While global market uncertainty has picked up in recent weeks, Fidelity’s Dominic Rossi believes we remain in an equity-friendly environment. He argues that it is significant that the recent falls in equity markets were not accompanied by elevated volatility.
I have been saying for some time that we need to see a low volatility environment as a precondition for a rerating of equities. In 2008, volatility spiked into the 30-to-40-per-cent range; in the most recent bout of uncertainty, it peaked briefly above 20 per cent before falling back relatively quickly.
I think the reason that equity volatility is so well anchored is because there is more certainty now about the outlook for the US economy than in previous years. The fiscal cliff has been a significant headwind that has dragged down US GDP growth by about 1 per cent. However, private sector growth has been strong, which has allowed the US economy to grow at a reasonably healthy level of around 2 per cent.
Indeed, the US economy is as healthy as I have seen it in the last 20 years thanks to the structural improvements we are seeing in the twin deficits. In 2009, the US fiscal deficit was 10 per cent of GDP, or about US$1.5 trillion. The Congressional Budget Office estimates it will be around US$640 billion or 4 per cent of GDP this fiscal year.
This is not only as a result of the ‘sequester’ and spending cuts but also because rising corporate profits and tax increases are boosting federal receipts. By 2015, the fiscal deficit is forecast to be 3 per cent of GDP, which is comparable to trend GDP growth and allows the US to reach a level of debt stabilisation.
At the same time, there has also been considerable improvement in the trade balance. For the first time in 30 years, the trade position has improved during a time of economic growth and the reason for that is structural – shale energy. The commercial exploitation of shale hydrocarbon fields has seen US imports of oil equivalent fall from 12 million barrels per day to 8 million basis points and further declines can be expected.
The improvements in the twin deficits have helped to stabilise the dollar, which is one of the reasons commodity prices have been under pressure. The combination of an improving growth outlook against a benign inflationary backdrop gives the Federal Reserve the scope to gradually unwind its quantitative easing program.
While inflation has been a great fear, it is a dog that has not yet bitten. As the pressures of fiscal drag peter out towards the end of the year, we have the prospect of the US economy growing at 3 per cent in a low inflation environment, which means the Fed can afford to taper quantitative easing gradually. This is a broadly supportive environment for global equity markets.
Japan and Europe need more time
The situation in Japan is quite different. The equity market is effectively policy driven. The first two arrows in prime minister Abe’s radical economic program – fiscal spending and monetary stimulus – should lead to increases in GDP growth in the next 12 months. Even GDP growth of 4 per cent would not be a surprise.
Against this backdrop there is room for Japanese equities to move higher but whether this rally will turn into a multi-year bull market is another matter. The answer will depend on Abe’s success in tackling his third arrow of structural reform – the most challenging of the three.
Japan’s long-term real growth rate will not increase unless the workforce is expanded or productivity is improved. There are two possible routes to increasing the workforce; firstly by increasing female participation rates and secondly by allowing greater levels of immigration, however, the latter of these options is less likely.
While we have seen some recent signs of recovery in Europe, this should be viewed as a statistical event coming off extremely low levels of growth. There is effectively no inventory in Europe, so any slight shift in demand is likely to have an immediate impact on industrial production and growth. Although there has been some sign of this in Germany, a modest cyclical improvement should not be confused with structural recovery, as the pre-conditions are not yet in place for the latter to occur.
There is still the risk that Europe faces a deflationary future given government policies on austerity. Monetary policy remains stubborn – in fact, the ECB is the only major central bank in the world, which has refused to expand its balance sheet to support recovery. The Achilles’ heel for Europe’s equity market remains an under-capitalised banking system exposed to peripheral sovereign debt risk.
Dominic Rossi is global chief investment officer for equities at Fidelity Worldwide Investment.
