Recession in Europe and the UK now looks certain and, if it has not already started, will be upon us within weeks. Growth is still tepid even in the US, with housing weakening again and negative shocks from Europe likely over the coming months.
China and the emerging sector also look vulnerable to a sharp slowdown in exports and a massive contraction in credit availability as the European banking sector shrinks its balance sheet. They still have the luxury of policy tools that could turn things around in 2012 but the trajectory is likely to be significantly lower in the short term.
The reduction in the Chinese reserve requirements is helpful in that the Chinese authorities recognise inflationary pressures are abating.
The announcement of greater co-operation on both sides of the Atlantic with regards to bank lending is similarly helpful because we have seen increasing strains in the European bank sector in the last month in how it funds itself, especially in relation to its US dollar liabilities.
To what extent these latest measures allow banks to make new loans and promote economic recovery remains to be seen but they should help avoid some of the worstcase scenarios.
The situation in Europe remains uncertain, with countries unable to climb out of recession because of the fiscal straightjacket being applied to peripheral governments. The expansion of the public balance sheet that often happens in response to a recession, along with fiscal relaxation, tax cuts and government spending to encourage growth, will not be allowed to happen. This will make the political situation even more volatile and Barings believes new governments in Italy and Greece will have about six months to get their reforms through before the general public realises just how painful their probable fall in living standards will be.
There seems little understanding on the part of the establishment that secondary market prices for government debt are the starting point for the private sector cost of credit. Banks can be kept alive on unlimited supplies of cheap liquidity from central banks but if the cost of funds is too high, their businesses are effectively in run-off.
Looking at the recent sell-off in non-German core government bond markets, real money, long-term investors, especially those overseas, seem to be losing confidence in the euro and until Europe sorts itself out, only German paper will be acceptable.
On a positive note, in October, equities rebounded from their September lows. The US and UK look cheap, according to Barings’ dividend discount model, even factoring in a recession, and we have upgraded the UK from neutral to overweight as a result. We also see opportunities in technology stocks, where there are a number of large-cap, cash-rich companies that should be able to ride out the storm. However, financials have been downgraded once again to underweight.
We have downgraded the euro to a strong under-weight and cannot understand why it remains so resilient given the systemic threat. We are marginally less negative on the yen but see emerging European currencies as vulnerable.
Next year could be a great buying opportunity for risk assets – or earlier if Germany relents on European Central Bank bond buying – but for now we want to keep our portfolio risk down to minimal levels.
Percival Stanion is head of asset allocation at Barings