Download Strategic Considerations

February 2013,
Scott Jamieson,
Head of Multi-Asset
Investing
Strategic Considerations
The hysteria may have come out of markets but that is just because those in charge are administering their
most potent tranquilisers. The underlying issues remain and those most challenging to investors are
summarised below.
Excess Debt
Too much is owed by too many. Consumption booms of recent decades have been fuelled by declining
interest rates, binges of credit creation and the exploitation of cheap labour pools; all these engines have hit
stall speed. The remedial effort of economic policy formulation hitherto has been to stimulate via low interest
rates to a degree without historic precedent.
Traditionally the yield curve has captured the ebb and flow of economic cycles as investors adjust their longer
term outlook for interest; as activity quickens the expectation is that central banks will temper demand by
tightening policy interest rates and vice versa. Historically the economic and interest rate cycles have been
strongly aligned (Figure 1).
The aftermath of the Credit Crunch of 2008/09 has seen yield curves steepen as never before (Figure 1). This
can be rationalised in one of two ways: either we are about to enjoy an economic expansion as never before
(so much fuel has been poured onto the fire) or we have created the platform for a substantially higher trend
rate of inflation.
13
3.5
11
3
9
2.5
7
2
5
1.5
3
1
1
0.5
-1
-3
0
-0.5
Source: Datastream
-5
Q4 1983
-1
Q4 1988
Q4 1993
Q4 1998
US Real GDP Growth (%, yoy)
Q4 2003
Q4 2008
Slope of US Yield curve (%, RHS)
Figure 1: US GDP and yield curve (lagged). Source: Datastream
The debt burden is too big to pay back in full. Default is inevitable and can come either through nonrepayment or through debasement of its nominal value – inflation. Great efforts have been taken in recent
years to avoid default through non repayment – for fear of the contagion that could create. Debt burden
deflation through price inflation is the end-game that bond investors expect.
We all know of examples of rampant price inflation and the economic ravages that ensue. Investors should
anticipate a protracted period through which the nominal values of debts owed will decline.
Monetary Policy Watershed
More than twenty years ago Paul Volker, then Chairman of the US Federal Reserve, declared war on inflation,
the then scourge of global economy. The logic was simple: defeat inflation and economic prosperity will follow.
In doing so Volker set the tone for a generation of central bankers and he led the way by exploiting economic
upswings to maintain a slightly tighter monetary policy stance that would have otherwise been consistent with
equilibrium in order to lower, incrementally, the trend rate of price inflation. Only in recent years have we
become to understand that in our modern economy an inflation rate of zero brings us perilously close to the
demon of deflation. In the early 1980s such a threat was only an academic consideration.
History will likely show that 2012 brought an equally seminal watershed in policy thinking when the primary
pursuit became economic growth itself. An unavoidable consequence may be a higher (than previous) rate of
inflation but haven’t we shown that we can always defeat inflation if we have to?
So, with a range of announcements from the incoming Japanese government, the US Federal Reserve and
the Bank of England, the concept of nominal growth targeting (NGT) has been born.
Volker’s disinflation spawned a multi-decade bull market in nominal assets; we wait to see the impact of NGT
on real asset values. Few expected bonds to prove THE investment of the past 25 years, are we
underestimating the potential for a dramatic rise in the nominal value of real assets?
Investors should examine their portfolios and maximise their exposure to real assets – equities, index-linked,
property.
Joblessness
There isn’t enough work to keep all the people of the world usefully employed. The process of household debt
reduction will continue to see saving/debt paydown take undue precedence over discretionary consumption.
Reform in sovereign finances restricts the ability of governments to create employment and fiscal policy will
continue to favour those that generate employment for voters. The trend toward lower rates of corporation tax
and other fiscal incentives will favour companies and share markets. We would do well not to underestimate
man’s ingenuity and his ability to transform the world economy but for the foreseeable future the imperative for
job creation – almost any job - takes precedent.
Greater emphasis will be placed on efforts to mobilise the assets held by the world’s savers – including the
German consumer, the Chinese and pension funds etc – into useful endeavour. The era of politically
independent policy formulation is over.
Investors need to recognise that the end will justify the means and there are few/no sacred cows that can’t be
slaughtered.
Fiscal Imbalances
The perilous fiscal position of the world’s major economies is well known and, to varying degrees remedial
measures are being applied; though whether they can all be applied in unison is extremely doubtful. Nowhere
is the need for structural reform more acute than in the Euro-Zone.
It is highly likely that those charged with driving macro-economic policy in the EZ as a whole have embarked
on their own version of Volker’s opportunistic disinflation. We can expect the EZ to apply opportunistic
fiscal/political reform by maintaining a tighter stance toward monetary policy than would otherwise be
appropriate precisely to ensure than politicians across the EZ, but primarily in the periphery, continue to
restructure their economy and mend their ways. This is likely to be a process that spans many years if not
decades. Throughout we can expect the EZ economy to lag the pace set by the global economy and for the €
to remain stronger than a more pragmatic growth-oriented agenda would require. The crisis of recent years
and the extra-ordinary concessions delivered by the European Central Bank will have been for nothing if the
profligacy of the Greeks, Italians and Spanish etc is not reversed. The corollary is that the € will continue to be
risk-prone and just one slip away from disintegration.
The EZ will remain a drag on, already subdued, global economic potential and ensure that interest rates stay
low.
Investors should not expect interest rates to rise to the norm of previous years – despite the watershed of
monetary policy.
Protectionism
Hitherto world leaders have understood that the challenges faced by us all and have tried to meet them
together. Eventually, should their response fail to deliver a self-sustaining recovery at the pace required to
address the underlying issues, self-interest will inevitably come to the fore. If/ when this happens the potential
impact on asset values, supported by the promise of an integrated, free-trade global economy risk falling
sharply; united we stand, divided we fall. It is likely that protectionism will also lead to a structurally higher
inflation rate.
A potential harbinger of protectionism is the manipulation of currency rates for domestic benefit. Until recently
the foreign exchanges have been notable for their stability; towards the end of 2012 we saw that change as
the Japanese started to engineer a sharply lower Yen in their determination to generate a higher domestic rate
of inflation (Figure 2).
In addition, in the UK it is becoming increasingly clear that the aggregate policy mix has been too tight to
foster economic recovery. As the pursuit of a stronger fiscal position seems set to continue and with official
interest rates already near zero the only safety valve is through a lower value currency. In the final analysis
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markets will deliver a fall in £, however, it is becoming increasingly apparent that the Bank of England will
encourage such weakness.
125
120
115
110
105
100
95
90
85
80
75
Jul 10
Jan 11
Jul 11
U$
Jan 12
£
Y
Jul 12
Jan 13
€
Figure 2: Evolution of major trade weighted currency indices. Source: Datastream
Recent changes in equity market values have exhibited a very strong relationship with currency shifts (Figure
3). This is indicative on an environment where growth in the aggregate economy is a lesser consideration than
market share. So if Japan is to finally create a more vibrant economy then this is going to have to be achieved
at someone else’s expense. The other nations of the world may tolerate this for a while if they believe that a
larger world economy will ensue but they won’t have someone ‘eat their lunch’ forever.
8%
6%
NZ
4%
Change in TWI
Europe
AUD
US
SEK
Norway
2%
0%
Switz.
Canada
Equity
-2%
UK
-4%
-6%
Japan
-8%
-10%
-5%
0%
5%
10%
15%
Figure 3: FX vs Equity. Source: Datastream
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Implications
1.
To paraphrase Churchill we have arrived at the end of the beginning rather than the beginning of the end;
the market conditions of recent years are the new norm by which the future should be framed.
2.
The prospective return on nominal assets held should be viewed through a real rather than nominal lens.
3.
Weightings to real assets should be maximised (within risk tolerances)
4.
Reliable sources of attractive income streams will remain scarce
5.
Challenges and risks will remain significant and asset market downdraughts may occasionally be
engineered to focus the minds of political leaders. The rewards available on risk-free investments are low
precisely because the risks are high.
What Could Go Wrong?
A.
Put simply, there is no alternative to genuine debt default. Where those who have lent capital are not
repaid and where those that have assumed benefit provisions (in old age, in ill-health) are disappointed /
obligations are simply torn up. We adjust to the world of scarce resources by accepting that the corollary
is scarce wealth and an era of relative austerity beckons in which all trust is broken. Only the strongest
governments survive and strife and unrest are common. The EZ fragments.
Selected long dated government bonds and strong companies are the favoured investments.
B.
Politicians fail us at the global level and they allow protectionism to blossom. Japan, early into the crisis,
is shown to be early into the scramble for anaemic world demand. Supported by new found domestic
sources of energy the US ‘pulls down the shutters’. Dramatic FX shifts become commonplace leading
ultimately to lower world growth and a move back from free-trade commitments.
Own gold (and the shares of domestically supported companies) as the last durable store of value
C.
Inflation expectations surge as all other forms of remediation fail and investors become disenchanted with
traditional stores of value – ‘better to have things than pieces of paper’. The world’s savers lead the way
by trying to turn fiat wealth into tangible assets. Monetary disorder becomes the norm.
Gold, property and index-linked strongly outperform
D.
The balance between workers and companies alters as the share of aggregate GDP represented by
corporate profits turns down and, supported by political developments, labour fights.
Index-linked bonds are preferred.
E.
Life goes on. The world proves far more resilient than (m)any expect and a normal economic cycle
unfolds around a lower interest rate equilibrium and as mechanisms are found to allow the long slow safe
work-off of past excesses. Workers work longer for less but at least they work. China turns in to the
growth engine of the world having successfully made the transition to an economy built on domestic
consumption.
Confidence improves and, supported by low interest rates, ‘risky’ investments, eschewed by so many, do
very well. Equities enter a brave new era where the valuation framework is defined not by bonds but cash
(when interest rates are very low and risks low almost any price of equities can be justified)
F.
Technological advances deliver a step change to economic potential e.g. through new cheap energy
sources.
Avoid everything that has offered sanctuary during the past 4 years.
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