There are slow but sure signs of recovery on the horizon of the world economy, says Rupert Elwes

While concerns surrounding the Eurozone remain at the forefront of investors’ minds and risks to the region’s growth outlook are to the downside, the creation of the long-term refinancing operations (LTRO) facility by the European Central Bank (ECB) in December (and its expansion in late February) has at least provided European banks with cheap alternative funding for the next three years, alleviating the near-term solvency concerns that so rattled markets last year.

Recovery path

US economic data has remained broadly encouraging, supporting our belief that the world’s largest economy is on a slow but sustainable recovery path; and inflationary pressures in China also started to show signs of easing, raising hopes that the authorities might look to ease monetary policy at some point this year.

Combined, these have helped to drive a rally in risk assets during the first quarter, with equities moving strongly higher (the FTSE World Index up nine per cent) and, in a reversal of trends seen over the course of 2011, with the worst performing regions and sectors of last year finding favour in the first part of 2012.

While all major regions produced solid gains, the Emerging Market and Continental European indices led the move higher. The disparity between the best and worst performing sectors was significantly wider, however, and there was a distinctly cyclical bias to the market, with the more economically sensitive technology, financial and industrial groups all registering double-digit gains.

This was at the expense of the higher yielding, defensively positioned sectors (such as telecom and utility stocks) that had delivered such strong growth in 2011 against the backdrop of significant global economic uncertainty.

Cash characteristics of the corporate sector remain extremely attractive when compared with government balance sheets in the west. The UK non-financial corporate sector alone currently holds £754bn cash on its balance sheets, equating to 50 per cent of the UK’s GDP. Given the fragility of the economy both here and in Europe, managements in the UK are still somewhat reluctant to expand capital investment in their businesses, although a growing amount of this cash is being returned to shareholders (a trend we are seeing worldwide).

Competitive advantage

In the US, however, where cash levels in the non-financial sector stood at a record US$2.2trn at the end of last year, there have been some signs of accelerating spending (admittedly helped by favourable tax treatment in 2011/12), reinforcing our belief that a slow and sustainable recovery is underway, despite the US’s own budget deficit issues.

Long-term benefits continue to be seen in the US economy from the vast discoveries of shale oil and gas in the US in the last decade, with estimates suggesting that the country (currently a net importer of energy) now has at least 100 years of energy reserves.

While oil prices have remained stubbornly high, reflecting ongoing tensions in the Middle East, drilling activity behind this newly accessible source of natural gas has recently seen the US gas price drop to a ten-year low of around US$2 per MMBtu (million British thermal units), which compares with prices approximately five times higher in Europe and as much as seven to ten times higher in Japan and Asia.

The competitive advantage to the US economy from such a ready supply of low-cost energy should not be underestimated. Combined with the availability of low-cost credit and high levels of unemployment, sustainably low natural gas prices have been the driver behind early signs of a manufacturing renaissance in the central corridor of the US.

As a result of this, many companies have moved their production back to the US from other parts of the world (including Latin America), bringing idle capacity back on stream and expand/build new facilities.

Rupert Elwes is a director and portfolio manager at J O Hambro Investment Management Ltd