It's been over two years since the financial crisis began to calm but significant headwinds remain. The following is a summation of concerns about the current economy.
Employment conditions are improving, consumer balance sheets are being repaired and lending/borrowing channels are opening up (although still not fully functioning), but U.S. housing prices have yet to form a solid base. Near-term threats to the bull market include a slowing of growth and profits as global leading indicators peak, a shift in monetary policy away from massive quantitative easing (including the end of "QE2" in June), the unresolved crisis in Europe's periphery and change in the Middle East. Longer-term challenges remain, including the ultimate impact of extraordinary monetary conditions on inflation and the lowering of potential growth rates in an era of overburdened sovereign balance sheets.
Inflation once again emerging as a key concern
The pattern of positive surprise in growth and profits that set the tone for markets since late last summer is at an end, at least for a time. Nevertheless, our prior forecasts require only subtle modification. We look for U.S. growth of 3.0% and 2.75% in Canada, with the U.S. rising to 3.25% in 2012 and Canada dropping slightly to 2.5%. In Europe, the crisis in the peripheral nations should hold growth below 2%. Japan's growth will remain below 1% this year, but likely to pick up in 2012 while growth for emerging nations should come in at 7.2% for 2011, slowing to 6.9% in 2012.
Inflation is once again emerging as a key concern. Rising food prices have fanned price pressures in the emerging world especially, but should soon begin to roll out of the data. In the developed world, though, market-based indicators of inflation expectations are testing the upper reach of our comfort zone. A mild downshift in global growth and a related moderation in energy prices may be enough to alleviate concern, but this must be closely monitored.
Total returns in fixed-income markets limited
Led by the emerging world and commodity producing nations, progressive "normalization" of the economy since the spring of 2009 set in motion the removal of extraordinary stimulus. The mild slowing of global growth that we project won't be enough to reverse the gradual tightening of monetary conditions. Europe's crisis may cause a temporary halt to rate hikes, but the trend there is clear. In the U.S., the winding down of QE2 marks the beginning of the end of "easy money," but rate hikes are unlikely to begin prior to the spring of 2013.
As global Purchasing Managers Indexes peaked and a variety of factors (Eurozone crisis, Arab spring) dominated the risk trade, bond yields have once again fallen below their equilibrium levels in most regions. The outlook for total returns in fixed-income markets is further limited by the expected gradual rise in the sustainable level for yields as economic normalization progresses, driving demands for inflation premiums and real rates of interest closer to historic norms.
Valuations remain compelling
Although equity markets have generally doubled, or better, since their crisis lows, valuations remain compelling in almost every major market. A lack of near-term clarity on growth, more demanding earnings/revenue expectations and the threat of volatility spilling over from the world's current hot spots are cause for concern, but unlikely the seeds of a bear market. Longer-term technical indicators remain constructive (market breadth, price momentum), but near-term measures of stock market health are mixed, suggesting heightened risk of a "tradeable" correction.
This article was supplied by Colin MacAskill CFP, CIM, a vice-president and an investment advisor with RBC Dominion Securities Inc., the wealth management arm of the Royal bank. Member CIPF. Colin welcomes your calls on his direct line (604) 257-7455.
