A year ago, in early 2012, the global economy was healing gradually. Growth rates in the developed world and some emerging markets were well below the long-term averages, if not actually negative. Investor confidence was fragile, with sentiment overshadowed by concerns over the banking system and public finance in the euro area.
So, what has changed? Russ Koesterich, the chief investment strategist of global investment manager BlackRock, believes that the risks in Europe have diminished, thanks in part to the actions in the third quarter of 2012 of the European Central Bank (ECB). Conversely, risks have risen in the United States. In the meantime, the various efforts of China’s government to boost that economy seem to be having the desired effect.
“A key issue for this year is fiscal drag. This is a slowing in overall economic activity as a result of net spending cuts by the government. There is a significant risk that economic growth in the US will be disappointingly low in the first six months of 2013.”
However, regardless of the decisions that are made, or not made, by the US government and the Federal Reserve, the longer-term investment environment is broadly the same as it was a year ago. “As in early 2012, investors should frame their investment decisions in the context of slower growth, financial repression and continued volatility in markets,” notes Koesterich.
The three dimensions that matter
This is largely because of three forces that are pervasive in most large developed countries and, if to a lesser extent, in some emerging markets – deleveraging, debt and demographics or 3D. In the US, the ratio of non-financial debt to GDP rose to about 250 per cent in 2009. Nearly four years later, the ratio is still at that level.
“There has been a major and well publicised reduction of debt by the US financial sector. To a certain extent, households have been cutting back on their borrowings. However, the government has continued to borrow,” says Koesterich. “This matters, because high levels of government debt are usually associated with slow growth. Basically, the deleveraging of the US has barely begun. For the US and the global economies, debt and deleveraging (outside the financial sector) are two sources of headwinds to growth in 2013 and beyond.”
Demographics is the third element of 3D. In the US, there has been a fairly clear inverse relationship between the age of the population and the level of real (after inflation) bond yields over the last 30 years or so. As the ratio of people aged 65 or over to people who are 15 or younger has risen, the real yield on the 10-year treasury bond has typically fallen.
Koesterich argues that this relationship is driven by two forces. “On one hand, older people tend to be more conservative in their approach to investment. They are more likely to buy high-quality and low-risk investments such as treasuries. This will tend to force treasury prices up and yields down.
“On the other hand, older people tend not to want to borrow as much as younger people. Sixty-year olds are generally less keen to take on debt than 40-year olds. An ageing demographic is, therefore, consistent with lower demand for credit and lower interest rates. Of course, the US is ageing more slowly than a lot of other developed countries.”
Converging risk levels
The 3D phenomenon is accompanied by another change. Emerging markets, collectively, remain more risky than developed markets. However, the risk levels of the two are converging. This is partly because of the higher growth and better financial position of most – but not all – emerging markets. More crucially, though, the economies of the developed countries have become increasingly volatile.
“It is widely understood that inflationary pressures have diminished. This is mainly because banks have become more reluctant to lend and households and companies (in many countries) have become more reluctant to borrow,” says Koesterich. “What is not understood is that inflation has become a lot more volatile. In the US, the volatility of inflation has risen to highs last seen in the mid-1980s. It is currently not far off the even higher levels of the mid-1950s. The volatility of industrial production in the US has also risen sharply and is back at levels seen in the middle of the 1980s.”
Nevertheless, much of this has been recognised in financial markets. In particular, equities have become cheaper in relation to bonds. The dividend yield on the MSCI World Index is now nearly two-thirds of the yield to maturity of Moody”s Baa Bond index. This is the highest percentage since at least 1995. “This means that income investors can, should, and probably will look at the opportunities from equities, rather than from bonds,” notes Koesterich. BlackRock also sees opportunities from some categories of credit (non-government bonds).
Get the right market
However, for equity investors, it will be important to select the right markets. According to Koesterich, many emerging markets will produce superior returns, in some cases because their economies are still growing reasonably rapidly. “Even if you only look at the BRICs countries, the dynamics are quite different in each of them. The emerging markets are not homogeneous. Investors are recognising that the opportunities are much more appealing in particular places.”
Among the developed markets, BlackRock favours Canada, Australia, Switzerland, Singapore and Hong Kong – the CASSH countries. These are markets where public debt levels, budget deficits and other imbalances are much less than in larger developed countries. BlackRock also suggests that investors with balanced portfolios should maintain a strategic allocation to commodities, including gold.