It is not without irony that the US could well turn out be the strongest of the major industrial economies over the next twelve months. This would be in marked contrast to the start of the year when the question more being posed was whether Europe could survive the US economic downturn. The Fed’s aggressive policy easing coupled the complacency of the European Central Bank accounts for this relative shift in economic fortunes and goes a long way to explaining the significant outperformance of US equities so far this year.
That is not to suggest that the US economy is now set on a fair course or that Wall Street’s relative outperformance will be sustained through to the end of the year. There are still major headwinds to be negotiated in the troubled technology sector. Business investment in the US recorded it biggest decline for 19 years in the second quarter. The worst of the earnings downgrades may be behind us but there is undoubtedly more bad news to come. The US market is no longer cheap relative to its peers and offers only limited upside even if things go relatively well. And, of course, recovery later this year would leave in place the structural imbalances that were troubling economists long before the tech boom and bust hit the headlines.
For much the same reason the medium-term outlook for the US dollar looks problematic. The late 1990s economic boom caused the US balance of payments deficit to run up to unprecedented proportions. No country has ever managed to get to grips with a deficit of such a size without a weaker currency playing a major part. This may seem an old-fashioned way of thinking while the US continues to act as a magnet for portfolio capital in search its economic miracle, even if that miracle is now somewhat tarnished. But a day of reckoning for the dollar is inevitable. Calling the time of its demise is the difficult bit for asset allocators.
If we do not like the US market or the dollar, what do we like? Parts of Europe look attractive to us. These markets have suffered bigger-than-average falls this year and offer greater upside potential once the ECB relents on policy. Lay-offs in the telecom and electronics sectors have risen to crisis proportions in Europe. Unemployment will inevitably rise and as long as inflation has peaked, which it looks to have done, European interest rates should come down. Once this happens, the euro looks capable of building on its recent stronger performance. Our preference is for the more peripheral European markets where growth is stronger, inflation higher and thus real interest rates are consequently that bit lower.
In contrast, we continue to avoid Germany, which looks especially vulnerable to the downturn in the global capex cycle. We also do not like the UK, though this is a long-standing view that predates the current crisis. Our negative stance has more to do with the constrained levels of competitiveness in UK industry as a result of the high levels of sterling in recent years. However, with the help of the Bank of England even the UK market begins to look more interesting at these lower levels.
What do we make of Japan? Not very much is the brief answer. If Europe has suffered from policy inertia this year, Japan has faced a policy paralysis for as long as many investment practitioners care to remember. Interest rates have been close to zero for most of the last two years. The economy remains mired in deflation. The banking system is virtually insolvent. And the grinding bear market in equities shows few signs of relenting. Fiscal policy is quite literally a spent force and no longer seems capable of providing an answer. Indeed, the whole political process seems incapable of providing any answers. There remains hope beyond hope that the new Prime Minister will forge the necessary consensus to force through much needed economic reforms. However, with the global economy deteriorating, things seem destined to get worse before they get better.
Noel Mills is asset allocation strategist at Barclays Global Investors in London

Topics