The path is clearing for a new financial cycle, says La Francaise

For the new cycle to really gather a head of steam, the real economy will need to confirm that it is a real takeoff, La Francaise AM says in its February report.

This is happening in the United States and, in more timid fashion, in the euro area while emerging markets are and will remain in a slowdown rife with uncertainty in 2014.

The global economy has continued its slow improvement although risk has shifted from the developed world to emerging markets. The euro area has resisted shocks and fears regarding its stability have receded. However, risks have heightened in emerging markets such as Turkey, Argentina and Indonesia whose currencies have dropped dramatically. The Brazilian real and the Chilean peso were also dragged down, raising fears that the currency crisis might spread. Plummeting exchange rates and monetary tightening are threatening these countries with runaway inflation, and inciting reactions from monetary policy and disrupting global stock exchanges. China has stayed above the fray where fears have centred on the distribution of credit instead.
The unemployment rate in the US has steadily declined. The early stages of US monetary policy normalisation triggered capital outflows from weak emerging markets, as seen in the steepening of the fall in the Argentine peso.

The US economic recovery is ongoing. Industrial production has in fact accelerated since early 2013. New orders of consumer and durable goods have increased markedly. Despite a blip in January, we believe that the manufacturing ISM (measuring purchasing manager sentiment) reflects the continuation of satisfactory industrial expansion. The ISM index in the service sector fell, however, to below 55, which points to less vigorous growth in services. Job creation trends remain between 180,000 and 200,000 jobs per month. The unemployment rate has dipped to less than 7% and the trend seems set to continue. Growth is gaining momentum amid a low-inflation environment (underlying inflation < 2% per year).

The federal budget deficit has improved from $1.6 trillion at an annualised pace in 2009 to around $500bn at the start of 2013. Deficit reduction seems to have slowed since then. Corporate profits are on the upswing, albeit moderately. In all, the US expansion is expected to continue at a pace of 2.5-3% per year over the course of the upcoming period, after a banner Q3 where growth topped out at 3% per year.

In the euro area, industrial production, which had been in hibernation for much of 2013, seems to waking up. According to European surveys, production trends, like business sentiment in industry, have returned to positive territory. In construction,
business sentiment remains mediocre and close to past lows while consumer confidence and business sentiment in retail have nearly returned to their historic averages.

We can definitely expect euro area growth to be fairly positive in the fourth quarter, although the capacity utilisation rate will remain extremely low. Inflation in the euro area is very weak (0.8% year-on-year, nearly 0% over the past two months). The
euro area’s M3 money supply is increasing at a paltry 1.5% per year and outstanding home loans to the private sector continue to contract. Lending conditions have loosened, however.

2013 finished better than it started, which sparked hopes of a genuine economic recovery. Easing tensions on European sovereign debt, hope of improvement in growth prospects and abundant liquidity from central banks sparked a radical shift in capital flows from bonds to stocks and from EMs to developed countries. Share prices in emerging markets lost, on average, 8% of their value in euros and nearly all commodities fell, particularly gold (-30%). The performance of bonds in “core” countries such as the US and Germany was negative. Currencies other than the euro were losers: 4% for the dollar and 12% for the yen. Housing prices were relatively uneven with drops in France and Spain and increases in the US, UK and, for the first time in a long time, Germany.

Our economic outlook is for the cycle in the real economy, which began in 2011, to continue in 2014 and accelerate very slightly. Europe also seems to be joining this same trend. On the other hand, the financial cycle seems to be struggling to get to its feet. The volume of initial public offerings remains modest in the euro area and the US where share buybacks are more popular than new issuance.

However, IPOs are expected to gain strength. M&A activity has bottomed out but is not showing many signs of a rebound. Private equity has held up relatively well. Fund activity is positive but cash is being hoarded instead of invested. This is a positive for the recovery, but for the time being it is the lack of opportunities that is winning out. The default rate on corporate bonds is still low.

The main risk of late has focused on emerging markets and on a few countries in particular: India, Indonesia, South Africa, Turkey, Brazil and Argentina where risk has exploded. Monetary policies remain loose and liquidity is increasing. It is likely that
long-term interest rates have bottomed out. However, rates will probably be kept low because inflation is forecast to remain low.

In conclusion, the path is clearing for a new financial cycle. For the new cycle to really gather a head of steam, the real economy will need to confirm that it is a real takeoff. This is happening in the United States and, in more timid fashion, in the euro area while emerging markets are and will remain in a slowdown rife with uncertainty in 2014.

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