In a time of severe stress and crisis, it’s easy to come to the conclusion that Armageddon is upon us. Those who believe the European Union is going to split up and China’s growth will come to a screeching halt are probably building bunkers and sharpening their survival skills right about now.
But Dr. Michael Hasenstab, co-director of global fixed income at Franklin Templeton and manager of $160 billion in assets, including the Silver-Rated Templeton Global Bond fund, isn’t in panic mode. In fact, he’s optimistic the eurozone will survive, and that no, China won’t move back into the feudal age. However, he does believe there are some game-changing events taking place in the financial markets and in China today that will have future consequences for investors—some potentially good, but others maybe not so much. As a long-term investor, he’s planning ahead for these potential future consequences, and is seeking out the high ground.
Thoughts on the Eurozone Crisis
We’ve heard Hasenstab’s views before on the European debt crisis. He still believes that should Greece ultimately leave the euro, that the “ring fences” are in place—that is, the European financial system is prepared to weather a “Grexit.” In the long-run, he thinks that outcome might not be a bad thing if the alternative is that the rest of the EU has to indefinitely subsidize Greece. He has noted seeing signs of slow progress underway in Spain and Italy, and believes there are reasons to be optimistic about Europe’s future.
“Things are difficult, but I don’t think we need to believe the Armageddon scenario. Greece appears financially terminal, but in my view, Italy and Spain by no means have to be financially terminal.”
Once the panic of the eurozone crisis ebbs a bit, there are two other issues Hasenstab thinks warrant meaningful consideration from a long-term investment perspective: the easy monetary policy many central banks have been engaging in for years, and an economic rebalancing in China.
Since the start of the financial crisis in the US in 2008 – 2009, the Federal Reserve and some other central banks across the globe embarked on a variety of stimulative measures to combat short-term market shocks and boost growth. What does Hasenstab think of the Fed’s prolonged approach to throw dollars at every problem?
“A country may print its way out of a liquidity crisis, but it can’t print its way out of a solvency crisis or print its way to lower unemployment rates. The US unemployment rate is high because it is going through a typical post-financial market crisis crash and recovery, which can take a decade to recover from. Printing money provides liquidity, but doesn’t speed up the process, and I think it’s starting to have more negative than positive consequences in terms of future inflation and capital flows.”
While some of this hot-off-the-presses cash does recapitalize a home country’s sick financial system, some also flows into other markets. Hasenstab believes those money flows can offer some help protecting against a potential credit crunch in the emerging markets, which is positive. However the “monetary tsunami” the US has created could result in inflation washing up first on distant shores as all those dollars flood the system and boost commodity prices.
“When the large economies print money and debase the value of their currencies, people have tended to look for places to store value. I think the financial-isation of commodities is a direct result of this prolonged quantitative easing policy. Rising commodity prices tend to hit emerging markets first because they are more dependent on commodity consumption and are less able to absorb higher prices. We’ve seen inflation temporarily slow in some of these markets, but inflation is still an underlying issue and one that isn’t likely to disappear. It’s something we have to be very defensive about given this extraordinary easy monetary policy experiment.”
Structural Change in China
There’s no debating the power China exerts on the global economy. Now chatter about the Chinese economy coming in for a “hard landing” is ubiquitous. According to the CIA World FactBook, China’s GDP was 10.5% in 2010, and 9.2% in 2011. Various forecasters predict growth somewhere around 7 – 8% this year. Hasenstab doesn’t see this gradual decline as a hard landing at all. But what might trigger one?
“There would have to be a massive policy error where China over-tightens and engineers a recession. I think that is unlikely. In my mind there is no question China is in a mini cyclical slowdown, but nowhere near a precipitous drop. The second way to trigger a hard landing is a banking system crisis, and a country like China with artificially repressed interest rates can be particularly vulnerable. However, I think China’s $3 trillion in reserves is a huge cushion against a banking system crisis.”
Even if China can engineer some soft landings, Hasenstab thinks China is still facing challenges tied to a necessary economic evolution, the liberalizing of assets in what Hasenstab calls “the factor markets:” land prices, the cost to the environment, and interest rates.
“Think about a typical project that might be going on in China: a coal plant. Right now, the owner can get a 2% loan from the government, build 1950s technology which pollutes the environment massively, and get the land for free. If you liberalize, he now might have an 8% loan, have to use more modern technology, and pay for the land. That’s a very different profitability or cost structure for his company. China looks like it’s on the cusp of embarking on a more efficient allocation of capital; moving from a higher growth rate with what might be considered lower quality of growth, to a lower growth rate but with a higher quality of growth. I think it’s essential to make this transition, but during the process there are a lot of potential vulnerabilities because it’s necessary for the government to kind of take its hands off the controls.”
China is also facing a potential labour shortage, which may seem hard to believe. We often think of China as having an infinite supply of labour, but its one-child policy is working its way through the population. The result? Rising wages.
“You can see this in the most basic of labour prices – migrant labour costs. They had been stagnant despite inflation, despite rising growth, and have begun heading up. Wage pressure in China will likely have important global implications. On the positive side, it will probably help rebalance the Chinese economy. One of China’s main challenges is investment outweighing consumption. How do you get more consumption? One way is to create social safety nets like unemployment insurance, healthcare or education so there is little need for a 40 – 50% savings rate. But that takes time to build out, decades. The other, quicker way is to increase wages so people will spend more. Consumers in China are no different than consumers anywhere. You earn more, you buy more stuff.”
The flip side of these structural changes in China could mean higher prices for the rest of us consumers who are content with inexpensive Chinese goods.
“When you think about one of the most important factors keeping downward pressure on prices, it’s been China. China has been exporting deflation for decades. Today, I believe China is on the cusp of exporting inflation, a completely different dynamic. It’s simply not possible to move China’s entire industrial basis into a country like Vietnam where costs may be lower. So if prices go up in China, the world might simply have to absorb them.”
No More Free Lunches
So where does this all leave an investor today? In Hasenstab’s view: “There’s no such thing as a free lunch.” As an investor, he believes it’s still possible to find opportunities in countries that are growing, appear to have fiscally responsible policies, and are not going through a deleveraging process. And he is! But, he believes the concept of the “risk-free” investment has, at least for now, gone into hiding.
“I don’t think there’s a risk-free asset anymore. The question is whether you are getting rewarded for the risk you are taking. Yes, things are bad, but I don’t think the world is ending either. There are always opportunities, and I think if you have a long-term perspective, you can be rewarded.”
This article is part of Morningstar's "Perspectives" series, which is a series of articles written by third-party contributors. The views contained herein are those of the author(s) and not necessarily those of Morningstar. If you are interested in Morningstar featuring your content on our website, please email submissions to UKEditorial@morningstar.com. This article was originally published in July 2012 on Morningstar.com.
