Global Economic Revisions

The sharp decline in global stock markets last week was in large part attributed by the financial media to economic warnings issued by the Federal Reserve and the International Monetary Fund (IMF). The reports spawned a rash of recession forecasts as markets tumbled. A closer look at the press releases of these institutions, however, reveals a far less ominous outlook of continued albeit more modest growth. 

Financial markets were well aware before last week that the U.S. and European economies were weakening and that there was a rising risk of further deterioration. It was the Fed’s language that startled investors. Their September 21 policy statement asserted that “there are significant downside risks to the economic outlook, including strains in global financial markets. ”This was a sterner warning than the Fed’s August 9 alert that “downside risks to the economic outlook have increased.” 

Investors evidently overlooked the positive growth forecast in the Fed’s statement: “The Committee continues to expect some pickup in the pace of recovery over coming quarters” and anticipates a gradual reduction in unemployment. Indeed, three members of the ten-member Committee believed the economy was not in imminent peril and voted against the Fed’s new “operation twist” policy on the grounds that they “did not support additional accommodation at this time.” 

In its semi-annual global economic report released last week, the IMF alarmed investors with the opening statement: “The global economy is in a dangerous new phase. Global activity has weakened and become even more uneven, confidence has fallen sharply recently, and downside risks are growing.” In the introduction, Executive Counsellor Olivier Blanchard pointed out that “fear of the unknown is high” and concluded: “In light of the weak baseline and high downside risks, strong policy action is of the essence.” 

The actual growth projections in the IMF forecast are more encouraging. Global GDP growth is expected to be 4.0% in 2011 with an additional 4.0% in 2012. The U.S. will avoid recession with 1.5% growth in 2011 and 1.8% growth in 2012. The Euro Area is projected to slip but remain positive: 1.6% growth this year will slide to 1.1% in 2012. The emerging and developing economies will continue to drive global growth with gains of 6.4% in 2011 and 6.1% in 2012. China and India will maintain their torrid pace with 2012 gains of 9.0% and 7.5%. 

 Supporting these forecasts of continued GDP growth this and next year is the consensus outlook of economists polled by The Economist. The U.S. is expected to grow 1.6% in 2011 followed by a modest rise of 2.0% in 2012. Euro Area growth will remain positive but slump from 1.7% this year to 1.0% next year. The widening gap between the developed and the emerging economies, so pronounced in the IMF forecast, is also reflected in the consensus outlook: China is predicted to slow only modestly from 9.0% to 8.6%, whereas economists foresee India’s GDP will rise from 7.9% to 8.2%. 

 In review, the broadly accepted, probable scenario projected by professional economists is that the U.S. and Euro Area will muddle through with the support of continued strong growth in the emerging economies. Even though the economists do not believe recession is likely, they acknowledge that the global economic outlook has dimmed, the risk of a further deterioration has risen, and a further reduction in estimates may be necessary. All eyes will focus on the policy makers to take decisive action to raise consumer and investor confidence and restore healthy growth.

Clouds Gathering on the U.S. and International Economic Horizon

There is a growing consensus among economists that the U.S. economy is slowing, and this revised outlook is being reflected in the stock and bond markets. A late April survey taken by the National Association of Business Economists, released on May 16, projected 2011 U.S. GDP growth of 2.8%, down from their early February forecast of 3.3%. The slowdown, first evidenced in disappointing 1st quarter GDP growth of only 1.8%, was also featured in The Economist’s recent cover article “What’s Wrong With America’s Economy” (April 30-May 6).

The reduced outlook for the U.S. economy comes at a time when doubts are also spreading regarding the strength of the international economies. In Europe the sovereign debt crisis has reached an ominous level: the austerity programs crafted by desperate governments in Greece and Spain are encountering increasingly belligerent popular resistance, and the policy makers at the European Central Bank (ECB), the International Monetary Fund (IMF) and leading Euro-area governments (notably Germany) have become more divided and intransigent in their failed effort to agree upon a remedy. Crippled by the economic consequences of the earthquake/tsunami/nuclear catastrophe, Japan has again retreated into recession. Within the leading emerging economies of China, India, and Brazil, intensifying inflation has forced governments and central banks to adopt ever stronger restrictive measures, which in turn has led to heightened investor fears of “hard landings.” In this perfect storm of economic concern, the Economic Cycle Research Institute (ECRI), a widely watched barometer of trends with an exemplary track record, issued on May 19 a statement that “there’s a downturn in global industrial growth in clear sight,” but added that they saw no sign of a renewed recession.

The response of global financial markets has been swift, and arguably excessive. Investors have suddenly turned cautious. In the midst of a flight to safety, the yield on 10-year U.S. Treasury notes plummeted from 3.59% in mid April to 3.13% on May 23. The U.S. dollar reversed a 4-month slide and in a three week period stretching from April 29 through May 23 rose 4.3% against a basket of currencies. On the other side of the coin, the prices of economy-sensitive commodities, which had soared for a year with only minor interruption, crashed: during this same three-week period, the CRB Index of agricultural and industrial commodities plunged -9.1%. Also damaged in this period were the international stock markets. As volatility rose to unnerving levels, the iShares MSCI ETF of developed countries (EFA) slumped -6.9% and the iShares MSCI ETF of emerging economies (EEM) sank a chilling -7.8%. The Standard & Poor’s 500 Index fared better with a more modest decline of -3.4%, but within the U.S. market there was a seismic rotation. Out of favor were many of the economy-sensitive, high-growth, low dividend, small and mid cap stocks that had led the market since the beginning of the bull market in March of 2009. Elevated to favor were many of the recession resistant, slow growing, high dividend, and previously underperforming mega cap stocks. Out were energy, materials, industrials, and information-technology stocks; in were health care, consumer staples, and utilities stocks.

If the recent economic developments and financial market trends persist and strengthen they will present a challenge to the consensus (and our) global economic outlook and investment strategy. Have we reached a point where it is necessary to alter our view of a healthy, if geographically unbalanced, multi-year global economic expansion extending through at least 2012 and abandon the growth-oriented equity strategies that have served us so well the past two years? At this point, we do not think so. The highest probable scenario, in our view, is that the global economy will experience a “soft patch” and choppy stock markets followed by a resumption of 4-4.5% economic growth fueling further market gains. We note that “soft patches” are a normal phenomenon of past economic cycles, and it would be very unusual for a cycle to last only two years.

It is not possible, at this juncture, to predict with conviction the severity or duration of a “soft patch,” but the prospect of a double-dip recession is quite low. There are many positive developments buttressing economic growth. The employment picture continues to improve gradually, consumer spending is resilient, corporate profits and balance sheets are very strong, interest rates are very low, exports are robust, financial institutions continue to strengthen and are more willing to lend, etc. Very important is that the outlook for inflation, which has been a major factor in igniting economic and market fears, is significantly improved by the recent sharp decline in commodity prices. Since the end of April through May 23, when the CRB Index retreated -9.1%, the price of crude oil dropped -14.2%. We expect a summer pick up in U.S. consumer confidence as gasoline prices fall, and relief from rising food and energy prices in the emerging economies may permit policy makers to back away from policies designed to slow their economies. The global equity strategy group at Citigroup on May 19 observed that the commodity price pullback indicates that a peak in inflation and interest rates is imminent in the key emerging economies of China, India, and Brazil, and predicted a 31% rise in emerging economy equities by the end of 2011.

Like the economy, there are also positive conditions supporting the U.S. stock market. Strong corporate profits continue to provide attractive valuations despite the large stock gains of the past two years. In addition, huge corporate cash positions should result in higher dividends, a pick up in stock buyback programs, and an acceleration in merger and acquisition activity. Further, interest rates are low and the Federal Reserve is implementing a very accommodative policy. Also worth noting is that a mountain of cash remains on the sidelines even though money-market funds yield little or nothing. The alternatives to stocks are not very appealing: bond yields are low and their prospects are limited by credit issues and the threat of future inflation. The real estate market is moribund and likely to remain so until well into 2012.

We currently encourage investors to exercise patience and adhere to long term asset allocation guidelines and norms. Conservative investors may chose to exercise a higher than usual level of caution to adjust for the more elevated risk in the economy and markets and to increase their comfort level in what may well be a choppy market. We also recommend that investors maintain broad geographic and industry diversification in their equity holdings, take a longer term perspective in the midst of heighted volatility, and monitor closely the fundamental progress of companies in their portfolio. This is a time when it is necessary to have a high level of confidence in the fundamental strength of portfolio companies. Above all, investors need to be especially vigilant and flexible.

China, India, and Brazil: When Too Much Growth is Bad

On December 25 the People’s Bank of China (PBOC) hiked both the key 12-month lending rate (from 5.56% to 5.81%) and the 12-month deposit rate (from 2.50% to 2.75%). This marked the latest effort in the Chinese government’s year-long campaign to ward off inflation by cooling its overheated economy. Although these steps were widely anticipated, the Shanghai stock market immediately retreated and triggered selling in many other emerging-country stock markets.

The related issues of strong economic growth, rising inflation, restrictive initiatives implemented by policy makers, and a disappointing stock market have been building for a year and are not limited to China. A similar set of conditions has plagued the leading emerging countries of India and Brazil. At the beginning of the year, consensus 2010 GDP growth projections were 8.6% in China, 6.3% in India, and 3.8% in Brazil; economists currently estimate 2010 growth of 10.2% in China, 8.8% in India, and 5.5% in Brazil (The Economist, 1/2/10 and 12/18/10). Along the way, inflation and fears of asset bubbles have spread: inflation in China is currently running at an annual rate of 5.1%, in India at 9.8%, and in Brazil at 5.6%. In all three countries the governments and central banks have reversed the economic stimulus initiatives of 2008-09 and are now applying the brakes.

In a May 12 blog on International Stock Markets: Searching for Goldilocks, we highlighted the negative impact that these restrictive policies in China, India, and Brazil were having on their previously sizzling stock markets. Since May, the inflation threat has grown and clouds have continued to hang over these markets: The Shanghai Composite (CSEX) is down -15.1% for the year to date, the Brazilian Bovespa (BSPI) is off -0.1%, although the India BSE 100 Index has mustered a respectable 12.9% gain. For the same period, the S&P 500 Index has rallied 12.7% despite unimpressive GDP growth of about 2.8%.

At this point the consensus view, which we share, is that in early 2011 the policy makers in each of these 3 countries will escalate their war on inflation with additional measures, and the consequence could well be stalled or disappointing markets. There will be many investors who fear that the steps taken by the policy makers will be too little and too late, and the result will be destabilizing inflation and asset bubbles. Many other investors will be convinced that the policy makers will go too far and cripple economic growth. To the contrary, our view is that the policy makers will be able to pilot a soft landing, i.e. to cool their economies to healthy and sustainable growth with reduced inflation. We note that most economists predict modest slowdowns in 2011 sufficient to arrest inflation fears: the latest poll taken by The Economist forecasts slowing 2011 GDP growth to 8.9% in China, 8.6% in India, and 5.1% in Brazil. If our view is correct, then we expect a buying opportunity lies ahead for the stock markets of these leading emerging countries and the multinational companies that supply the rising demand of their mushrooming middle classes.

U.S. Corporate Profits and Stock Prices

Our forecast for the U.S. economy, corporate profits, and stock prices in 2011 supports a positive if cautious outlook:

• The U.S. stock market’s rally since 3/9/09 rests on a solid foundation of rising corporate earnings.

• The market is not currently overvalued, and there is room for a further advance if the 2011 profit expectations of market strategists and research analysts are valid.

•  We caution that these 2011 earnings estimates underlying a further U.S. bull market advance rest on shaky economic ground. If the economic outlook deteriorates further, companies with excessive exposure to the U.S. and other developed countries may report earnings disappointments and suffer stock price declines. We recommend investors take a global perspective and emphasize markets in fast growing economies and the stocks of multinational companies in the developed countries that have strong business opportunities in these fast growing economies.

Despite an anemic, subpar economic recovery, the Standard & Poor’s 500 Index has soared 74.9% since hitting bottom on March 9, 2009. The headwinds have been and remain formidable: weak consumer spending and confidence, sky-high unemployment and underemployment, a soggy housing market flooded by foreclosures, a troubled financial system that continues to restrain credit, and a nagging fear in business circles that Washington not only can’t remedy the problems but may make matters worse. On the other hand, the roster of positives boosting the market has evidently more than offset these negatives. These include strong corporate profits, low inflation and interest rates, a very accommodative Federal Reserve policy, an attractive market valuation coming off recession lows, and the relative lack of appeal of money market funds, bonds, and real estate.

In our view, the most important ingredient in the bull market recipe has been surprisingly robust corporate earnings. According to First Call, the trailing 4-quarter earnings per share (EPS) for S&P 500 companies rose from $62.85 as of March 31, 2009 to $79.05 on September 30, 2010, which is an increase of 26%. This includes an estimated 13% gain in year-over-year profits for this year’s 3rd quarter. Bloomberg reported on October 4 that more than 70% of S&P 500 companies have exceeded the average analyst profit projection for 4 consecutive quarters, which marks the longest streak since Bloomberg began tracking corporate earnings in 1993. We are convinced that positive earnings surprises and upward revision of future earnings estimates are the most powerful catalysts in lifting stock prices. The jump in earnings also keeps the market’s valuation attractive despite the huge run up in stock prices: the P/E ratio of the S&P 500 Index based on trailing 4-quarter earnings was 15.0% on September 30, which is close to the long term norm.

The key question now is whether 2011 profits will be strong enough to sustain the bull market. Clouding our optimism is that many economists are now predicting GDP growth next year to slow from its current sluggish rate. In The Economist’s latest polling of economists (10/23/2010), the consensus trimmed its 2010 U.S. forecast to 2.6% and predicted a further slide to 2.4% in 2011. We pointed out in our October 21 blog that in early October the International Monetary Fund (IMF) issued a similar 2011 GDP slowdown to 2.2% for developed countries as a group (the U.S. Europe, Japan, Australia, et.al.). As the IMF sees it, the economic recovery over the past 15 months has been driven by fiscal stimulus and inventory accumulation, and both are coming to an end. In the future, growth will have to come from consumption and investment, which in the developed countries are weak and not expected to improve much. A possible income tax increase in the U.S. and budget austerity programs in Europe would exacerbate the already meager 2011 prospects for growth.

There are two ways to measure 2011 S&P 500 profit expectations. A top-down forecast of market strategists, based on fundamental economic and financial market assumptions, is rosy: experts canvassed by First Call foresee a 14% advance, whereas the participants in Bloomberg’s poll anticipate a 9% rise. Even more optimistic is the bottom-up aggregate outlook provided by research analysts estimating company profits: 8,500 analysts tracked by Bloomberg expect a 15% increase. It is noteworthy that these 3 EPS estimates, which range from $87.34 to $95.95, are all above the pre-recession level of $86.20 reached in 2007. Also noteworthy is Bloomberg’s assessment that the S&P 500 is currently valued at 12 times projected income for 2011, which is “the cheapest level since 1988 (excluding October 2008 to March 2009 after New York-based Lehman’s bankruptcy), relative to reported profit from the past 12 months.”

Global Growth Opportunities: India

We are impressed with the strength and future prospects of India’s economy, and we think its equity market is increasingly attractive. During the 2003-2007 global expansion, India’s robust GDP growth (which hit 9.1% in 2007) was driven by consumer demand arising from a mushrooming middle class. With only about 20% of the GDP dependent on exports, the economy was relatively isolated from the recent recession in the developed countries and enjoyed growth of 5.1% in 2008 and 7.7% in 2009. Now the economy is accelerating again: the World Bank estimates GDP growth will top 8% in 2010, with further gains of 8.7% in 2011 and 8.2% in 2012.

India’s astonishing growth, second only to China’s among the leading emerging economies, will continue to rest on the size, youth, and growing prosperity of its working class. The U.N. forecasts that the working-age population in India is expected to expand to 275 million, a rise of 46%, by the year 2025. An article in The Economist indicates that by 2020 three out of every ten new entrants to the global workforce will be Indian. Conversely, the working-age populations in the U.S and China are expected to grow by a mere 12% and 10%, and the working-age populations in Japan and Europe are expected to decline by -17% and -13%, respectively.

In addition to a burgeoning workforce, household incomes are also rising. In 2009, the IMF estimated India’s per person annual income at $1,031. At less than half the annual per person income in China and the other leading emerging economies, there is plenty of room for income growth without damaging productivity or international competitiveness. Multinational corporations, including those in China, are expected to increase outsourcing to India.

Challenges that may restrict long term growth include high inflation, inadequate physical and social infrastructure, and an ineffective and protectionist government. The Economist lists India’s inflation at 11.3% and their latest poll of economists predicts full-year 2010 inflation to be 11.4%. Recent trends such as moderating food and commodity prices, however, should reduce 2011 inflation to a manageable 5-6%.

A retardant to India’s current growth but a boost to future growth is a dilapidated infrastructure, which the government intends to upgrade with a $1 trillion investment between 2012 and 2016. To successfully implement these upgrades, India needs government reform. Historically, India’s democratic government has favored protectionism, complex labor laws, regulations that differ from industry to industry and has tolerated a lack of coordination among local government agencies. The 2009 election of Mr. Singh and Mrs. Gandhi is promising.

The investment implications of India’s rapid and assured future growth, coming at a time when the economies of the U.S., Europe and Japan are struggling, are manifest. The benchmark Sensex Index of India stocks rocketed 501% during the 2003-2007 expansion, and it soared 130% from the beginning of the global stock market rally on March 9, 2009 through September 12, 2010. In contrast the S&P 500 advanced a modest 67% and 63% during these two periods. We recommend investors focus on the stocks of Indian and other multinational companies which provide goods and/or services to the surging working class or which support infrastructure improvements.

International Stock Markets: Searching for Goldilocks

Heading into 2010, we shared the view of a majority of international investors that the best performing stock markets this year would be China, India and Brazil. This expectation was based on the consensus forecast of economists polled in December by The Economist that these 3 countries would enjoy 2010 GDP growth of 8.6%, 6.3% and 3.8% respectively. In contrast, the major developed economies of the U.S., Europe and Japan were projected to experience anemic, subpar growth ranging from 0.6% to 2.4%. Since then, the economic performance of each of these leading emerging economies has exceeded expectations, and growth estimates in the latest poll of The Economist have been raised to 9.9%, 7.7% and 5.5% respectively. Nevertheless, the stock markets in these countries have been disappointing: for 2010 through May 10, the Shanghai Index (CSEX) has retreated -17.6%, the India Sensex (IBSI) is off -0.8% and the Brazil Bovespa (BSPI) has fallen -8.3%. In the much slower growth U.S., where 2010 GDP growth is currently pegged at 3.1%, the S&P 500 Index is down only -0.4%.

Why is this happening?

The problem with the stock markets of China, India and Brazil is that their economies are too hot. That is, accelerating growth is giving rise to fears of excessive inflation and asset bubbles. In China, for example, the government recently announced that April year-over-year consumer prices rose a more-than-expected 2.8%, producer prices jumped 6.8%, and property prices soared 12.8%. Consumer prices in Brazil are projected to rise 5.2% in 2010, and India inflation could top 12%. In response, the central banks in these countries have initiated policies designed to cool their economies. Some observers think the steps taken by the policy makers are too little and too late, and the result will be the dreaded inflation and asset bubbles. A contrary opinion is that the central bankers will be excessively restrictive and cripple economic growth. It is normal in the economic cycle for governments and central banks to reverse stimulative polices in the aftermath of recessions as recoveries gain strength. It is also normal for investors to question the outcome of a change in policy, and there is ample historical precedent in the U.S. and abroad of investors pulling back to wait and see if the policy makers are able to pilot a soft landing.

At the opposite extreme are the economies of Europe and Japan, which are too cold. Growth outlooks for these countries were weak at the beginning of the year, and the future now appears to be even bleaker. The highly publicized debt problems of Greece, Portugal and Spain will surely lead to austerity measures that will further retard growth, and quite possibly push the countries back into recession. Italy, Ireland and even Great Britain also have severe deficits that will require government action. The massive holdings of these countries sovereign bonds held by the leading banks of Germany, France, and Switzerland could spark a further crisis if the debt laden countries are unsuccessful in implementing adequate austerity programs. The consensus foresees 2010 Euro and GDP growth of only 1.1%, and we suspect that this gloomy assessment may be revised downward. It thus comes as no surprise that for 2010 through May 5 the Euro Area (FTSE Euro 100) stock index suffered a -9.6% decline. As for Japan, we expect another year of very modest growth (2.0%) and debilitating deflation (-1.0%).

Positioned comfortably between the too-hot Asian economies and the too-cold Euro Area and Japan, the U.S. economy is providing a propitious environment for common stocks. Favorable employment, consumer spending and manufacturing data indicates that the recovery is picking up steam, and the 2010 GDP growth outlook is now above 3%. Corporate profits have been above Wall Street expectations, and research analysts are raising significantly their 2010 earning estimates. On the other hand, growth has not been so strong that inflation forecasts have become ominous and, of great importance to investors, the Federal Reserve has repeatedly expressed its intention to keep interest rates at a historically low level “for an extended period.” To be sure, the major headwinds buffeting the U.S. stock markets thus far in 2010 have emanated from Asia, South America and Europe.

What lies ahead? Can investors anticipate a change?

We think the policy makers in China, India and Brazil will successfully guide their economies to a soft landing, and will then halt their restrictive measures in order to usher in long-term sustainable economic growth with controlled inflation. The Economist’s latest poll supports this view: consensus 2011 GDP forecasts for China, India and Brazil are 8.1%, 8.0% and 4.5% respectively. We expect the governments and central banks to complete their braking activities some time in the next 6 months, and investors will likely anticipate this green light and restore bull markets for the duration of a multiyear expansion. It makes sense that investors will migrate back to these geographic areas where growth is greatest once government and central bank policies are no longer threatening.

We are less positive regarding the stock market prospects of the developed countries over the next year. Japan and the Euro area will simply not have sufficient growth to attract investors. On the other hand, some of Europe’s leading export-oriented companies, aided by the weak euro, deserve investors’ attention. We expect the U.S. stock market, which has rallied for 14 months without a 10% correction, to stall, or possibly retreat, when the Federal Reserve signals its decision to gradually restore long-term norm interest rates from the current recession lows. There is much debate as to when this might occur, but most Fed watchers believe it will be within the next 9 months. We think the Fed may wait until after the November election, by which time job growth and a stabilized housing market will put the recovery on firmer footing. We further expect the Fed to alert investors of a new tightening policy several months in advance by eliminating the “extended period” language in statements regarding their interest-rate deliberations. Worth noting is that 1-2 years into the past 2 recoveries from recession, in 1994 and again in 2004, the Fed commenced to hike rates, and on each occasion stock market rallies abruptly halted as investors turned more cautious.

We remain convinced that investors who take a global perspective will be amply rewarded.

Global Growth Accelerating

In yet another indication that the global economic recovery is gaining momentum, the International Monetary Fund (IMF) has again raised its projections (see our January 28 blog). On April 21 the organization bumped its 2010 global GDP forecast from 3.9% to 4.2% and reiterated its prediction of 4.3% in 2011

The IMF continues to emphasize that the expansion will be lead by the leading emerging economies of China, India and Brazil with growth increases of 10.0%, 8.8%, and 5.5% respectively. The IMF also continues to anticipate sluggish growth in the Euro Area (1.0%) and Japan (1.9%) but they are becoming more optimistic regarding the U.S. with GDP growth raised from 2.7% to 3.1%.

The IMF forecast is supported by a consensus of economists that the latest monthly polling by The Economist foresees modest 2010 GDP growth in the Euro Area (1.2%) and Japan (1.9%), slightly higher growth in the U.S. (3.1%) and robust growth in China (9.7%), India (7.7%) and Brazil (5.5%). Worth noting is that these economists anticipate a broad-based as well as a multiyear expansion. The consensus expects positive 2010 growth in 38 of the 42 countries included in the survey (negative growth is projected for Greece, Spain, Hungry and Venezuela) and additional gains in 2011 for 40 of the 42 (Greece and Venezuela are the exceptions).

Threats to Global Economy and Markets

The blood pressure of the investment community has been elevated several notches in recent weeks as threats to the global economic recovery have surfaced. Stock markets around the world have slumped with unnerving volatility, even though a consensus of economic forecasters have reassuringly continued to project a solid if not spectacular global recovery in 2010 and the latest batch of corporate earnings reports have been well above analysts’ expectations. Creating additional palpitations has been a sharp drop in commodity prices and a corresponding rise in the dollar as risk-averse investors have responded with a flight to safety.

The Economist (February 13-19, pp. 13, 70-72) provides an excellent, succinct overview of the dangers confronting the world economy and offers pragmatic recommendations to government and central bank policy makers. In its cover article, the magazine emphasizes the gulf between the troubled U.S., European, and Japanese economies “where there are few signs of strong private- demand growth,” and the leading emerging economies of China, India, and Brazil, where there is “strong growth in domestic demand and scant spare capacity.”

The challenge for the policy makers in the developed countries is to engineer growth even as they are forced to come to grips with massive budget deficits. The problem is especially vexing for European leaders, who are under pressure to formulate a rescue plan for Greece and, possibly, for Portugal and Spain as well. We think the European Union will successfully if grudgingly provide a solution that will calm jittery currency markets, although the remedy may result in painful austerity for the indebted countries and political fallout for those governments, notably Germany, that may be called upon to finance a bailout.

In sharp contrast, the Chinese, Indian, and Brazilian governments are concerned that rapid growth will trigger inflation and create asset bubbles. Policy makers here are taking steps to rein in growth, which in turn worries some investors that their braking activity will become excessive and produce a slowdown that endangers the global recovery. The focus is on bank lending restrictions imposed by the Chinese government since the beginning of the year. We share The Economist’s view that “for all the market’s worries, there are few signs that it [the Chinese government] will tighten too much too fast. A slowing is possible, but a serious stumble seems unlikely.” We also note a recent article in The Wall Street Journal (2/8/2010), which reports that last week Citigroup, Bank of America Merrill Lynch, Goldman Sachs, and J.P. Morgan Research all issued reports touting upside expectations in emerging markets this year.

Although we think these threats to the world economy and equity markets will eventually be resolved without calamity, we also acknowledge that investors should not become overly sanguine. We will continue to monitor closely these international developments and we remain flexible. We also alert clients to expect market volatility until these matters are resolved.

China and Brazil Watch

In our January 4 Outlook, we contrasted the accelerating economic strength of China, India, and Brazil with the struggling U.S. and European recoveries. Fresh evidence of Chinese prosperity is the surprising surge in both exports and imports in data released overnight. Another indication may be found in today’s Financial Times in an article “China lenders eclipse U.S. rivals.” The article reveals that all 7 of the world’s top valued banks (ranked by bank share price to book value) are Chinese or Brazilian, and concludes the data “reflect growing [investor] confidence in emerging markets, particularly China and Brazil.” In 2000, 5 of the top 6 highest valued banks were American. To highlight the contrast among economies, another article on the same page of the Financial Times, “Lingering doubts over recovery keep European inventories low” reveals that European business executives continue to have very low confidence in their own economic future. To be sure, the latest The Economist poll of forecasters (1/9/2010) foresees an anemic 1.4% real GDP growth for Euro area in 2010.