Positive outlook for Markets in 2013, but risks in France

What will move markets this year? After a year of extraordinary policy intervention and stimulus, investors seem to have tired of rationally analysing prospects. It has paid to bet on the unexpected. Markets have proved resilient despite bad news; aggressive intervention has consistently trumped economic data. But if the stimulus draws to a close in the year ahead, this complacency could be challenged. The next surprises may not all be nice.

Politicians and central banks now have much less room for manoeuvre. Economic prospects are deteriorating across Europe, and austerity is becoming a harder sell to voters. Targets are being missed, and could be again within months. Eurozone gross domestic product will fall this year and as the year progresses, the prospect of German federal elections will start to constrain policy in Europe. It would be a bad time for Greece or Spain to look for any new concessions. The disappointing fact is that trillions in stimulus and record low interest rates have failed to spur much credit growth or pickup in economic activity.

Spain’s bond market – helped so far by the mere threat of bond purchases by the European Central Bank – may be challenged early in the new year. So far, markets have been far too impressed by rhetoric such as the promise by ECB President, Mario Draghi to do “whatever it takes”. Before long, investors might demand more clarity on this. Five years on from the financial crisis, the only natural buyers of peripheral bonds are captive domestic investors, and institutions such as the ECB and European Stability Mechanism.

The big surprise for the coming year could be an outright challenge on French credit. So close has the relationship with Germany been over the decades, that French economic policy has been little questioned. Investors have crowded into French bonds, for a slim yield pick-up over German debt that is assumed to be riskless. Investors who still fear Spanish bonds, are happily backing France. This ignores the recent signs of a chill between Merkel and Hollande. Emerging differences in the Franco-German alliance are not just about the right mix of austerity and growth policies, but the speed of European integration and whether to accommodate the UK.

Soon, hedge funds, tiring of the attacks on the periphery, could turn their focus to the assumed core of Europe. If French GDP disappoints early in the year, Europe could have a new crisis. Already, French productivity is losing ground against rapid improvement by Spain. And, Fitch Ratings has kept the pressure on French President François Hollande, warning that it will more likely than not take away the country’s triple-A rating next year. It might not be easy to reassure markets that France can be turned round.

Recent help for France and the euro has come from a surprising source. Some of the money betting against the euro has flooded into the Swiss franc, but ended up in French bonds. This is a consequence of effectively pegging the Swiss franc to the euro, but it does mean that some of the support for the euro and France is not soundly based. Many money market and bond funds also are underpinned by the same strategy of backing French credit, so desperate is the hunt for yield. Spreads could widen very quickly should the French economy drift into recession.

Despite Europe’s risks, the global economy will grow this year, with the US economy helping to drive it. The US is enjoying consumer confidence at a five-year high, and it has taken bad news in its stride. While the earnings season may have disappointed, there has been a more positive tone in recent economic data. The Federal Reserve has announced a new round of monetary stimulus, taking the unprecedented step of indicating interest rates would remain near zero until unemployment falls from the latest 7.7% to at least 6.5%.

Falling US energy costs should trigger further manufacturing resurgence, already evidenced in improving exports. And, the US housing sector should strengthen. Housing and construction represents one-sixth of the US economy, and equal to the total French GDP. As confidence grows, US corporates are likely to increase capital expenditure, which will be a key driver for many UK and European businesses. The market’s main fear – of fiscal drag – may be a topic for the first half of the year only. Indeed, a surprise for 2013 could be a much stronger US dollar, if the Fed is the first to drop out of further stimulus as employment hits its target, but Europe is compelled to print money.

However, a stronger US dollar would not be helpful for emerging market corporates that tend to view dollar borrowings as cheap money. IMF forecasts for emerging markets were revised down in 2012, with a sharp deceleration in economies like Brazil. Although emerging markets are typically growing, without any obvious credit bubbles, some negatives could lie ahead. A downturn in the commodity cycle is possible, with oil and base metal prices already weakening. Commodities could be impacted by slower demand from China for base metals, and a resurgence of geopolitical tensions. Many emerging markets also have over-valued currencies that do not recognise slower productivity growth. A hard landing for China is unlikely, but it may need to inject more stimulus.

Against this background, the US could look strong relative to other nations. And, even in the UK and continental Europe, there are some positives for equity investors.

Statements by the next UK Bank of England governor Mark Carney have indicated he will act much more aggressively to revive the UK economy when he takes charge next summer, including abandoning the BoE’s 2% inflation target if growth fails to pick up.

And the strongest companies are enjoying very cheap credit, and can use this to retire equity, restructure or acquire. And pressures on pension funds could see rebalancing back towards equities. Instead, the risks seem greater in the parts of the market that have been distorted by extremely loose monetary policies and by the search for yield. Despite the challenges in Europe, banks will be supported. Politicians need growth to get re-elected and the banking sector is key to that. Expect delays in bank recapitalisation, so that de-leveraging is manageable.

This year may not bring the day of reckoning for the eurozone, but US stimulus should end and in Europe further intervention should be more measured. Investors need to remember that they are buying companies, not economies. Many businesses have coped well with the challenges so far, and can make further progress in the coming year.

This article is for informational purposes only. The opinions in this article are the author’s own. The information presented in this article has been obtained from sources believed by the author to be reliable, however, he makes no representation as to their accuracy or completeness and accept no liability for loss arising from the use of the material. Colin McLean may have an investment in any of the companies mentioned in this article.

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