Friday, August 12, 2011

Musings on "the week that was"...

The sell-off in equity markets in recent days is not justified by the fundamentals – either economic or political. A number of “worry factors” have combined to create a climate of heightened uncertainty and fear. These include the risk of another recession in the US and Europe, uncertainty created by the US credit downgrade and continued political dithering in Europe over an enduring solution to the Euro debt crisis.


The US and Europe growth stories have not changed: both are in fragile debt-constrained recoveries. Both public and private debt levels are too high, and bringing that debt back to more sustainable levels would keep growth constrained for a number of years. We have also previously talked about how their recoveries would tend to be non-linear; that is, periods of relatively good data would, from time-to-time, be followed by periods of weak data.

What we are seeing now is another one of those weak patches. However, rather than being caused by transitory factors, it’s another soft patch which has been exacerbated by these factors. They include global supply chain disruptions following the Japan earthquake, disruptions from bad weather and high commodity prices acting effectively as a tax on household incomes. As a result US Q2 GDP data was soft. Expectations are that in Europe, where the slowdown is running at bit behind that of the US, Q3 GDP will print close to zero.

While recent and near-term growth looks softer, we have not changed our medium-term view of continued weak but positive growth. In America that view is, as it always has been, based on strong (non-financial sector) corporate balance sheets and the fact those corporates are looking to invest. We have always looked to business investment and exports to be the strongest components of US GDP growth in the early stages of this recovery. The concern is if recent uncertainty and volatility is prolonged, it could knock confidence to the extent that investment and hiring plans get delayed. We will be watching developments on that front closely.

There are good news growth stories out there too. China growth looks solid. We continue to expect a soft landing there with GDP growth of 9% this year and perhaps a tad lower next year. Japan is also recovering faster than expected.

It’s timely to be reminded of one of our long-term themes: growth in developed markets will be hard work over the next few years while it will be stronger and more sustainable in emerging markets. That was the reason we shifted our global equity managers to the MSCI All Country World Index, or ACWI, which includes an exposure to emerging markets. The weighting to these countries will rise automatically over-time as the balance of global growth shifts to what we, at least currently (!!!), call emerging markets.

US downgrade

The US downgrade didn’t tell us anything we didn’t know. The US is in a weak growth environment and fiscal policy settings are unsustainable. We continue to believe the downgrade by Standard and Poor’s was aimed mostly at the politicians who are unable to articulate a medium-term plan for fiscal consolidation. The political challenges are immense, but the risks of not doing this are even greater.

If politicians fail to develop such a plan, they will continue to be forced by market pressures into increasingly ad-hoc and short-term measures that threaten the important balance between fiscal consolidation and supporting economic growth. After this week I can now type that sentence blind-folded! Countries facing the debt sustainability issue need to grow their way out of it. All other options are unpalatable, but they are most certainly avoidable.

One risk of the US downgrade is that other AAA countries seek to speed up their fiscal austerity plans in order to preserve their own ratings. This would be counterproductive. It’s not the speed of achieving fiscal sustainability, it’s about having a credible plan to get there.

We have warned for some time that as the focus turned to fiscal and debt issues in the US, we would inevitably see an increase in the US risk premium. Any impact of the S&P decision on that front has been well and truly swamped by heightened concerns about the growth outlook and the still strong “safe haven” status of US Treasuries. The Fed reinforced the low-interest rate case this week by signalling it is likely to keep the current level of exceptionally low interest rates in place until mid-2013.

But we also see it as symptomatic of the changing world order. America has lost its AAA credit rating. We have seen a structurally weakening in the US dollar and a structurally stronger Chinese Yuan. That’s important for the required rebalancing in global growth. The G20 has supplanted the G7 as the lead group of countries that will determine the future look and feel of the global monetary system. These are all signs of the shifting balance of economic (and eventually political?) power in the world. All fascinating.

Europe debt crisis

The US needs to learn from the recent experience of Europe. Without a long-term plan, things can get very untidy. The latest developments and concerns have been mostly to do with Italy. Again, we think the concern is overdone.

The primary problem in Italy is weak growth: GDP growth has averaged less than 1% per annum since the start of the recovery. The other important point is that Italy’s finances are actually not that bad. Italy has committed to a balanced budget by 2013 (one-year earlier than previously) and is already running a primary budget surplus. Much of the concern has been around its high sovereign debt (120% of GDP), but its net external debt is only around 20%. That compares to 100% for Greece and 17% for America.

The good news is that decisions taken at the Euro area summit on July 21 did take important steps forward. The strengthening of the EFSF and the ECB’s subsequent decision to reopen its Securities Market Program were positive. But all this is doing is buying time for politicians to work out a long-term solution for the management of funding for Euro area governments. We believe this must include a high degree of fiscal co-ordination or some degree of fiscal union. This would probably lead, in time, to the issuance of Euro Bonds which could end up rivalling Treasuries for safe haven status, assuming they are designed well.

There is still plenty of work to do and in the meantime markets will fret. The concern is that if Italy does fall over (unlikely), the European Financial Stability Fund is not big enough to bail it out.

In summary, for us, not a lot has changed on the economic or political front over the last few days. This is NOT a re-run of 2008. We started the week committed to our neutral growth/income position in the multi-sector funds, and that’s where we end the week. We will keep you informed when that changes! Have a restful weekend.