With most of the developed world at stall speed or in outright recession, and with the OECD recently slashing its forecast for growth in 2013 while calling on central banks to ease their monetary policy, any policy mistake that leads to an exogenous shock becomes a major risk. This explains why the focus is gradually shifting to the world’s largest economy, the United States.
Although the problems in the eurozone are far from solved, the ECB chief Mario Draghi’s commitment to address the peripheral debt issues through a new bond buying plan has been largely perceived as a key factor in reducing tail risk.
“Through the OMT (Outright Monetary Transactions), the ECB has bought European politicians some time,” says Russ Koesterich, global chief investment strategist for BlackRock's iShares business.
While the slowing down of Chinese growth and issues in the Middle East are also key concerns, for the remainder of this year and early 2013, the key risk for markets is the ‘fiscal cliff’ in the United States, he says. “Deleveraging, debt and demographic risks are shifting away from Europe and toward the US.”
The tax hikes and spending cuts that are scheduled to hit on 1 January 2013 amount to roughly $800bn (€620bn) – the equivalent of 5 per cent of US GDP. These measures will mainly affect the vulnerable US consumers, who represent around 70 per cent of all economic activity and are still largely deleveraging.
Other key issues that can hamper the US economy, which is expected to grow by 2 per cent over the next two to three years, are the US sovereign debt, which is now around 100 per cent of GDP, and ageing demographics.
“The world’s largest economy may inadvertently push itself back into recession in 2013, if we can’t address the fiscal cliff. But this risk is not really priced into the market. Investors have become conditioned to expect these last minute compromises in the US,” says Mr Koesterich, referring to past debates such as the debt ceiling.
However in this case the time frame for reelected President Obama and the divided Congress to negotiate a compromise is very short. “The main issue at this point appears to be the disagreement between President Obama and Congressional Republicans over whether or not tax rates for upper-income Americans should rise,” says Mr Koesterich.
“If we do not see any signs of progress in this debate, it is likely that broader negotiations will drag on over the next several weeks, which would put stocks under renewed pressure,” he adds.
However, some parts of the world are in a better shape, particularly from a fiscal and monetary perspective and may be in a better position to withstand this shock. Mr Koesterich suggests investors may want to decrease their allocation to US, Europe and Japan, to fund their position in smaller, developed countries, such as Canada, Australia, Singapore, Switzerland and Hong Kong (CASSH countries).
EMERGING MARKETS
Another long-term theme is that of emerging markets that today trade at about 22-23 per cent discount to developed markets, he says. But are Asia or emerging markets really insulated from the risks coming from the more mature economies?
“A double dip recession in the US would be clearly negative for Asia, as it is still very export focused,” says Anthony Cragg,Singapore-based portfolio manager of Wells Fargo China Equity Fund and Wells Fargo Emerging Markets Income and Growth Fund.
A reduction of the world trade activity is the biggest risk, particularly for those markets that are intimately entwined with the global cycle, such as Korea and Taiwan that are part of the tech chain, he says.
However, the increasing exporting activity of Asian companies within the region and the continued growth of the domestic fund management industry makes Asia more resilient to shocks coming from the West and less at the mercy of foreign funds, smoothing market volatility.
In China, after the political scandal around politician Bo Xilai, the transfer of power seems to be running more smoothly than anticipated, he says. The slowing down of the Chinese economy, which is today growing at 7.5 per cent, is fairly normal in a world of declining GDP and world trade, believes Mr Cragg, who has been investing in the region for more than 30 years.
Dynamics such as urbanisation, spend on infrastructure coupled with the Chinese government’s objective to build a social safety net for its inhabitants are still in place.
Because of uncertainty in the global economy, investors have shunned heavyweights such as China and India, but also Korea and Taiwan, in favour of smaller markets such as Indonesia, Malaysia, Philippines or Thailand, which have performed well. “As a whole we are tending to take profits in Asean and gradually move back to China or India,” says Mr Cragg.
Another major theme is equity income investing in emerging markets, which will increasingly become mainstream, he says.
Dividend paying companies are a good indicator of management quality, and in emerging markets they have growth characteristics too, unlike mature economies such as the US, where equity income is associated with “boring old utilities, which never grow but pay fat dividends,” according to Mr Cragg.
“In emerging markets, when we are more conservative, as we were last year, we will invest more in dividend paying telecoms or utilities. If we were more aggressive, we can move to banks, financials, property, tech, all of which are relatively high beta sectors, but still paying nice dividends. It is really a strategy for all seasons.”
Stockpicking is vital, as demonstrated by the fact that equity income yielding names have not been the highest income payers.
“Yields from dividend-yielding equity products are still reasonably attractive versus history and are very attractive versus risk free yields,” confirms Eric Sandlund, head Investment Management APAC at UBS. Over the last 20 years, more than 50 per cent of total returns of equity investing in Asia have come out of dividends, he says.
Value is also found in the fixed income space, where many private investors have invested a large proportion of their assets in recent times. Whether a near term reversal in interest rate would really pose the biggest challenge in the fixed income space, the spreads do not appear to be at extremes yet, says Mr Sandlund, and major central banks are yet to show that their primary concern is inflation.
“Right now we are neutral on equities and we are neutral on fixed income, but within the fixed income space we are extremely underweight government bonds and overweight corporates; in particular we are overweight high yield and emerging market corporates.”
On a risk adjusted basis high yield looks more attractive than equities. Today, they have an attractive spread and in the current global environment the outlook for defaults is not increasing significantly in the medium term, he adds.
VALUE IN EQUITIES
“The areas investors today are looking at are regular income and protection against extreme inflation outcomes,” argues Steve Brice, chief investment strategist at Standard Chartered in Singapore.
While high yield and gold are overvalued there is consensus that equities are looking very cheap particularly on a relative basis and reasonably cheap on a historical basis as well, he says. High dividend yielding equities will be a key area of interest through 2013 he predicts, although clients are still very worried about equity markets.
“In an environment where we do believe in inflation, where dividend yields are above G3 sovereign bond yields – so an inflationprotected asset is giving you higher cash yields than a no inflation protected asset – it is difficult to argue in favour of fixed income at this moment,” he says.
Mr Brice states that “tail risk has actually reduced markedly through 2012, firstly in Europe, with the LTRO (long term refinancing operation) and OMT programmes. Greece may not be a part of the single currency in 12 months, but that probably won’t be too negative an outcome.” China is in a recovery phase, although a very modest one, and the fiscal cliff may be a challenge in the short term but not in six months time, he says.
One way to be protected against risk in every asset class is to make sure to be paid sufficiently for taking the risk, points out Richard Cookson, global chief Investment officer of Citi Private Bank. “Buying stocks that are cheap, because have been absolutely hammered, does guard you against downside risk. Over a 10 year period, your single biggest determinant of returns is the valuation at which you bought that stock.”
Richard Cookson, Citi Private Bank
It is not possible to predict whether markets will become cheaper, but comparing current cyclically adjusted multiples with their historical values helps. “If I look at US valuations, for example, they are very expensive, with a cyclical adjusted multiple of almost 22, which is almost double what it is for most of Europe,” says Mr Cookson.
“If you are worried in macro-global risk terms about Spain or Italy, which are trading on a cyclical adjusted multiple of 8.3 and 7.8 respectively, how could you be that bullish about the US? The short-term answer is probably ‘property has been relatively robust and the US economy is fairly insular,’ but the long-term argument does not hold. If systemic risk rises in Italy or Spain, by definition, US multiples will come down. It is very important to look at all markets in a global perspective,” he says.
TRUE DIVERSIFIERS
In today’s markets, which are far more correlated than ever before, the only two assets that really diversify portfolios are creditworthy government debt – which is expensive – and government debt-like instruments, ie investment grade credit. The latter is what Citi recommends to its clients, as the bank is largely overweight corporate debt as well as emerging market hard currency corporate debt, and bullish about the long end of the Treasury curve, while being significantly underweight government bonds.
This is also supported by the view that politics, in a slow growth environment, with recession in some parts of Europe, become a much bigger constraint and worry within portfolios. Political risk causes higher volatility, which will tend to benefit volatility as well as government debt-like instruments, he says.
With the global economy slowing and “nasty potential stocks out there”, Citi has been underweight equities since February last year and overweight fixed income.
“Systemic risk has not been removed by ECB actions,” believes Mr Cookson, “but has been pushed out and transmogrified into political risk.” Countries such as Spain and Italy are going to find it politically very difficult to implement the measures required by the ECB, if they request a bail-out.
Citi Private Bank’s view is that Greece will probably exit the eurozone at some stage, “but the bigger point when it comes to the eurozone is that unless you restructure an awful a lot of peripheral debt – and by restructure I mean get rid of some of it – the eurozone as it is currently constituted will not survive,” he predicts.
While the focus has been on sovereign debt in recent times, a few surprising findings emerging from the analysis of household debt in this year’s Global Wealth Report by the Credit Suisse Research Institute brings a totally new perspective.
When balancing the very large amount of private wealth against the rather high levels of government debt, then Italy looks almost as good as Germany does, with France looking better than Germany on that measure, and Spain ranking just below Italy, comments Giles Keating, head of global research at Credit Suisse.
“Italy in particular is the best example of all where public finances have been and are in a state of being transformed,” he explains. “Aside from interest payments, the Italian government runs a very large surplus.”
It is unlikely that the problems of Spain and particularly Italy can destabilise the entire system, as their private sector is not heavily indebted and that provides an “enormous buffer”, says Mr Keating. This makes it easier to deal with the problems of the smaller countries such as Greece and Ireland, at least in economic terms, he says.
“These figures make us feel more reassured about our view on the eurozone and more comfortable about stockmarkets at global level.”
