From time to time, Morningstar publishes investment commentary and insight from asset managers, educational institutions, and registered investment advisers under as part of our third-party "Perspectives" feature. If you are interested in Morningstar featuring your content, please contact Online Editor Holly Cook at holly.cook@morningstar.com. Here, Philip Poole, Global Head of Macro and Investment Strategy at HSBC Global Asset Management says that despite double dip concern, activity remains encouragingly robust in much of the world. This article was first written on September 7, 2010.
Struggling to Adjust
London is struggling to cope with a strike by underground staff. Today’s disruption will not be the last and industrial action in the UK is unlikely to be limited to the tube or the transport industry more generally. Moreover, industrial action will not be confined to the UK. It is likely to prove to be a general feature of the economic landscape in much of the developed world for several years to come.
Why so gloomy a prediction and what are the implications for investors?
The reality is that the UK, in common with the US and much of the rest of the developed world has been living beyond its means. In the pre-crisis ‘party’ world, governments and households were borrowing to support a life-style they couldn’t afford. Now the party is over but the bill is still to be paid.
In the UK, the ratio of government debt to GDP rose from 45% in 2000 to more than 70% at the end of 2009. The story for households is even more extreme. Over the same period household indebtedness as a percentage of GDP has increased from 77% to close to 115%. The US tells a similar story: government debt increased from 55% to 83% and household debt is now close to 100% of GDP. The global crisis intensified the deterioration in developed world financial performance as governments and central banks stepped in to stave off economic collapse, massively increasing public sector liabilities in the process.
The upshot is that government spending will have to be cut across much of the developed world – in some cases savagely – and this will include public sector jobs as government activity is resized to reflect a world where de-leveraging not leveraging is the order of the day. There will be understandable public resistance and anger over job cuts and reduced service provision. The current debate about whether to cut (as the UK or Germany are doing) or continue to spend (as the Obama administration in the US is keen to do) is not about substance. It’s about timing.
The US will also need to tackle its fiscal problems but this will have to wait until mid-term elections are out of the way.
With double dip concerns still prevalent in the eyes of many investors, this harsh fiscal reality raises the concern that the direction of global policy will move out of sync with the business cycle. But this is where monetary policy comes in. Against the backdrop of the need for fiscal consolidation in the developed world monetary policy is likely to remain extremely loose. At the last FOMC meeting the Fed already took ‘passive tightening’ off the table by deciding to reinvest maturing MBS proceeds in treasuries. This is important for risk assets since it makes it clearer that we are unlikely to face a situation in which the US economy is seriously struggling but the Fed decides not to act. As already argued (see Too Much Gloom and Doom, September 1, 2010), given that we are not in the double dipping camp, this ‘comfort blanket’ of residual liquidity will ultimately be positive for risk assets.
And there could be more to follow. Here the labour market will be key. Employment in the US fell by more than 4 percentage points during the recession and if the US unemployment rate moves towards 10% in the coming months, the Fed is likely to re-start quantitative easing (QE).
Developed World QE Creates a Bid for Emerging Markets Assets
The initial phase of QE led to a surge in base money creation in late 2008/early 2009 but it did not translate into commensurate broad money creation in developed economies. This reflected the fact that demand for money and the ability of traumatised banking systems to intermediate and multiply the expanded base money were both weak. In fact, part of the base money that was created in the developed world ended up flowing to emerging markets as investors sought out growth and yield – things that were so palpably not on offer in developed economies. And here the banking systems, many already purged of excess leverage by reform following previous crises, were strong enough to intermediate and in many cases demand for credit also remained robust. This was particularly true of emerging economies where currencies were pegged to the US dollar or where unsterilised intervention to prevent currency appreciation led to an injection of high powered money.
Additional QE from the developed world, which would partly be compensating for the need for fiscal tightening there, would likely have the same result in the future, re-accelerating broad money supply growth in emerging markets and in turn supporting real estate and equity markets in emerging economies.
Emerging Markets: The Other Side of the Rebalancing Story
The emerging world is the other side of the global rebalancing story. Irrespective of whether there will be additional QE the fundamental dynamics are already asset price supportive in many emerging economies. Fiscal positions and debt metrics are generally much more comforting and in many cases growth is surprising on the strong side.
Take Brazil. The economy expanded by 8.8% in real terms in Q2 relative to the same period of last year. These numbers reinforce our view that the economy is still growing at a pace above its long-term potential, implying significant medium-term inflation risks. While interest rates may be on hold for now, the tightening cycle is most likely not over yet. India’s economy is also showing little evidence of cooling despite central bank tightening and Q2 GDP also grew by 8.8%, accelerating from Q1. Credit and money supply growth may have slowed in China but it is still sufficient to fund ongoing infrastructure projects. With consumption also remaining resilient, the economy will continue to cool for a while yet but growth should remain a robust 9%, more in line with the economy’s long-term potential.
With much of the developed world likely to deliver sub-trend growth and with government bonds there offering very low yield, it is worth reiterating that we see significant relative value in emerging government debt and yields are likely to remain supported in both external and local debt markets. For external debt, a rally should be expected to produce outperformance of higher yielding sovereigns and a general compression of spreads for the asset class. Markets could also become less aggressive on expected hikes in policy rates in economies where inflation is not an immediate threat.
The environment should also be positive for emerging carry currencies given the dearth of yield on offer in developed economies. Many central banks in the emerging world are likely to have a tightening not an easing bias, reflecting robust on-going growth and food price inflation concerns. Asia, for example, is likely to continue to tighten with rate hikes forecast in Korea, India, Indonesia, Philippines and Taiwan before year end while G3 monetary policy is expected to remain ultra loose. This is likely to be mostly about the carry differential rather than nominal currency appreciation but performance could also be supported by appreciation if central banks in the emerging world loosen the reins to counter rises in global food prices.
Having corrected from recent highs earlier in the year, on many standard valuation metrics, emerging markets equities also now offer medium-term value. We still believe that in a BRIC context Russia stands out.
In sector terms, we favour gaining equity exposure to the emerging consumption theme. This is the positive side of the global rebalancing coin and we believe investors should actively seek it out.
Disclaimer: All views expressed in this third party article are those of the author(s) alone and not necessarily those of Morningstar. Morningstar is not responsible for the comments nor will it be liable in any way for any information provided by the author.
