Global Equities: Caution Warranted

According to our Global Investment Strategy service, increasing macro risks against a backdrop of elevated valuations warrant a more cautious stance (neutral allocation) on global equities:

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  • The probability of a December hike has tracked the steepness of the OIS curve. In essence, by signaling to markets its intention to hike rates in a few weeks, the Fed has pushed forward the timing of future rate hikes. Given that the Fed’s “dots” are still a fair bit higher than current market expectations, the risk is that rate expectations will continue to adjust upwards, tightening financial conditions in the process. Such an outcome would be bad news for stocks.
  • A strong greenback and an increasingly hawkish Fed is bad news for emerging markets, given that over 80% of EM foreign-currency debt is denominated in U.S. dollars. If emerging markets were on solid footing, this might not be much of a problem; unfortunately, they are not. The ratio of private-sector debt-to-GDP has doubled since 2001. Remarkably, debt levels continue to rise in most emerging economies. If things are tough now, imagine how tough they will be when debt begins to decline. Reducing debt in a smooth and orderly manner is hard enough in advanced economies with their strong economic institutions; it is virtually impossible to pull off in emerging markets. According to ourGlobal Investment Strategy service, there is a high probability that shocks from the EM world will spill over into developed markets.
  • Apart from the impact of Fed hikes and emerging market stress, the potential for a growth slowdown in Europe is another reason that makes us increasingly worried about the outlook for global equities.

Government Spending In The Euro Area

According to our European Investment Strategy service, government spending might give the euro area economy some much-needed support over the coming quarters – particularly relative to other major economies like the U.K., U.S. and Japan.

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In the near term, the refugee crisis and counter-terrorism security provide a clear and urgent rationale for more government spending. Although such spending means that euro area governments will stray from the Commission’s official deficit targets, Brussels has nonetheless given its tacit approval. Brussels is showing leniency because, after five years of centrally-imposed austerity, the euro area is now close to a structural budget balance. Even the individual country structural deficits in France (-2.5%), Italy (-0.6%) and Spain (-2.3%) are now smaller than those in the U.K. (-3.6%), the U.S. (-3.1%) and Japan (-5.5%).

To get to this near-balance in its structural budget, the euro area has gone through extended austerity: most recently, three back-to-back years of a negative fiscal impulse, based on government spending. The good news is that this pain is about to end. The IMF forecasts the euro area fiscal impulse to stabilize in 2016 and turn positive in 2017. Any additional spending on the refugee crisis and counter-terrorism security will simply accelerate this rebound in government spending.

Interestingly, the opposite is true in the U.S. The economy has benefited from three back-to-back years of a strongly positive fiscal impulse. But according to the IMF forecasts, the fiscal impulse is about to turn negative through 2016-2017.

Bottom Line: The euro area has a lot more fiscal stimulus bullets left compared with other major economies.