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Euro Zone Slipping Into Recession

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Uncertainty prevailing in the Euro-zone has seen Nick Cringle, global co-CIO, RBS Wealth Management, cutting his client exposure in equities by 40-50 per cent for investors — both conservatives and risk takers. Instead, he has been parking their money in safe havens like Swiss Franc, gold, US dollar and US bonds. Talking to BusinessWorld's Mahesh Nayak, he said the European crisis would see risk assets (equities) moving further south and market momentum and sentiment would return only if sustainable policy measures like aggressive quantitative easing and short-term fiscal stimulus are introduced in the US and Europe along with credible medium-term fiscal consolidation plans. As for the Indian market, he expects it to move in line with the global markets.
Excerpts from the conversation:

What is your view on Indian and global financial markets?

Recent events have reinforced our cautious view on risk assets as game-changing policy is still not evident and valuations are yet to reach compellingly attractive levels.  We continue to be cautious due to the high level of political risk, especially in Europe, and increasing evidence of a globally synchronised slowdown. In such circumstances, it is often the case that markets only bottom when valuations become compellingly attractive, or there is some sort of positive policy hammer blow that convincingly changes the direction of markets. So far we have not seen either. We expect the Indian markets to move in line with the global markets, even though valuations appear attractive. The prevailing volatility in global markets combined with domestic high inflation, rates and earning downgrades could contribute to domestic pessimism.

When do you see the clouds of uncertainty getting clear?
Market momentum and sentiment will only turn if some sustainable policy measures are introduced. These would include aggressive quantitative easing in the US and Europe; a shift to explicit inflation targeting in the US; short-term fiscal stimulus in the US and Europe combined with credible medium term fiscal consolidation plans and/or a combination of monetary and fiscal stimulus in China and material currency appreciation.

In the absence of such concerted policy action, risk assets can be expected to weaken further in the coming months. At some point, valuation will kick in as a driver, but before it does, risk assets will fall further in price.

What are the major challenges and concerns for the markets — Indian and global?
In the recent weeks, the European crisis has entered an even more serious phase, with Italian and Spanish bond yields reaching around 7 per cent level, prevented from going higher still only by ECB bond buying in the secondary market. Also, it is difficult to see how the EFSF bailout fund can remain credible. Perhaps even more worrying, the crisis has moved right into the core of the Euro Zone with the spread between German and French 10-year bond yields hitting 200 bps. Political risk at a European level is still very high, with Germany and France in open disagreement about the extent to which the ECB should intervene in government bond markets.

In addition, the newly appointed technocratic governments in Italy and Greece could face immense difficulties and opposition in reforming their economies. In addition, the Euro Zone is tipping into recession, making fiscal consolidation that much harder for periphery and core Euro Zone countries alike. Leading indicators suggest the Euro Zone is already slipping into a substantial recession driven by banks' deleveraging, fiscal consolidation and the shock to business and consumer confidence that the European financial crisis has created. It is not inconceivable that one of the smaller Euro Zone countries such as Greece should attempt to leave the Euro Zone in the next twelve months as domestic populations rise up against years of fiscal austerity. Such an event would quickly lead to contagion to other European periphery markets and increase financial stresses further.

Even if the ECB does eventually relent, and engage in full-blown quantitative easing (QE), this will no longer be the silver bullet that it could have been 6 or 12 months ago. Put simply, despite some improvement in the US outlook, the risks to the global economy lie firmly to the downside because of the escalating crisis in Europe. This policy coordination may have to include not only ECB QE, but also outright reversal and pursuit of fiscal stimulus in major economies like the US and China in particular.

In case of India, growth is tempered by high cyclical inflation and rates combined with delay in policy decisions. Further, with heightened risks of slowing global economic growth, Euro Zone's debt crisis and concerns of contagion effects have kept the markets volatile in sync with the global equity markets and also kept external investors guarded. However, India's resilience, reflected by over 8 per cent GDP growth during the global slowdown is the re-iteration of its strong fundamentals driven by domestic consumption and investments and its minimum dependence on external trade. While this inward nature of the market would insulate partly the economic growth, we expect moderation in growth at 7.5 per cent in FY12.

What would you advice investors to do in the current environment?
Due to the risk factors highlighted above we believe that there will be increased volatility in equity markets going forward, with a downside bias. We have already taken action to de-risk our global portfolios in light of the above mentioned risks. From an overweight Indian equities in March'11, we have turned to underweight in three phases from Aug'11 on the back of global developments. We like defensives namely Health care and Consumer Staples, while we are underweight cyclicals namely Materials and Industrials.

This would be a great opportunity for Indian investors to increase fixed income allocations, to benefit from the prevailing cyclical high yields & our belief that Interest rates are close to peaking out. Clients should look at investing in a mix of accrual & duration strategy to take advantage of this interest rate cycle.

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