China: Still On Course For A Soft Landing

The most recent economic data out of China confirmed that the economy remained incredibly resilient in the wake of slowing external demand and harsh policy tightening last year.

China Soft Landing or Hard Landing

L ooking forward, business activity will likely continue to moderate. Our model currently predicts that GDP growth will continue to decline to about 8.3% in the first quarter, with no bottom yet visible, suggesting high odds that growth will dip below 8%. Nonetheless, barring a major global shock, our China Investment Strategy team expects the Chinese economy to be sluggish but able to avoid a crash.

It is important to note that the economy’s various trouble spots were able to withstand severe policy headwinds in the second half of last year, when the tightening campaign was at its maximum strength. The odds of an economic crash will likely decrease because the policy pendulum is clearly swinging back to easing. This should increase the availability of credit, reduce the cost of borrowing and help the economy to stabilize. In terms of the stock market, we suspect that investors have become pessimistic enough on both China’s cyclical outlook and structural fundamentals.

This means that the market has priced in enough bad news and is more likely to respond to positive growth surprises and policy reflation going forward.

Can The U.S. Dollar Be Pro-Cyclical?

Factors behind the positive dollar/stock relationship from the late 1990s are no longer in place.

U.S Dollar Pro Cyclical

I n level terms, the rolling 26-week correlation between the trade-weighted dollar and U.S. equities is about to turn positive. But this is nothing out of the ordinary as it occurred for brief periods in the past and none of those previous episodes marked a structural return to a positive relationship. Our Foreign Exchange Strategy service argues that the fundamental factors that drove the dollar/stock relationship in the late 1990s are not in place today. A key reason for the positive correlation in the 1990s was the growing importance of foreign equity inflows, which tend to be unhedged.

Currently, government fixed income instruments account for the vast majority of capital flows into the U.S., and these flows are more likely to be hedged. If the U.S. current account deficit continues to reflect the large fiscal deficits, then foreign capital inflows must be largely into government fixed income securities, not into U.S. equities. This will make it difficult for a positive dollar/equity correlation to reassert itself. Also, in the 1990s, “risk on” meant buying U.S. tech stocks and therefore the dollar.

Today, the risky assets that investors want are outside of the U.S., particularly in emerging markets. So, when markets have a “risk on” bias, private capital leaves the relative safety of U.S. government securities for risky assets elsewhere; consequently, the dollar comes under pressure.

Bottom line: Over the last few weeks, both U.S. stocks and the dollar have managed to strengthen. We doubt that this is the start of a long term positive correlation like that seen in the late 1990s.

Corn: A Gloomy Picture In 2012

Global corn supply will expand while demand will falter in 2012. This is bearish for corn prices.

Corn Price For 2012

C orn prices were well above 600 cents per bushel most of last year. This was a reflection of a many factors including the Russian drought in mid-2010, the U.S. drought in 2011, rising corn use for ethanol in the U.S., and the boost in hog production in China. These factors should either disappear or diminish in 2012.

  • On the supply side, production is expected to increase in 2012 on the back of higher world acreage and a recovery in U.S. corn yields.
  • On the demand side, two major drivers of global corn consumption (U.S. ethanol expansion and rising protein consumption from China) will lose strength in 2012, according to our Commodity & Energy Strategy service.

At current ethanol and corn prices, ethanol producers’ profit is negative. Corn prices will fall as some producers start to cut production and/or go bankrupt. Also, last year’s boost in Chinese hog production may drive down pork prices in 2012, which in turn would undermine hog production and feed grain (mainly corn) consumption. The major risks to the bearish view are weather events (that could curtail supply) and an oil price surge (because it increases demand from corn-based ethanol producers).

Bottom line: Rising supply and faltering demand will replenish depleted global inventory and drive down corn prices. Corn prices are likely to drop to the range of 350-450 cents per bushel by the end of 2012 in the absence of major weather events and/or an oil price surge.

Investing In A Volatile World

Even assuming moderate earnings growth, equities should still deliver reasonable returns relative to alternatives in the medium term.

Global Equity Returns

B CA’s Annual Outlook, published in December, emphasized that the tail risks facing the global economy and financial markets will hang over markets in 2012, making it another difficult year for investors. While monetary policy will remain extremely easy, low rates by themselves do not guarantee that risk assets will perform well, especially since profit margins are extremely high (i.e. the risk is to the downside). But at least valuation is reasonably attractive.

Over the medium-to-long term, the total return to equities should easily surpass bonds, even factoring in very weak growth. For example, if we assume extremely pessimistic nominal earnings growth of 3% over the coming decade and a compression in the price-earnings ratio to 10, equities would still deliver returns above current bond yields. A more reasonable expectation for global equity returns would be something between 7% and 8% a year. For the U.S., equity returns should be around 6%, reflecting lower earnings growth and a lower dividend yield. The bottom line is that equities should still deliver reasonable returns relative to bonds over the medium-to-long run.

We therefore expect to move back to overweight equities sometime this year.

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.