After a strong 2012, global equity markets continued to rally in the first quarter of 2013. The MSCI World Index rose 7.7% during the quarter, with developed markets generally outperforming emerging markets. As we look forward to the rest of 2013, several forces are likely to favor some sectors and regions over others.
Fundamental changes in the United States and Japan appear promising in the near to medium term, while the European economy will continue to face challenges. Emerging economies, particularly those in Asia, should continue to grow faster than the developed world, although Central and Eastern Europe will be held back by sluggish conditions in the eurozone. Against this complicated and uneven macroeconomic background, we are finding many instances of sustainable earnings acceleration at the company-specific level, an environment that favors American Century Investments’ investment approach.
Actions by the European Central Bank (ECB) in the past 18 months, while not solving the deep, underlying problems of the eurozone, have significantly reduced the risks of systemic failure. Two initiatives are helping to contain the crisis. LTROs, or long-term refinancing operations, are loans by the ECB at very low interest rates to those eurozone banks that can offer sovereign bonds as collateral. This program has provided liquidity to banks and increased bank demand for sovereign bonds, thus helping to restrain sovereign bond yields. OMT, or outright monetary transactions, allow the ECB to buy sovereign bonds in the secondary market when countries requesting such assistance agree to certain domestic conditions. The combined effect of these programs has been to reduce fear and to buy governments time to fix their budgets and spur their economies.
Across the Atlantic, the United States’ private sector withstood the headwinds of restored payroll taxes, increased tax rates for the wealthy, and the initial impact of sequestration. Spending by U.S. consumers and businesses increased. The U.S. unemployment rate fell to 7.6%. Across the Pacific, a change of policy direction in Japan boosted confidence and led to a strong rally in Japanese equity markets. Further to the east, China appears to be growing at a real rate of about 8%, even as the new government attempts to control various excesses in its housing and financial markets. Geopolitical risks, from Iran’s nuclear program to rebellion in Syria to saber rattling by North Korea to disputes over islands in the East China Sea, made headlines but were not disruptive to financial markets.
As we look forward to the rest of this year, we believe three regions—the United States, Japan, and emerging markets—seem to hold special promise, while the eurozone may continue to struggle.
Despite higher taxes and initial steps toward austerity at the federal level, a number of powerful trends portend well for the United States economy this year. First, we see a continuing strong recovery in the U.S. housing market, both in terms of house prices and housing starts. A difficult economy during the past recession thwarted the pace of household formation and created a large backlog of young people, currently living with their parents, who now need their own homes. An improving job market, more confidence, and low interest rates are combining to stimulate demand. Strong demand and limited inventory is boosting home prices and encouraging builders. Housing starts, which had collapsed in 2009 to an annualized rate of about 600,000, are expected to recover to a rate of 1,300,000 by the end of 2013. Higher home prices are restoring personal wealth and consumer confidence.
Second, the United States is in the early stages of an energy boom, fueled by advances in the recovery of natural gas. This cheap, clean fuel may make the U.S. a net energy exporter in the decades ahead, creating jobs and reducing costs for U.S. businesses. Third, U.S. manufacturing is experiencing a renaissance as overseas labor and transportation costs have increased, the U.S. dollar has weakened against some currencies, and companies have recognized the advantages of more closely tying manufacturing to design.
After years of a strong yen, persistent deflation, and its third recession in five years, the Japanese people have effectively said, “Enough is enough.” The election of Prime Minister Shinzo Abe by the Japanese Diet in December has resulted in a profound change in the direction of Japanese fiscal and monetary policy. Prime Minister Abe has announced a $100 billion stimulus program to help lift the country out of recession.
The new head of the Bank of Japan, Governor Kuroda, has announced that the Japanese central bank will achieve a 2% inflation rate at any cost. While some doubt the magnitude and timing of this goal, Japanese confidence and equity markets have rallied while the yen has weakened considerably, enhancing the competitiveness of Japanese exports. Japan faces daunting demographic challenges in the decades ahead, but the policies being put in place now should bolster economic growth in the short to medium term.
We expect continued, strong growth from emerging markets, particularly in Asia. Manufacturing production in emerging Asian countries has increased for the past four months and should remain strong based on solid demand in export markets. Korea has been in a soft patch recently as it contends with the competitive impact of a weaker yen, but Thailand, Taiwan, and China have picked up. China’s government has taken recent steps to curb excesses in its housing and wealth management sectors, but we do not expect these steps to derail China’s longer term secular growth trends.
Emerging economies continue to benefit from a rapidly growing domestic consumption and infrastructure investment. It does not appear that we’ll see in 2013 the food and energy price shocks that roiled many emerging economies last year. Central and Eastern Europe will be an exception, however, as these economies are closely tied to those of the eurozone, which account for a very high share of emerging European exports. Latin America should see moderate growth this year, with Peru, Colombia, and Chile leading the way and Venezuela, plagued by mismanagement and political uncertainty, lagging its neighbors.
Conditions in the eurozone are likely to remain difficult. While systemic risks have decreased, fundamental problems persist. The most fundamental issue is the structure of the eurozone itself, with a common currency but separate, national fiscal policies. The political will to address this weakness will be a long time in coming, if it ever does.
In the meantime, many eurozone countries today face recession, high unemployment, staggering debt, continuing budget deficits, and the economic impact of austerity measures. While countries in the periphery continue to struggle, France is now under pressure, facing more austerity this year than it did last year. Economic weakness has even extended to powerhouse Germany, which may see real gross domestic product (GDP) growth of only 0.6% this year. Political uncertainty in Italy raises questions about that country’s ability to continue the reforms implemented under Mario Monti, and most recently Cyprus has taken center stage.
Though Cyprus only represents 0.2% of the eurozone’s GDP, the ultimate resolution of its banking crisis has implications for other European banks, particularly those in the periphery. Banking relies on trust, and proposals that have depositors pay part of the cost of bank failures weakens that trust and raises the specter of contagion to other weak banks. At the time of this writing, we expect Cypriot capital controls to remain in place for some time. If there is a bright spot in Europe today, it is that governments appear to be becoming more patient with efforts to control budget deficits, avoiding extreme austerity demands and allowing countries to find a path to growth. We expect the recovery, when it comes, to be slow.
While we are bottom-up stock pickers, these economic tides are currents through which we must navigate. Despite many deep problems and potential hot-spots around the world, we generally see an environment of slow growth with less fear and systemic risk. This may explain why asssets are starting to flow back into equities. Investors today appear to have a higher appetite for risk. In a climate less dominated by fear, investors are turning their attention to improving fundamentals wherever they can find them.
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International investing involves special risks, such as political instability and currency fluctuations. Investing in emerging markets may accentuate these risks.
The opinions expressed are those of Mark Kopinski and are no guarantee of the future performance of any American Century Investments fund. This information is for educational purposes only and is not intended as investment advice.