Notz Stucki Investor Conference

Macro themes to shape investing over the coming year

Originally published in the February 2011 issue

Some 200 investors participated in the 2011 Notz Stucki Investor Conference that the alternative asset manager hosted in Geneva in mid-January. Founded in 1964, Notz Stucki’s portfolio managers have invested through a wide variety of market conditions, but it is a fair bet that the current environment is unique in offering such an unusually wide range of possible economic outcomes. The conference heard from three macroeconomic strategists and an emerging markets specialist.

The proceedings opened with Anatale Kaletski, chief economist of Gavekal. He enunciated the broad theme that the world economic recovery is moving from recovery mode where growth rebounded to a new phase of steady expansion. To his mind, it means that the quality of the assets in investor portfolios will need to change.

Economic history: a new phase
Kaletski argued that over the past 15 years two crucial points have emerged about world economic history. One is that capitalism is an ever-changing, evolutionary process. Over 200 years it has gone through three phases – the classical model in the 19th century, the Keynesian reforms of the 1930s and the Thatcher/Regan revolution of the early 1980s – but is now entering a fourth phase. This is the transformational event that began with the post 2007-08 financial collapse and is expected to continue for many years. Kaletski is sure this will result in the evolution of a stronger system since crises, as Karl Marx noted, are a natural part of the evolution of market economies.

Overlaying these events are changes that he terms ‘unidirectional’, which are bringing about an irreversible transformation. Thus in quick succession over the past two decades the world has witnessed four mega-trends: the end of communism, the rise of Asia, the technology revolution and, finally, the attainment of supremacy for paper money over real assets like gem stones or gold. All of these factors, according to Kaletski, create unique conditions for macroeconomic policy. What’s more, the response in 2008 to the financial storm wasn’t possible in earlier crises due to the existence of the gold standard. The scale of the sovereign response – particularly in the US, China and Europe – couldn’t have occurred with gold since supply would have been inadequate to the support that was needed. The positive implication here is that the government measures succeeded. But the consequences for the future could be severe if an inflationary spiral sets in.

Deleveraging continues
The additional consequence of the rescue is that deleveraging will carry on for some years to come. But the first three mega-trends, Kaletski believes, are more powerful and still have some distance to run. It means capitalism looks well placed to prosper for some time yet. Much of the growth behind that prosperity, however, will be occurring in emerging markets which he claims will account for around 60-80% of incremental growth in the coming years.

From a financial stand point, companies look strong. Profits have rebounded and corporate profits as a share of GDP are at an all time high. It is thus a good backdrop for assets that depend on corporate earnings. Kaletski believes this means company valuations are still attractive and his research shows that many price/earnings ratios are more than one standard deviation below their long run mean. In sum, equities are cheap.

The implication here is that market analysts who worry that central banks are creating an asset bubble are quite simply wrong. “Assets moving back from cheap to fair value is not inflating a bubble, it is helping the recovery,” Kaletski says. “This is what many central banks think they are doing.” Other bullish points are that equity risk premia are at highs not seen since the 1970s, which is another signal that equities, relative to other asset classes, are inexpensive. Thus to Gavekal equities are poised to outperform bonds.

Risks to recovery
There are, however, five general risks to this scenario. The first is the possibility of a double dip recession in the US. Though the recovery mirrors earlier rebounds, the decline in employment from the peak in 2007 is higher than in earlier contractions. The second risk is the impact of massive imbalances between China and US (which are nonetheless declining), and between northern and southern Europe. The third risk is deterioration in the euro system which gets much worse and gives rise to a Lehman-type situation. The fourth risk is expansive fiscal policy giving roots to inflation, not from the bailout but from the structural rise in deficits due to health care and pensions. This is exacerbated in the US by the gaping political divide, a factor that Kaletski finds more worrying than other single issue in the world economy. The fifth risk is whether China can successfully rebalance growth down to the 6-7% level and contain inflationary forces.

For the investment landscape, Kaletski sees a further rise in bond yields to come with long-term rates rising for the next few years. He favours corporate bonds over sovereigns as a way to play this. Growth in emerging markets is discounted, but this is not true of growth in northern Europe and the US making it the right time to invest in big cap developed market stocks. Investors should hedge exposure to corporate growth through shorting Italian or Belgian credit default swaps. Among currencies, the dollar is cheap, sterling will get cheaper, the euro is overvalued, while the Canadian and Australian dollars as well as basic materials carry embedded call options even if commodities as a whole are expensive.

Current cycle to be shorter
Stephen Jen, managing director of macroeconomics and currencies at BlueGold Capital, followed up with what five thoughts about the current macro environment. First, on the global economy, Jen expressed cautious optimism. Earlier only China and other emerging markets were growing, but now growth in the US and Euroland is kicking in. Where Jen is cautious is in expecting the cycle to be much shorter, meaning the next recession will arrive sooner than the eight or nine years between recessions observed in earlier cycles. The risks to the optimistic scenario in depreciating order of importance are: renewed fall in US housing cycle; a European debt crisis; oil and commodity price hikes; severe monetary tightening in China; and sovereign debt insolvency.

Second, Jen expressed considerable bearishness about the financial problems facing Europe. Greece, Ireland and Portugal are likely to be insolvent, he argued, while Spain could encounter a liquidity crisis. The solvency problem for the PIGS is the result of growth coming in at about 1.9% compared with an annual 7% cost of servicing debt. If investors turn away from this proposition, Jen sees the resulting pressure hitting the Euroland’s five ‘AAA’ rated countries. He estimates the total PIGS debt exposure at $2.4 trillion with $1.8 trillion of that held by European banks. Exposure among French banks is at 30% of GDP compared with German banks having 18% exposure and UK banks 15% exposure. Linkages among the banks mean that if one falls, others likely will as well.

Jen’s third point is that emerging markets are likely to continue to face inflationary pressures. Emerging markets can develop for a long period without wage inflation, but when it does happen the problem becomes a structural one. This is evidenced by recent jumps in the minimum wage in China. The competitiveness gap between China and the US means that the former wants an inflation solution, while the latter wants an exchange rate solution with the renminbi adjusted upwards. The stalemate means that as long as China persists with a currency peg it will have inflation, while the Federal Reserve’s vigilance on forestalling deflation in the US means inflation in China.

Dollar reserves excessive
A fourth point is that Jen finds dollar reserves of emerging markets to be excessive. The top eight emerging markets hold $5.5 trillion in reserves, out of which Jen says $3.7 trillion is excessive. Benefits from the policy include preventing home market currency appreciation and positive carry during the previous decade, but the dollar holdings now carry costs in terms of generating negative carry and political complications.

Jen’s final point is that the dollar will continue to enjoy hegemonic status. The dollar’s international currency status means that it will remain dominant in international trade settlement and capital flows. Indeed, dollar settled trade amounts to 50 times the settlement of trade in local currencies. In the meantime, the dollar’s reserve currency status will fluctuate. It accounted for 88% of reserves in 1973, fell to 50% in 1990 and in 2009 stood at 62%.

Luigi Buttiglione, chief economist and strategist at Brevan Howard, said the 2008-10 period showed the fallout of a differentiated shock. Thus some developed markets, including Switzerland, Canada, Australia and Sweden performed better than core developed markets, but were still hurt. Among emerging markets, a similar pattern was found with China and India doing better, while Latin American and South Korea trailed. In consequence, the events didn’t really constitute a fully fledged world crisis.

PIGS in great depression
He compared the crisis that hit the US and UK to the one that hit Sweden from its banking sector in the early 1990s. It is characterized by persistent lost output as trend growth emerges unchanged but without a period of out-performance. In contrast, the most severe form of crisis is the one that has hit Portugal, Ireland, Greece and Spain. It is similar to the 1930s Great Depressions in the US where output losses were never recovered and trend growth became lower.

Buttiglione argued that the differentiation was driven mainly by the balance sheet quality of the different countries. The PIGS have the biggest weakness followed by core developed markets, peripheral developed markets and then emerging markets. He noted that this is highly correlated with post-2008 GDP performance where emerging markets grew the most, the PIGS the least and others somewhere in between.

However, foreign exchange markets have yet to adjust to the post-2008 differentiation of balance sheets with the exception of the Swiss franc and sterling. Thus Buttiglione believes that considerable adjustment in relative currency values is to come.

“We live in a world where the new normal for growth is not that much different than the trend for the time being,” he said. “What’s more, deflation is much less likely than a rise in inflation.” Thus Buttiglione believes the output gap is probably smaller than is generally considered and the OECD measure of this looks to have overplayed inflationary pressures.

The final speaker was Mahmut Kaya, chief economist and emerging markets specialist, at Turkey’s Garanti Securities. He addressed the phenomenon of how Turkey has become a growth story. During 2002-08 he noted that Turkish GDP growth doubled to an annualized rate of 6% helped by the benign interest rate environment and a sustainable decline in inflation. But there was also a radical policy change on privatization which brought in proceeds of $45 billion during 2003-09 compared with just $8 billion during the 17 years to 2002.

Kaya forecast that Turkey, in common with other emerging markets, will continue to grow at a much faster pace than developed markets. Among emerging markets Turkey looks likely to be a top performer since it benefits more from low short-term interest rates than many other emerging economies owing to its current account deficit. This view, he noted, is shared by the OECD which has Turkey topping its league table for forecast growth during 2011-2017 with expansion of 6.7% per annum. Kaya sees opportunities in real estate and utilities as well as in financial services which should benefit from moves to develop the mortgage market, which to date is virtually non-existent.