International Equity Commentary: April 2014

Equities See Upside, but Loss of Momentum in Japan and Slowdown in China a Concern

International equity prices made moderate gains in April, helped by signs of continued economic recovery in Europe. Economic indicators from the region suggested further gains in industrial output and consumer spending. Borrowing costs for the countries most affected during the downturn remain very low, comparable to stronger economies such as Germany. However, gains for international equity indices were held in check by concerns about the Japanese recovery losing momentum. In the absence of robust export growth, the Japanese economy is expected to slow down during this quarter as higher consumption taxes restrict consumer spending. Emerging markets underperformed during the month on persistent doubts about weaker growth in China, even as Russia declined further on heightened geopolitical risks.

Global manufacturing activity data for the month of April confirmed the positive trends in the developed world, even as some of the emerging economies continue to see stagnation. In the Euro-zone, manufacturing output expanded in all countries as healthy growth in Germany continues to lift the region. Spain and Italy saw acceleration, though the gains were muted in France. The Euro-zone unemployment rate saw a marginal decline, but remains high. U.S. factory output growth remained steady while Japan saw a decline as businesses have become less optimistic of consumer demand after the consumption tax hikes. Among the emerging economies, output growth remained subdued in China for the third month. Korea, Taiwan, Indonesia, and India continued to expand, though the pace of growth in some of these countries remains restricted. Most Asian countries have seen relatively soft export growth in recent months, except Korea which reported better than expected gains in April.

Near-Term Outlook

The optimism about the Japanese economy making a strong rebound, which fuelled the significantly large equity market gains in 2013, has faded this year. While the Bank of Japan continues to maintain its aggressive monetary easing measures, consumer spending is expected to decline as taxes have been increased to cover the government’s widening fiscal deficit. Exports from the country have not improved as expected, despite the sharp currency decline since the last quarter of 2012. In fact, export growth during the first quarter was the slowest in recent years and the trade deficit has widened further. While inflation has picked up over the last year, it remains below the central bank’s 2% target and may slip if consumer demand weakens. The Bank of Japan has recently lowered its GDP growth forecast for the fiscal year ending March 2015 to 1.1%, from 1.4% earlier. To ensure that the recovery is not derailed, the central bank may have to expand its asset purchases. Also, in our view, the government cannot delay any further the proposed structural reforms such as lower corporate taxes.

In contrast, investors appear to have become more optimistic about the economic prospects for Europe. Nominal long-term bond yields of countries such as Spain and Italy have declined further this year, and are widely seen to confirm the improved outlook. However, inflation is also well below expectations and real yields have not declined as much when compared to last year. Inflation in the Euro-zone increased to 0.7% in April, but remains well below the European Central Bank’s target of 2%, and may prompt additional monetary measures during this quarter. While the Euro-zone economy has improved appreciably from last year, the pace of growth is not yet strong enough to reduce the exceptionally high unemployment rates in select countries. In the U.K., inflation has trended lower in recent months and remains below target. However, the better than expected aggregate growth and the sustained surge in average home prices could encourage the Bank of England to consider hiking the benchmark rate later this year.

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