We need to revisit our asset allocation thinking from the ground up.
The strain in the real economy is sharp and it is under considerable contraction. The global financial system itself is impaired and the appropriate approach to reconstruction is unclear. The past 50 years have seen a sustained increase in credit with severe acceleration of debt in the last decade. At present, there is a significant shortage in credit, the impact of which is likely to be widespread and long lasting. Capital and leverage for investment has been constrained and re-priced, although outcomes mainly depend upon the timeliness and aggressiveness of the ‘right’ policy responses.
As future returns from various asset classes carry significant uncertainty, we look back at how the world economy has undergone structural changes, making a return to the previous ‘normal’ economic state improbable.
Over the last decade there has been a fundamental shift in the world economy. Ongoing ‘globalisation’, involving the integration of highly competitive emerging countries (especially China) into world trade and capital structures, has allowed emerging economies to capture an increasing market share of aggregate exports and significant capital inflows. This has driven a secular transfer of real economic wealth from developed to emerging economies.
Fixed exchange rates with the US dollar made China overly competitive, which pushed their companies’ earnings to extremely high levels and created large global imbalances (see Figure 1). High savings rates in emerging economies caused an abundance of liquidity and this money was used to purchase US-denominated assets (mainly treasuries and credit), pushing yields down.
Other secular and cyclical factors compounded the abundance of liquidity from emerging markets to create very easy monetary conditions. The US Federal Reserve dramatically cut rates to manage the collapse in the US equity market in 2000. Moreover, interest rates stayed low as the supply of cheap labour from China kept a lid on inflation, despite strong global growth. Finally, financial innovation allowed a substantial expansion of bank balance sheets (Figure 2) and credit availability.
Cheap credit created a bubble in debt (Figure 3) fuelling increased consumer spending, housing and leveraged buyout booms. The imbalances between debt levels and household saving rates, the imbalance between the US and the rest of the world (as witnessed in the US current account deficit) and the rise in financial leverage, were booms which are now unwinding.
The structural economic dynamics were compounded by a failure of regulation to keep up with the pace of change in the financial sector and the substantial misalignment of interests between those in some parts of the financial sector and their clients.
The scale of today’s financial crisis is not readily comparable with historic events, which makes its effects on the real economy difficult to gauge. However, housing and debt bubbles, banking system crises, excess leverage and imbalances in balance of payments typically take considerable time to correct. These will create significant multi-year headwinds for spending and economic growth. Savings rates, for example, have fallen below historic ‘equilibrium’ levels (as shown in Figure 4). While an increase in savings may be necessary to repair consumer balance sheets, without significant fiscal intervention by the government to boost income, it would only lead to a sharp pull-back in spending.
Many assets have been affected by the macro factors currently driving the global economy, in particular the frailty of the financial system and its spreading impact on the real economy of the world (especially in Europe and in the US). There is still considerable risk in the form of large credit losses, which will not be fully known for some time.
Global financial markets have been under severe stress, experiencing elevated levels of volatility which we think will remain high due to the fear of increased uncertainty in the financial markets and the depth of the recession.
Additionally, the ‘usual’ rules of capital markets have been suspended, with government intervention and elevated political risks. Investors’ valuation models struggle to incorporate political factors – most notably expeditious measures – which only serve to foster risk aversion.
However, market participants have and are reducing leverage to conserve capital and reduce balance-sheet usage. This is creating different market prices for real and synthetic economic exposure, such as investment grade bonds versus credit default swaps. In bond markets there is currently a high yield premium for buying physical exposures whether corporate bonds or government debt. This premium for liquidity is typically elevated in uncertain times, but is particularly high at the moment given global deleveraging. Therefore, we believe there are attractive risk-reward opportunities in credit.
The structural financial landscape altered dramatically in 2008. The impact of the deleveraging process will not remain limited to the way that capital markets are operated and regulated – it will have a significant effect on the macroeconomy as well. The US continues to suffer from a problem of excessive debt. Given the elevated stress levels in financial markets, the outlook on the world economy remains uncertain. Recent market shocks are the outcome of structural debt problems and will not be quickly fixed. Therefore, whilst various risk premia have risen, a significant amount of time may be required to profit from them.
Overall, the complexity of the ongoing transformation process makes it hard to identify which asset classes are going to benefit most. However, there is a high premium for liquidity in uncertain times. This is especially true at the moment, as market participants are forced to delever and deal with assets that are difficult to price and difficult to sell. Having said that, the current dislocation in markets is providing some interesting opportunities for investors with capital and long time horizons.
Forward-looking returns from all asset classes carry significant uncertainty. Asset price falls have been severe but ‘normal’ reversion cannot be expected because the causes are structural.
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