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For the third year in a row, solid first quarter global equity market performance and investor optimism has taken a hit as a result of yet another growth scare and a flare up of the European Union (EU) sovereign debt crisis. Rising concerns surrounding growth both in the developed and the emerging economies of the world, coupled with renewed uncertainty around the future of the Euro, have fueled declines in stock prices in most of the world’s markets.

Charts 1, 2, and 3 illustrate the similarities between 2010, 2011, and 2012. While there are a lot of commonalities between these three periods, there are also some notable differences this year that will likely have a material impact on global equity returns going forward. The U.S., Europe, and the Emerging Markets are at different points in their economic cycles. Coupled with the differences in their economic cycle positions comes a difference in the valuations of these regions. In this article, we will discuss our economic and market outlook for each of the three regions and the current opportunities we see.

Economic Overview

U.S. economic growth remains on a slow growth trajectory, though many economic indicators show that conditions are generally healthier and the sustainability of growth is improving. While there has been an improvement in some areas of the economy, several challenging headwinds remain.

On the plus side, credit is flowing more freely and the latest data on housing suggests that this area of the economy is becoming less of a drag on growth:

• The economy has now enjoyed four consecutive quarters of positive housing-related contributions to GDP growth for the first time since 2005 (Chart 4). While housing activity is unlikely to improve drastically from here, it is also unlikely to be the headwind it has been for the past several years.

  

• Low interest rates have also benefited consumers through a meaningful increase in refinancing activities. The median rate reduction for 30-year mortgages was 1.5 percentage points or approximately 27% of the interest rate. This represents the largest percentage reduction ever.
• Consumers also have more money in their pockets to spend elsewhere due to the decrease in energy prices. According to AAA’s Fuel Gauge Survey, national average gasoline prices have fallen more than 50 cents/gallon since April.

The ongoing improvements in the housing sector and the health of the consumer are clear positives for the U.S. economy; however, sufficient headwinds remain to keep growth expectations below historical norms. The bad news for the U.S. economy is that the sustainability of labor market growth is still in question, as payroll numbers slowed from the gains experienced earlier in the year and wage growth is anemic (Chart 5). Job creation appeared to be gaining momentum during the first quarter, but lost steam heading into the spring and summer months, only recently showing better than expected improvement. This is a negative for consumption growth as we continue to believe payroll growth and wage growth are required for a sustained improvement in consumer spending. On top of this, government spending will likely continue to be a drag on growth. These factors should keep the U.S. economy in slow growth mode as Government Spending and the Consumer together make up over 85% of GDP.

Economic growth has been uneven from quarter to quarter since the economy emerged from the last recession, and this choppiness is likely to persist. However, barring a substantial spillover of weakness from Europe, or significant policy errors in addressing fiscal challenges in the U.S., overall growth should remain positive. Given the lack of extremes in economic indicators today, we believe that the U.S. economy is later in the economic cycle, but is neither about to enter into a severe recession nor experience a strong upturn in activity.

Europe is now much later in its economic cycle than the U.S. In fact, the aggregate Eurozone economy contracted 0.4% on a year-over-year basis in the second quarter. This is a noteworthy decline in addition to the flat year-over-year growth in the first quarter, as well as the already weak 0.7% year-over-year growth pace experienced in the fourth quarter of 2011. It is clear that economic momentum has downshifted and growth is weakening in Europe. Moreover, leading indicators remain in negative territory on a year-over-year basis having declined -1.7% over the past year, suggesting that growth may continue to decelerate/contract. It is important to note that conditions remain quite different across the Eurozone as conditions in the core (e.g., France, Germany, Netherlands), though soft, are certainly better than the periphery which is in outright recession (Chart 6). Indeed, net trade was the only positive growth driver in the first quarter for the Eurozone. A weaker Euro relative to other global currencies should help buoy European exports and provide some support to growth in the region. However, the weak growth environments in most of the rest of the developed world will likely limit demand for European goods from abroad.

Many countries within the Eurozone face additional economic pressures from austerity programs which seek to address the root causes of their current debt crisis. As economic output has continued to decline, discontent with these austerity measures has been on the rise and is clearly impacting results at the polls. While the political dynamics among the Eurozone member nations means that the situation will continue to progress in fits and starts, the European Central Bank (ECB) has shown a willingness to step in when needed to help stabilize the bond markets. Further bouts of stress in the European financial markets are likely, but the combination of negative stock returns, negative GDP growth and falling policy rates over the past year suggests that the markets have grandfathered in a lot of the bad news already.

While slow/no growth remains the base case for most of the developed world (e.g., U.S., U.K., EU, Japan), many Emerging economies have substantially better growth dynamics. Several of these nations faced rising inflationary pressures in recent years and as a result, embarked on monetary tightening campaigns in 2011. Today, inflation is largely under control in many of the Emerging markets (India and Singapore are notable exceptions) allowing monetary policies to shift toward either a holding pattern or in the case of countries like China and Brazil, an outright easing cycle (Chart 7).

China has reduced the reserve ratio for their banks (a key regulatory factor determining a bank’s ability to lend) three times since December and the central bank has cut interest rates twice since June, marking the first time such action has been taken since the global credit crisis. Recent economic data shows that growth slowed to an annualized 7.6% in the second quarter, its slowest rate since 2009. Other emerging markets, including Brazil, have taken similar steps to enact pro-growth monetary policy. We see this as a positive as policy acts with a lag, showing that the easing is beginning to take hold. For example, we are starting to see early signs of a reacceleration of money supply growth in China – historically a positive indicator for future growth (Chart 8). While weak demand from the developed world will be a drag on overall emerging market growth, the domestic outlook (i.e., the consumer) in many of these countries continues to be positive.

Market Overview: Opportunities in Europe are Growing

The graphic in Chart 9 represents Manning & Napier’s approach to asset allocation over the course of each asset class’ unique market cycle. The bottom line on the parallelogram represents the progression of risk over the course of a market cycle, while the top line captures our desired exposure to each asset class.

Reading this chart from left to right, we see risk fall throughout the bearish phase as investors increasingly price in bad news and lower their expectations for the future. As this is happening, our investment discipline leads us to steadily increase exposure to these areas as lower and lower expectations get baked in.

Eventually, the market reaches its trough and asset values start to recover. As this recovery unfolds, investor sentiment tends to go from skeptical, to positive, to outright speculative bullishness. We seek to monitor the progression of the cycle, taking cues from valuations, sentiment and economic indicators. As we see higher valuations, stronger sentiment and/or later cycle economic conditions, our investment discipline causes us to decrease equity exposure gradually rather than trying to guess an exact peak (as seen in the top line, which peaks well before the market does). Today, we would place the Eurozone somewhere in the bearish phase of its market cycle, whereas the U.S. would be well into its recovery (albeit a lackluster one).

The point here is not that the U.S. is on the precipice of a severe recession/bear market, but rather that there are compelling opportunities developing outside of the United States that investors should be carefully evaluating. Chart 10 helps to put these opportunities into perspective by comparing valuations in the U.S. versus the Eurozone as a whole as well as several individual European markets. A couple things jump out on this chart. First, while the U.S. is certainly far from richly valued versus the last ten years (an impressive feat considering this time window includes two severe bear markets!), the Eurozone trades at less than half the valuation of the U.S. market. Second, these low valuations in the Eurozone are not just limited to countries on the periphery – notice for example that the German and French markets can be had for valuations similar to Italy and Spain.

Valuations are also very attractive across many sectors within the Eurozone – not just within the Financials sector which is at the heart of the crisis. Chart 11 displays sector level valuation metrics for the Eurozone expressed in terms of the number of standard deviations from their ten-year average. The majority of the sectors within the Eurozone are trading at extremes of over -1 standard deviation versus their levels over the past ten years on one (often several) of these valuation metrics. We believe that these widespread low valuations – both on a country and sector level – represent opportunities for long-term investors to gain exposure to the best countries/sectors/companies in Europe. It is important to understand that while we believe there are good long-term opportunities in the Eurozone, investors must be prepared for additional bouts of short-term market stress as events on the continent continue to unfold.

Conclusion

The illustration in Chart 12 has been a staple of our market updates for the past several quarters. It represents our understanding of investors’ collective tendency to over-extrapolate both good and bad short-term trends in news flow and economic releases. Over the past two years we have already experienced several such swings in sentiment both towards the U.S. as well as the EU. While it is not possible to predict when these swings in sentiment may turn, as it moves further and further away from the underlying economic reality, the odds of a return towards reality certainly increases. We continue to recommend investors avoid falling into the risk on/risk off daily trading mentality that has gripped the markets these past several quarters, and instead seek out long-term opportunities created by the current high degree of uncertainty in the world’s markets.

Unless otherwise noted, figures are in USD.

Analysis: Manning & Napier Advisors, LLC (Manning & Napier).

Manning & Napier is governed under the Securities and Exchange Commission as an Investment Advisor under the Investment Advisers Act of 1940.

Sources: AAA, FactSet, Financial Times, Freddie Mac

All investments contain risk and may lose value. This material contains the opinions of Manning & Napier Advisors, LLC, which are subject to change based on evolving market and economic conditions. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

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