It was been quite a month since the last newsletter (just as well I was on extended travel schedule!) , culminating in the events of this past week with the announcement of the Euro rescue package. These are uncertain times with markets fluctuating frenetically between the "risk-on" and "risk-off" trade, and it is important during times like these to re-evaluate (and stay with) the "big picture" view on global markets and economies. Few investment greats do that better than Bill Gross and Mohammed El-Erian , co-CEOs of the world's largest and one of the most successful bond fund managers – PIMCO. They were both interviewed recently by Counselo Mack of Wealth Track , and I have summarised below the key points:
-US growth is likely to average 0 to 1% over the next 12 to 18 months. This is because of weak consumer demand (which is 65-70% of total growth) arising from real wages being unable to keep pace with the growth of profits and other metrics.
-The struggles in the Eurozone, being the biggest economic region in the world, has serious negative implications and has brought the world to the brink of a systemic crisis.
-Europe needs two things to begin resolving this crisis – a circuit breaker to stop the crisis from spreading further and a clear vision where the Eurozone is heading over the next 3 to 5 years.
-A circuit breaker for the banking sector requires three things: ECB to provide liquidity (which is happening), equity infusion into the banks via the EFSF and improvement of the asset quality of banks.
-Europe will eventually solve the crisis and thereby prevent a downward spiral , but that does not imply that the world will return to the "old normal" as there continue to be serious structural issues facing the developed world which will take a long time to resolve.
-A key structural issue facing the US according to Bill Gross is that "long term profits cannot ultimately grow unless they are partnered with near equal benefits for labour. If main street is unemployed and under-compensated, capital can only travel so far down the prosperity road".
-These type of structural issues, and their solutions or lack thereof, have an impact on markets as they influence growth, government yields and equity prices which discount growth potential.
-Policy actions are having a huge impact on markets today and given the lack of cohesion amongst policy makers the impact is largely negative. Policy actions are also distorting fundamentals making the investing process even more difficult.
-Unfortunately the policy options are limited going forward - for example, on the monetary front with interest rates already very low, the positive impact of further declines in rates is limited.
-Therefore the focus of policy needs to shift from monetary and fiscal solutions, which have worked well in the past, to develop structural solutions to regenerate the economy.
-It is not just about stimulating demand, it is focussing on: 1) reviving housing which is critical to the health of the economy, 2) addressing structural unemployment, 3) get credit flowing again to the small and medium-sized companies, and, 4) increasing investment in infrastructure.
-The current debate between the Republicans and Democrats on whether to reduce the deficit or not is important but it needs to be dealt with later as the immediate priority is for the government's balance sheet be substituted (in a productive way) for the private balance sheet because the private sector is unwilling to take risk.
-Growth is the best way to reduce the debt problem in the developed world but we are unlikely to see growth because of the structural impediments. This has huge implications for investment portfolios.
-Portfolios should be well diversified and weighted in high quality assets in the developed world (government guaranteed bonds like US mortgages, high grade corporate bonds, equities in corporations with good balance sheets), emerging market local currency and $ bonds, diversified currencies, and "tail risk hedge" assets which provide protection against disasters like gold.
Interesting views from two investment greats and very helpful in keeping focus on the "big picture" and not getting swayed by extreme market volatility. The key lesson learnt over the last few months is the critical importance of diversity of assets – in these uncertain times it is almost impossible to predict the short to medium term movement of various asset classes and constructing a portfolio with weightings in cash, longer dated developed world government and high quality corporate bonds, EM local currency and $ bonds, developed world high quality equities, EM equities, commodities and gold should be able to withstand (to a reasonable degree!) market volatility. It is equally important not to overreact to extreme market movements, but use them to perhaps lighten or increase exposure as opposed to panic driven buying high and selling low!
On the European rescue package – it is a step in the right direction and embodies the Angela Merkel "step-by-step" approach rather than the Sarkozy/Cameron "bazooka" approach. Therefore, expect more summits in the future in response to more crises, but also realise that European leaders have shown that they have the resolve to address them (temporarily) and prevent downward market spirals (which is likely to lessen the fear factor in markets). Eventually, they will need to resort to ECB funding to support government bond markets and finally a quasi fiscal union in the form of eurobond issuance. As the above note highlights, the developed world is destined for 1% economic growth for a long while, which when combined with financing costs of 5-6% (for Italy and Spain) on a large debt burden, is not a viable scenario over the medium term.
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