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Ross C. DeVol
Chief Research Officer
Bioscience and Business and California and Energy and Global Economy and Health and Human Capital and Innovation and Labor and Medical Research and Regional Economics and Technology and U.S. Economy
Ross DeVol is the Chief Research Officer at the Milken Institute. He oversees research on international, national and comparative regional growth performance; access to capital and its role in economic growth and job creation; and health-related topics.
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The State of the Markets
By: Ross C. DeVol
February 11, 2013
   
   
In considering President ObamaaEUR(TM)s State of the Union address, we imagine he must be relieved that financial markets are excited about prospects for the global economy. Expectations are important for determining where the economy is headed, and the current excitement will be good for job growth. At the beginning of 2013, financial markets were cautiously optimistic, but are now bordering on euphoria. Prices of riskier assets have been pushed higher in recent months, with equities, high-yield corporate debt, and Eurozone peripheral sovereign debt markets benefiting the most. Riskier instruments in emerging and developing countries have profited from more favorable sentiment as well.

More of the optimism on the Eurozone stems from misplaced complacency than actual improvement in market sentiment. It will likely reverse itself in coming months as the deepening regional recession forces market participants to reassess conditions and conclude that they were too happy early in the year. However, the magnitude of the risks to the global economy has subsided, and financial markets reflect the lower probability of black swan outcomes. Central banks in the advanced economies seem committed to providing liquidity and keeping nominal short-term interest rates low and real rates negative for an extended period. In the U.S., the Fed has announced its guidelines for removing extraordinary monetary measures. It will do so when unemployment falls below 6.5 percent and will tolerate inflation of up to 2.5 percent to achieve it.

A more balanced distribution of macroeconomic and financial risks seems justified with upside possibilities emerging, especially in the U.S. and China, the two largest economies in the world. My previous expectations for world economic growth and financial market conditions were more sanguine than the consensus over the past 12 months, with the exception of the Eurozone, where my more negative views were validated. My current view is that the outlook for global growth is brighter, and therefore stock markets are reflecting higher earnings expectations and less risk. But despite this improved environment, markets are in too much of a celebratory mood. Once it becomes clear the Eurozone is in recession, equities and other riskier assets will pull back some in the spring. However, equities in most regions will end the year higher than they are today, as some leading indicators suggest that the Eurozone is seeing early signs of reaching a trough.

  • U.S. economic growth will be 2.5 percent in 2013 and 3 percent in 2014, supporting equity prices (S&P 500) hitting 1,550 by year-end 2013, but not before pulling back to 1,475 in the spring.
  • The reality is that Eurozone real GDP will fall another 0.5 percent in 2013 before recovering a modest 0.9 percent in 2014.
  • By 2014, ChinaaEUR(TM)s expansion pulls the entire global economy along with it.
  • Recent readings on the industrial sector suggest it will begin to support Brazilian growth in 2013 rather than detract from it.
  • The Eurozone recession restrains world real GDP growth to 3.2 percent in 2013, but it accelerates to 3.8 percent in 2014.
President Obama should be happy that the fundamentals in the U.S. economy have improved over the last several years. Corporate balance sheets are robust, banks have rebuilt capital buffers, consumers have shed debt, jobs are growing modestly, housing prices have stopped falling, and low natural gas prices have improved industrial competitiveness in energy-intensive industries. If the President and Congress can put aside partisan bickering and work out a medium-term deficit reduction plan that avoids the sequestration cuts, financial market optimism may be proven correct.

See the full report: Is the New Year Too Happy?