International outlook - 2012
01 October 2012 - Tony Gibson
In the investing world, even doing nothing is doing something
By Tony Gibson, senior portfolio manager
Global equity markets performed well over the quarter, with the MSCI World Index rising by 6.8%. In terms of news factors, on the negative side we were faced with the continued reduction in the outlook for Chinese economic growth and the sharp rise in the oil price – increasing by 22% over the three months. On the indifferent side was further ambiguity in terms of the economic signals emanating from the US, while the positive news (surprisingly) came out of Europe.
In aggregate, despite ongoing evidence of slowing global growth, equity markets held up well. This is probably indicative of the depth of negative sentiment among the broader investor community, whereby expectations have been re-based at ‘disappointment proof’ levels. Indeed, the negative economic data was almost positively perceived as it was thought to hasten incremental policy action. Such a view did not seem unreasonable given the debates in almost all geographies about possible future action, all of which seemed to have a clear pro-growth bias.
Looking at the negative factors, further evidence of a Chinese economic slowdown was reflected in the sub-50 level of both the official and HSBC manufacturing PMIs – a reading which confirms a manufacturing slowdown. This picture was mirrored in weak export data from both Taiwan and South Korea to China; down 4% and 5% respectively year-on-year for the months of July and August. This slowdown has also manifested in a rise in non-performing loans, albeit from very low levels. That said, the most pronounced impact has been seen in commodity markets, particularly iron ore. With the Chinese residential property market remaining robust and the political leadership undergoing transition, expectations for a meaningful policy response proved to be overly optimistic.
The rapid oil price rise is in our opinion overdone, notwithstanding the obvious uncertainties in the Middle East. We find the longer-term view that impending supply has caught up with (and surpassed) demand projections increasingly compelling, given developments over the past year. Again, while the obvious risk from Iran cannot be clearly defined, we suspect that precautionary inventory build-up in the oil industry has been quite aggressive, and will provide significant protection against any temporary supply shortfall.
The news from the US showed that a broadly defined economic uplift is proving elusive, despite definite signs that the economy is at a turning point. Importantly, the housing market has formed a base and it is realistic to forecast that house prices will recover by 5% or more over the next year. Real consumption has also improved with a trend recovery in personal incomes, leading to forecasts that, over the next six to 12 months, real consumption could increase by 1.5% and 2%. There has also been an upturn in consumer credit availability; normally an indicator of recovering consumption expenditure. Additionally, high levels of corporate liquidity have started to decrease, driven by increased share buybacks, higher dividends and an increase in real investment spending. Given these positive comments, where does the indifferent news come from? The answer lies in the stubbornly high unemployment statistics, the most politically important indicator by which the incumbent government will be measured.
Not surprisingly therefore, Ben Bernanke, chairman of the US Federal Reserve Bank (US Fed), announced further quantitative easing in the form of an open-ended monthly purchase of $40 billion of mortgage-backed securities over an indefinite number of years. The key text of the announcement from the Federal Open Market Committee was that it will continue these purchases for as long as ‘the labour market does not improve substantially’ and that it will maintain a ‘highly accommodative stance of monetary policy … for a considerable time after the economic recovery strengthens’. The message specifically noted that its highly accommodative stance would continue at least until mid-2015, implying nearly $1.5 trillion of increased bank liquidity.
Turning to Europe, the ongoing dithering by the poli-tical leadership continued unabated. The brinkmanship between the (frugal) German government and the (fiscally undisciplined) southern states looked set to continue under-mining investor confidence around the world. Within this low-expectation environment it was therefore surprising that Europe, for so long the disruptor of investor confidence, provided an unexpected boost to sentiment. This came in the form of a pledge by Mario Draghi, European Central Bank (ECB) president, to do ‘whatever it takes’ to preserve the euro. As a result, the threat of Europe’s monetary union breaking up, thereby spelling catastrophe for Germany and the continent as a whole, has receded. The ECB stated that it would – similar to the US Fed – undertake a new open-ended strategy whereby it will buy short- term Italian and Spanish bonds, with no limit on the amount, for as long as those countries have economic adjustment plans approved by the European Commission and the European Stability Mechanism (ESM). In doing so, the ECB can now substantially reduce the interest rates on the sovereign debt of those countries, helping them to grow by removing the discipline that the bond market has had over their fiscal actions.
That said, once the process of buying large quantities of sovereign debt has begun, the ECB will face a difficult choice. Italy and Spain may improve their policies but they are also likely to stray, at least a little, from whatever plan they agree with the commission and the ESM. When that happens, will the ECB stop buying their bonds, allowing their interest rates to rise sharply? Or will it accept the deviations from plans and thus weaken their incentive for fiscal reform? In short, the ECB, like the US Fed, is now locked in a high-risk strategy.
There are two fundamental reasons that leaders of the developed world are taking such aggressive and unprecedented steps to promote growth and stability. The first, as mentioned, is of course the political imperative to create many more jobs for their electorates. There is, however, a somewhat darker reason – and one that we have touched on in past commentaries. That is the problem relating to the smothering level of government debt that is overwhelming developed world governments. While the current benign level of interest rates makes this burden tolerable, at a future date – when interest rates may be substantially higher – the funding costs of such large debt levels may be crippling. Leaders are therefore acutely aware of the need
to reduce this debt but seem unable to live with the political consequences, which will surely follow if the necessary austerity measures are taken. In fact, it is not only the politicians who need to shoulder the blame. Electorates in the developed world are increasingly voicing a strong aversion to living through an extended period of lower welfare spending, coupled with higher taxation.
Given this stalemate, and when in doubt, we need to look at what history shows us. For the sake of simplicity, we will focus on the US economy, although the trends from the UK and European countries are very similar. In 1945, following the financial burden of funding its involvement in World War II, the US was saddled with a high level of debt that was without historic precedent. Its public debt stood at 116% of GDP which, seen in the context of the past 100 years where the average public debt levels ranged from 25% to 50% of GDP, was alarming to the country’s government. Theoretical studies suggest that 10 years later, in 1955, had the situation been left to market forces, the debt burden would have deteriorated to a level of 141% of GDP. Faced with this scenario, the government opted for a 10-year strategy of what is today known as ‘financial repression’. That is a set of policies which promoted growth, irrespective of the impact on savers and holders of fixed interest investments. During this period, the rate of inflation steadily ticked up, while interest rates did not, thereby creating an environment of negative real interest rates. Therefore while (nominal) growth improved at a rapid rate, those who held interest-bearing investments experienced dramatic erosion in the real value of their capital.
Fast forwarding to 2012, the national debt levels in the US are currently around 100% of GDP, depending on the definitions of debt used. What is much more alarming is the estimate of future debt levels, assuming no improvement to the current burgeoning US budget deficits and taking into account the current abnormally low level of interest rates. Forecasts of 200% public debt to GDP in 20 years’ time are not uncommon. It seems to us that the burden of proof lies with those commentators who do not believe in the principle that ‘one ignores the lessons of history at your peril’!
As much as a rise in inflation seems unlikely at present, surplus labour is not the only factor at work in determining inflationary pressures. We believe that a rise in the years ahead is inevitable. At that point, even if the US Fed wants to start raising interest rates to reduce inflationary pressures, Congress is likely to object if the unemployment rate is still high. Faced with the alternative of antagonising the Congress (the Fed is legally accountable to Congress) the Fed may delay raising interest rates to control rising inflation. The result could be significant increases in inflation and inflation expectations.
Investors should note that, in the 10 years following 1945, equities produced real annualised returns of 5.8%, commodities 2%, while cash and government bonds returned -0.5% and -3.3% respectively. Although the absolute numbers may very probably be lower over the coming 10 years, we doubt that the relative returns will be much different.
The present investment valuations are also instructive. After years of derating, global equities have probably reached a point where they have more than adequately reflected the economic stresses and risks brought on by the financial crisis. At the same time, the relentless decline in interest rates over the past three decades has pushed up the price of many government bonds to levels that no longer offer attractive returns to maturity. Both the derating of equities (from the unrealistic highs during the late 1990s tech bubble) and the rerating of
bonds (as inflation continued to surprise on the downside) were understandable given the starting points. The onset of the financial crisis has merely extended and exaggerated these trends as investors have become increasingly sceptical about the ability of economies to grow, as they struggle with record levels of debt.
The challenge today is that there are risks and the majority of people are desperate for safety. That is why investors can invest in less-than-safe assets, at relatively cheap valuations. The outlook isn’t overwhelmingly bleak and risk assets such as equities are not overwhelmingly cheap. That said, keeping money under the mattress is not an option. In the investing world, even doing nothing is doing something. All actions must be undertaken on the basis of serious analysis and active decision-making.
TONY GIBSON is a founder member of Coronation and a former CIO. He was responsible for establishing Coronation’s international business in the mid-1990s, and has managed the Coronation Global Equity Alternative Strategy Fund since launch in 1996.
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Notes to the editor:
Coronation Fund Managers Limited is one of southern Africa’s most successful third-party fund management companies. As a pure fund management business it provides individual and institutional investors with expertise across Developed Markets, Emerging Markets and Africa. Clients include some of the largest retirement funds, medical schemes and multi-manager companies in South Africa, many of the major banking and insurance groups, selected investment advisory businesses, prominent independent financial advisors, high-net worth individuals and direct unit trust accounts. We are 29% staff-owned, have offices in Cape Town, Johannesburg, Pretoria, Durban, Gaborone, Windhoek, London and Dublin and are listed on the Johannesburg Stock Exchange. As at the September 2012 quarter-end, assets under management total R339 billion.