Additionally, central banks around the world (including the US Federal Reserve) have remained committed to retaining exceptionally accommodative monetary policies. There are certainly some significant downside risks that investors should remain aware of, including rising oil and gasoline prices that have been exacerbated by escalating geopolitical tensions.
Signs of US economic strength
Additionally, we have seen some continuing progress regarding the ongoing debt crisis in Europe and while the risks of chaotic defaults seem less today than they were in the middle of 2011, political developments could trigger some setbacks.
In any case, however, we believe that the macroeconomic and policy backdrop remain broadly supportive of risk assets. In the US, we expect the labour market to continue to improve as the year progresses and even the long-beleaguered housing market has been showing increasing signs of life.
Recent comments from Ben Bernanke indicate that the central bank remains concerned about economic risks and the Fed has made it very clear that its desire is to keep interest rates at historic lows for the foreseeable future. At this point, we believe that the odds for QE3 remain very low given the positive trend of leading employment and economic indicators.
One wildcard that has the potential to disrupt our generally positive outlook is the US political situation.
‘Lame-duck Congress’
The US faces some enormous economic, tax policy and debt-related issues that need to be resolved by the end of 2012, but it is becoming increasingly clear that little or no action is likely to be taken until after the November elections. There appears to be a general consensus that a lame-duck session of Congress in December will become the venue for cobbling together some new economic and tax policies, but there is no guarantee that Congress will be able to act in time to write and pass legislation.
Specifically, we believe Congress needs to extend or redesign the Bush-era tax cuts that are scheduled to expire at the end of this year and reconsider the budget sequestration that calls for $600bn over ten years in cuts for both defence and domestic discretionary spending. Should Congress fail to act, we believe there would be significant negative effects for the US economy and financial markets.
The consensus among economists is that if nothing is done, higher tax rates and sharp spending cuts would shave between 3% and 4% off the pace of US economic growth, which could trigger a high probability of a recession.
An additional issue is that the debt ceiling may need to be raised again before the end of 2012, and as we saw from the acrimonious debate surrounding this issue last year, such issues cannot be taken lightly.
Market still has potential
In recent years, Congress and the Administration have made a habit of waiting until the last possible minute to address these sorts of issue, and they certainly could do so again this year, but in any case, investors have reason to be concerned.
Our overall view about the markets is that improvements in the global economic outlook, continued easy financial conditions and slowly improving investor risk appetites are all reasons that stock prices should continue to crawl higher.
Markets have, however, paused somewhat in their rally over the past several weeks. To a large extent, this can be attributed to the fact that prices had risen so far so quickly and we have been saying for some time that markets were overdue for a period of consolidation or correction, but it is also important to emphasise that we believe we will need to see further evidence of economic improvement for gains to continue.
We continue to believe that stocks are headed higher from here and do not believe that we have seen the market highs for 2012 yet, but we would caution that the pace of gains is likely to be slower and more uneven than they were during the first quarter.
