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The Investor Spring 20122012 Investment Outlook - Ireland & the WorldThe second half of 2011 was a disappointing period for risky assets like equities and Corporate Clientcommodities. Major economies have struggled to build on the positive cyclical momentumfrom the end of 2010. The continued fallout from the earthquake in Japan and more recentlythe Eurozone debt crisis and rising oil prices in the last quarter, have all played their part indamaging the recovery that was expected.The US and European economies slowed 2. Progress in moving towards a more factor for the Eurozone authorities to improvethroughout the year and there were signs coordinated and more supportive system matters because the costs of not doing sothat China’s high economic growth could of fiscal cooperation in the Eurozone (e.g. are so severe.slow. Government bonds have been the star step by step moves towards fiscal union,performers in a year where Central Banks which would narrow forward spreads Why, then, have the politicians allowed ushave done little in terms of interest rates and feed back into current spreads). to move into a “Eurozone systematic crisis”,and where US Treasuries were downgraded. as EU Commission President Manuel BarrosoUnorthodox monetary policy actions like 3. More substantial buying of government has characterised it? Is it basically a failure ofquantitative easing and operation twist have debt under the SMP (Securities Markets coordination and a reflection of the fact that thehelped bring yields down even further. Programme ) of non-programme country interests of the Eurozone are not compatiblewith debt (Italy or Spain) or applying the up the interests of individual national politicians?Global Market Outlook scaled EFSF (European Financial Stability The fact that core countries are being draggedFiscal crisis in the Eurozone will probably Facility) to ensure these countries can achieve into the whirlpool of the sovereign crisis is a verycontinue to impact the world economy in adequate funding in 2012 and beyond. bad thing, however it will force countries in the2012. The Eurozone debt crisis will continue core to find common ground. This would meanto dominate the Eurozone economy in 2012. 4. Managing monetary policy from the that things would have to get worse beforeThe crisis could take a turn for the better ECB, including quantitative easing to they get better.(which requires action on a number of fronts) help to overcome the possible recessionin which case global growth could strengthen that could affect the whole of the Most analysts believe the ECB has the power toin the second half of 2012. Alternatively, the Eurozone in the next six months or so. prevent the liquidity crisis spinning out of control.Eurozone debt crisis could worsen causing a However, the ECB also believes acting too earlypossible European recession and an adverse If there isn’t progress on a solution to the could lead to insufficient action by politiciansspill over to global trade and growth. For Eurozone debt crisis, then growth could be in the core to support the periphery, and in thethe Eurozone debt crisis to be resolved, the worse than most analysts currently predict. Bond periphery directly.following would probably have to be achieved: yields in safe havens could be lower and global risk appetite will be adversely affected. The table below describes the revised consensus1. Substantial progress on a national level in forecasts for the main economic indicators for addressing fiscal and structural problems, The consequences of this risk scenario could 2012. Again, economic growth forecasts, inflation, most notably in Italy and Spain. be a very substantial reduction in growth and interest rates have declined. Unemployment prospects in Europe. This is a huge motivating forecast figures have also increased.Summary of key economic projections for 2012 Region GDP Growth (%) Interest Rates (%) Inflation (%) Currency per USD 10 Year Yields (%) Unemployment (%) Global 2.7 n/a 2.6 n/a n/a n/a Ireland -0.8 0.8 1.0 1.3 n/a 15.0 US 2.1 0.3 2.1 1.0 2.7 8.7 Eurozone -0.2 0.8 1.9 1.3 2.5* 10.5 UK 0.6 0.5 2.6 1.6 2.6 8.7 Japan 1.7 0.1 -0.3 80.0 1.3 4.3 China 8.5 6.5 3.5 6.2 3.5 n/a Brazil 3.4 9.8 5.6 1.7 n/a 6.4Source: Bloomberg Composite (* German 10 Year Bond) (n/a = not available)
2012 Investment Outlook - Ireland & the World Ireland been especially weak and are indicative of a should keep the economy growing. InflationIrish GDP increased by 2.3% year on year in Q2 sizeable contraction in industrial output in could continue to moderate in 2012.2011 but dropped to -0.1% year on year for Q3 the period ahead.2011. This level of output is nearly 10% below Congress may approve a US$ 1.2-1.5 trillionits pre-recession peak. Domestic demand is Unemployment has been increasing since package of longer term deficit reduction thatweak, reflecting the ongoing housing market the summer and the rate of increase is starting could appease ratings agencies and shore upcorrection, banking sector restructuring and to speed up. The deterioration in economic confidence. In addition, Congress could actfiscal austerity. In the short run most analysts conditions has been broad based across on most of the stimulus measures proposeddon’t expect that to change. With an export sectors and member states of the Eurozone. by President Obama, which will remove theto GDP ratio of around 100%, the Irish economy Even the member states with better structural tightening in fiscal policy slated for 2012. Thisis heavily dependent on the strength of growth prospects, such as Germany, have seen would leave federal policy fairly neutral forIreland’s trading partners to generate growth. economic conditions deteriorate markedly. growth, even as state and local fiscal policyHowever, recent monthly data suggests activity They should be better placed to rebound continues to weigh on activity. The Fed hasis beginning to be adversely impacted by the however, if the event risks recede. Economic been early and proactive in addressing risks toglobal slowdown. With growth slowing conditions in the periphery will remain the economy with language that has postponedsharply in the wider Eurozone and in the UK, Irish challenging, due to continued budgetary rate hike expectations. Furthermore, havinggrowth is expected to slow significantly in 2012. consolidation and competitiveness problems. learned from bitter experience in the past two years, the Fed has lowered its growth outlookInflation rose to 1.7% year on year in November. The ECB’s quarterly Bank Lending Survey and indicated a willingness to do more.Energy price increases have been partly behind is indicative of deteriorating conditions on boththe rise. Domestically generated inflationary the demand and supply sides. Demand for loanspressure remains very weak. With a further rise has plunged across all key sectors. In addition, Japanin unemployment ahead as growth slows, wage banks’ lending standards have tightened, in part A fall in GDP is probably to be averted. Exportspressure will remain nonexistent. So the inflation because of deteriorating market conditions. and production returned to pre-disaster levelsrate may fall back next year and further in 2013. The ECB is reversing the hikes in policy rates in June-July thanks to the rapid restoration of delivered in 2011. Under the presidency of Mr supply chains. The economy returned to robustIreland’s economic performance and the Draghi, the ECB’s benchmark interest rate is likely growth in Q3 2011. However, with the globalgovernment’s commitment to delivering to be cut to below 2009’s record low of 1%. economy’s deceleration, exports and productionon its pledge to return its finances to a have lost steam since September and asustainable level have been commendable. substantial slowing in growth is expected fromThe progress of the EU-ECB-IMF programme United States Q4 2011. Even so, with reconstruction demandof financial assistance to Ireland continues The US economy has shown surprising finally kicking in, a fall in GDP should be averted,to be seen as positive. Nonetheless, there are resilience in the face of financial turmoil and even if exports falter. While there still is a risk thatclear risks. The economy would do well to falling confidence. The economy grew by a solid all nuclear reactors could be offline next April,achieve the 1.6% growth pencilled in by the 2.5% quarter on quarter in Q3. Early indicators significant constraints on production are unlikely,Department of Finance for next year should suggest that the economy’s momentum has as aggregate demand growth will also be weak.activity in key trading partners be contracting. moderated a bit. Many analysts expect 2012The Medium Term Fiscal Statement published to get off to a sluggish start, with a 0.5% quarter Consumer spending has slowed sharply nowin early November revised up the discretionary on quarter rise in Q1 expected. This will the post-disaster catch up process is over.fiscal tightening needed to meet the deficit probably be caused by a slowing momentum Domestic demand has been chronically weaktarget of 8.6% of GDP. With the economy from the Japanese related bounce back since 2000 due to the rise in the average agemoving backwards further consolidation as consumers seek to maintain higher of the population, leaving Japan dependentmeasures may be required or some leeway savings rates than during the last period of on exports to drive the economy. Japan’sfrom the EU and IMF will need to be given. economic expansion. For 2012 as a whole, per capita trend growth rate is currently many analysts expect growth to be on a par estimated at around 1%, but with the working with 2011. The expectation is that growth age population declining at a rate of roughly Europe will increase steadily throughout the year. 0.9% annually, the overall trend growth rateEurozone leading indicators are signalling a The fate of the US economy has increasingly could be close to zero. Aging has been largelyhigh chance of a contraction in GDP. Sentiment been tied to that of global developments rather responsible for pushing the jobless rate downsurveys have continued to deteriorate across than the other way around. The recessionand since the 11 March disaster, as the growingsectors against a backdrop of continued stress fiscal crisis in Europe therefore, pose downside number of retirees reduces the labour force.in financial markets and ongoing uncertainty. risks to the outlook, although domestic and In this way, the jobless rate is likely to continueLeading indicators for the industrial sector have global policy easing and organic momentum to fall, even without robust economic growth.
2012 Investment Outlook - Ireland & the WorldJapan seems mired in a deflationary equilibrium Market Performance: 01.01.2011 to 31.12.2011of roughly –1% per annum in terms of the GDPdeflator. If global commodity prices reverse Market Index Local Currency Eurocourse and rise, there could be a temporary Ireland ISEQ -5.5% -5.5%jump in Japanese inflation. But such importedinflation would ultimately fuel deflationary UK FTSE 100 -8.7% -6.7%pressures as Japan’s already lacklustre domesticdemand weakened further on deterioration in Europe FT/S&P Europe Ex. UK -19.6% -19.6%the terms of trade. US S&P 500 -3.0% -0.4% Japan Topix -19.5% -13.7% ChinaChina’s domestic tightening policies over the Hong Kong Hang Seng -20.6% -18.6%past year have dented growth momentum. Australia S&P/ASX 200 -12.3% -12.4%The gloomy external outlook is also hamperingChina’s already weakening growth momentum. Bonds Merrill Lynch Euro over 5 yrs 3.9% 3.9%The prospect of a downturn in developed Source: Bloomberg: 01.01.2011—31.12.2011nations has further clouded the growthoutlook. Major leading indicators, such as PMIs(Purchasing Managers Indices) and budgets to loosen restrictions on the approval and With growth and inflation moderating,for existing and newly started projects, financing of projects. property prices are showing signs of aindicate growth is set to lose more steam. correction, so policymakers started selective In 2012, China will enter the second year of its easing in October to mitigate financial riskEconomic growth of more than 8% current five year plan. The second year typically and avoid over cooling the economy.might be essential to ensure a smooth sees the highest FAI growth, as it is when most This selective easing may help the governmenttransition of power when the next leaders projects enter the construction phase. So FAI manage a soft landing. However, China is notof the Chinese Communist Party are could pick up in the second half of 2012 once expected to reverse policy completely or launchpromoted in 2012. As exports are primarily the newly selected local government officials another stimulus package, as it is still tacklingdetermined by external factors, investment take office. the side effects of excessive stimulus in 2009.is the main way to shore up growth. Monetary tightening has contained inflation,Budgets for existing investment projects are while softer growth and a slower than expectedgrowing by 20% year on year, suggesting rise in commodity prices point to mild inflationFixed Asset Investment (FAI) will not be strong in 2012. CPI inflation has moderated fromits peakenough to sustain economic growth above 8% of 6.5% year on year in July to 5.5% in Octoberin 2012. Therefore, the government is likely thanks to the tightening of monetary policy.Bond Markets - The Potential RisksBond yields in the four main global bond markets are at record lows. We look at the factors thathave led to bond yields reaching historic lows and the potential risks that may be lurking in thetraditional “Safe Haven” bond markets.A bond yield is the percentage return an usually very sensitive to interest rate changes. and the yield rises. A government bond yieldinvestor will receive by holding a bond When interest rates rise, bond prices fall, and is an indication of the benchmark interest rateto maturity. Generally, the strength of the conversely, when interest rates fall, bond prices at which governments borrow to fund theireconomy dictates the level of interest rates. rise. By the same token, when the price of a countries. For countries like the US, Germany,Bonds are loans investors make to the bond bond rises, usually because demand for the Japan and the UK, low bond yields means theissuer whether the issuer is a company or a bond is high, the yield drops. When fewer cost of their borrowings are historically very low.government. Since bonds are loans, they’re people want to buy bonds, the price drops
Bond Markets - The Potential RisksHow have we reached these may be significant pressure on yields in 2012. so low now, an inflationary shock of anyvery low yields? Governments of the world’s leading economies sort could be devastating, as rates couldThere are a number of factors that have led (the G7) have approximately $7.6 trillion of debt spike in response. If yields on a 10 yearto bond yields reaching historic lows: maturing this year, with most facing a rise in US Treasury bond increased by just three borrowing costs. Led by Japan’s $3 trillion and percentage points there would be a capital1. The beginning of the financial crisis the US’s $2.8 trillion, the amount coming due loss of approximately 23% for an investor. in 2007 negatively affected investor’s for the G7 nations, Brazil, Russia, India and China confidence. When investors are fearful is up from $7.4 trillion at this time last year. While no one expects a big jump in inflation in they tend to sell risky assets like equities the near term, it could come as an unpleasant and buy safer assets like bonds. Ten-year bond yields may be higher by year-end surprise. For example, in 1974, OPEC flexed its for these countries if most forecasts turn out muscle and US inflation topped 12 percent. It2. The Euro government bond debt crisis to be correct. Investors may demand higher can also happen as a result of war. After Iraq has also increased this fear leading compensation to lend to countries that struggle invaded Kuwait, consumer prices rose at more to further purchasing of government to finance increasing debt burdens as the global than a 6 percent rate in the Autumn of 1990 bonds especially in the US, Germany, economy slows. The International Monetary in the US. Inflation also rises in less traumatic Japan and the UK which are regarded by Fund cut its forecast for growth for 2012 to 4% periods when economies are performing many as “Safe Haven” bond markets. from a prior estimate of 4.5% as Europe’s debt normally. Most notably, inflation rises as a crisis spreads, the US struggles to reduce a result of loose monetary policy measures like3. Investors expect economic growth to slow budget deficit exceeding $1 trillion and China’s quantitative easing, increased money supply globally as the financial crisis impacts on property market comes under pressure. and government bond purchasing programmes. nearly every country in the world. This has also contributed to reductions in bond yields. The amount to be refinanced rises to more Conclusion than $8 trillion when interest payments are Major bond markets have been seen as “SafeThe process of selling risky assets and buying included. As Standard and Poors cut the US’s Havens” in recent years and have producedgovernment bonds is often referred to as a rating to AA+ from AAA in 2011 and more attractive investment returns but there are“Flight to Quality”. This process of moving recently downgraded nine European nations, risks like high inflation, over supply and ratingmoney out of risky assets and into “Safe the competition to find buyers is heating up. downgrades in the coming years. These risksHavens” has been very profitable for investors. could lead to investors suffering significantWhen the yield of a bond goes down the Some investors are worried about something capital losses even though they are investingprice goes up. If an investor bought a US most bond investors haven’t had to deal with in something that they perceive to be safe.10 year bond on 1 January 2011 and sold since the 1970s, which is the prospect of aon 31 December 2011 they would have sustained rise in interest rates. With yieldsmade approximately a 20% capital gain. 10 Year Bond YieldsThe Potential Risks Country Historic High Yield Current YieldBond yields could go down further in 2012 andover the next few years, as investor fears over USA 7.9% (Nov 1994) 2.0%the Euro debt crisis and the world economycould continue. Although yields could go down Germany 8.1% (July 1992) 1.9%they are already at very low levels. Therefore, Japan 5.0% (March 1992) 1.0%there is a risk that bond yields could rise to UK 9.8% (March 1992) 2.1%more normal levels causing significant capitallosses for investors in these bonds. There Source: Bloomberg 10 Year Bonds* For further information please contact Paddy Swan (email@example.com) or James Finucane (firstname.lastname@example.org)