Monetary Conditions And Regional Equity Allocation

Although better performance in the U.S. and U.K. is hardly a secret, this trend should persist in 2012.

Monetary Policy U.S. and U.K.

M onetary policy in the U.S. and U.K. is much more proactive than in the euro zone and Japan. The euro zone is in the worst position, as it faces the combination of fiscal austerity and a dogmatic central bank. Monetary conditions are very tight in Europe, somewhat tight in Japan, but highly stimulative in the U.S. and U.K. Not surprisingly, U.S. and U.K. stocks have been outperforming this year. In addition, the dollar and sterling are cheap, while the euro and yen are expensive.

Our Global Investment Strategy service does not expect these basic conditions to change much going forward, even though the ECB may be dragged into more easing and the BoJ could embark on a program of half-hearted currency market intervention. The U.S. and U.K. will continue to have easier monetary conditions than the euro zone and Japan.

Bottom line: Continue to prefer U.S. and U.K. equities over euro area and Japanese counterparts.

S&P: Domestic Vs. Global Bias Is Intact

A number of indicators are consistent with the expectation of our U.S. Equity Strategy service that U.S. industries reliant on the domestic economy will gain more ground relative to globally exposed industries.

US Equity Strategy | S&P Financials Sector

T he relative PMI of the U.S. over the average of the euro area and China has soared, suggesting that domestically exposed industry groups in the S&P 500 will continue outperforming globally oriented stocks. Also, the November U.S. employment report revealed that domestically geared sectors are still experiencing a rise in activity, while global-exposed ones continue to reduce hours worked. That is consistent with domestic sector earnings outperformance.

The earnings breadth is also most supportive in domestic sectors, as evidenced by the rise in the number of financials and consumer discretionary groups experiencing an increase in earnings estimates. Conversely, earnings support in the materials and industrials sectors continues to sink, whereas the energy and tech sector remain positive exceptions. These indicators reinforce that select domestic industries are becoming very well positioned to outperform global-exposed areas.

The S&P financials sector is top on our list to positively surprise in the coming quarters and we recommend upgrading it to overweight (via a boost to a regional bank index to overweight).

Long Term Outlook For Commodity Currencies

Stepping back from the day-to-day market noise, we remain long-term bulls on the commodity currencies.

Long Term Outlook Commodity Currencies

O ne way to value commodity currencies is to compare their real effective exchange rates against their terms of trade. Despite being near multi-decade highs, the Canadian, Australian and New Zealand dollars are trading at a discount to the levels implied by their terms of trade.

There are many potential sources of upside in the commodity currencies.

First, the current level of commodity prices and terms of trade will drag these currencies higher over time to simply close the undervaluation gaps. The “mean reversion” suggests there is about 10% upside from today’s levels.

Second, assuming that our long term view on commodities is correct, the terms of trade will rise further, placing additional upward pressure on the fair value of the commodity currencies.

Third, there is the potential for overshoots. Canada, Australia and New Zealand are small economies. If global investors (both private and public sector) want to increase their allocation to these relatively small and illiquid currencies, they can very easily overshoot their fundamental values.

Finally, the resource boom will boost domestic incomes and spending, which will force their central banks to keep interest rates relatively high. In a world where the Fed, ECB, BoJ, BoE and SNB have policy rates near zero, investors will be attracted to the higher interest rates in Canada, Australia and New Zealand.

Bottom line: Our Foreign Exchange Strategy service remains a long-term bull on commodity currencies.

Stick With Gold Shares

Gold still has upside, and gold shares could soon play “catch up”.

Stick With Gold Shares

O ur Commodity &  Energy Strategy believes that it is too soon to give up on gold and the same is true for gold shares. Gold miner profits track gold prices and this has not changed in the past few years, although the tracking is far from perfect. What has changed is the traditional 2:1 relationship between changes in gold shares and underlying prices. Global gold shares are flat year-on-year in dollar terms, yet the dollar price of gold is up 22%. This is despite the fact that gold company hedge books are leaner than they have been in years.

One possible explanation is that commodity-sensitive currencies have been strong in recent years. This places a wedge between revenues and costs for many gold producers. Put another way, gold in C$, A$ and SA rand terms has been weaker than in U.S. dollar terms. However, that has not been the case in recent months as the commodity currencies have dropped in the face of investor risk aversion.

A more likely explanation relates to the ETF phenomenon.

Gold company multiple compression accelerated as ETF holdings hit successive new highs in 2010 and 2011. While the divergence is unsustainable, it is difficult to tell when it will end. Even if gold shares are in a bear market versus gold prices, they are stretched relative to the downtrend in place since 2006. P

erhaps global reflation and a softer dollar will spur a “broadening” of interest in lagging liquidity plays, such as gold shares.

Bottom line: Continue to hold strategic positions in gold and gold shares.

Eurozone Growth Remains Weak In Q3

The euro area managed to eke out a 0.2% growth rate in Q3, matching the previous quarter

T he solid growth in Germany and France (at 0.5% and 0.4%, QoQ respectively) seems to be the only remaining driver of the struggling euro area economy, according to Eurostat’s flash figures for Q3 GDP growth. Growth in Spain came to a standstill, while the Portuguese economy continued to contract. Going forward, the downward trending confidence indicators and PMIs suggest that the entire euro area is headed towards a recession. Also, additional fiscal drag and the prospect of raising bank solvency ratios by shrinking assets will not bode well for the European economy.

A worrying implication of the lack of growth is that the periphery countries will find it harder to reach their deficit targets by implementing austerity programs. This possibility of worsening debt dynamics will make markets even more wary about the current efforts to deal with the European crisis. Indeed, widening French, Italian and Spanish spreads already highlight the dangers of indecisive action and political turbulence.

Bottom line: The looming recession makes it ever more pressing for euro area policymakers to bolster their efforts, but also limits their ability to rely on fiscal belt-tightening to restore confidence. We maintain that growth oriented policy changes and more aggressive action by the ECB are required to resolve Europe’s crisis.