debt. US investors who can benefit from tax-free income may consider municipal bonds in lieu of corporate bonds. Our portfolios also favor the higher yields and strong credit fundamentals provided by emerging market debt. Given the steep yield curve, a situation whereby longer-maturity debt offers significantly higher yields than shorter maturities, we remain underweight in short-duration instruments and cash.
A recovering global economy, led by economic growth in the developing countries, should spur demand for commodities. An upturn in economic fundamentals should also improve the supply/demand balance for commercial real estate. As a result, our portfolios have tactical overweight positions in two liquid alternative/absolute return investments: commodities and REITs. Given the considerable amount of slack in developed economies, we expect inflation to remain subdued. Thus, we maintain a tactical underweight position in inflation-linked securities.
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