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The money manager PIMCO has an annual event where they debate the major trends that are likely to play out over the next three to five years. Their Co-CEO Mohamed El-Erian has written a note (http://www.pimco.com/EN/Insights/Pages/Policy-Confusions-and-Inflection-Points.aspx) which summarises these discussions and the theme for this year's outlook is "Policy Confusions & Inflection Points". The note covers a lot of ground and I have summarised below the key points:
On EM equities, last week I had made the case for taking a contrarian exposure to Indian equities which are at historically attractive valuation levels. The chart below (from BCA research) extends the theme to the EM universe and looks at both relative equity valuations (y-axis) and currency valuations (x-axis). From that perspective, China, Taiwan, and Emerging Europe looks cheap (India is very cheap from a currency viewpoint and close to being cheap from an equity viewpoint) while Indonesia, South Korea and Latin America look expensive.
-Looking at the whole EM universe, the chart below (from Morgan Stanley) illustrates the cheapness of EM equities, which at 1.6x book value are 1 standard deviation (16%) below their 20 year historical average. So attractive valuations, combined with the secular theme in favour of emerging markets as outlined in the PIMCO note, make it a compelling case!
-The world remains mired in a self-reinforcing cycle of reactive partial policy responses, subsequent complacency and recurring crises. The longer this goes on the higher the risk of major inflection points, heralding another global crisis, over the next three to five years.
-The developed world continues to be characterised by low growth, too much debt, high unemployment, political polarisation and increasing calls for greater social justice.
-The status quo is no longer an option for Europe over the next three to five years. The likely outcome is that Europe will evolve into a smaller but a more stable union, comprising countries with similar economic and political systems (including the big four – France, Germany, Italy and Spain).
-However, there remains a risk that the eurozone fragments due to the population losing patience and causing a political and social rejection of the union and resulting in massive disruptive private capital flows.
-The US is likely to look good compared to Europe, outperforming in terms of growth and financial stability, but will be increasingly dominated by extreme political polarization and disagreements amongst policy makers. For example, the fiscal cliff debate is likely to get very acrimonious over the coming months and provide an insight into how this theme plays out over the next several years.
-The Federal Reserve is likely to continue its policy of financial repression (i.e. zero rates) for many years and other regulatory bodies are also likely to pursue more restrictive policies. This will exacerbate concerns about growth, jobs, inequality and deficits and make the economy and financial markets more fragile.
-Emerging markets are expected to outperform both Europe and the US over the next three to five years, and account for 50% of global GDP (in PPP terms) and grow at 5% annually compared to 1% for the developed world. The debate between inflation and disinflation will continue as the effects of the stimulus versus debt deflation play against each other.
-However, over the next few years inflationary pressures are likely to build slowly as cyclical factors become more structural and impede the long-term growth potential, particularly with reference to the labour markets. Central Banks will therefore be forced to do too much, and inflation could be a politically attractive option to delever.
-Meanwhile, political uncertainty will increase as elections and transitions become more prevalent – 50% of global GDP will face a politically defining change in 2012 and 8 out of 17 eurozone governments have been voted out of office in the last few years. Potential for political upheaval is high.
-Over the next few years, elections will increase the pressure that governments feel from increasingly restless populations – especially countries with high youth employment like Greece and Spain (51%), and Italy and Portugal (36%). With "hope and opportunity" being replaced with the older generation's debt burden and low growth prospects, the possibility of unpredictable socio-political reactions remains.
-The longer it takes for the developed world to tackle their growth and debt problems, the greater the need for emerging markets to transition to domestic demand led growth. This is particularly important for China.
-In such a world, investors need to retain a claim on the upside while protecting their portfolios against "tail risk" type events. They should supplement bottom-up security selection with a macro framework which deals with the implications of various policy approaches being used to induce growth in over-indebted economies.
-This implies a bias towards quality sovereign debt and exposures in the credit and equity space in companies with high cash balances, low financial leverage, high operating margins and exposure to growth areas. In addition, focus on shorter duration sovereign debt to benefit from an attractive roll-down, and equities with high dividends to effectively shorten duration.
-Real assets (i.e. commodities) to hedge against inflation and other aspects of financial confiscation (i.e. default, appropriation) , in areas which have supply constraints and stable geopolitical risks.
-Currencies are difficult to predict – with EM currencies being supported by higher growth, strong balance sheets and capital inflows, but governments trying to keep their appreciation in check in an uncertain world driven by excessive liquidity creation in the US. The US$ is also expected to be a beneficiary of a flight-to-quality, at least during the initial part of the three to five year horizon.
-At some point over the next three to five years we are likely to reach a point where either the central bank policies of financial repression work as a bridge to more effective policies and unleash a flood of private capital or they don't work and become counterproductive and bring about various unintended consequences. In the former scenario, government bonds would be a bad place to be and under the latter scenario, principal protection would be the key theme.
-The secular outlook is therefore, to borrow a phrase from Ben Bernanke, "unusually uncertain". This does not imply investor paralysis- but requires a well thought investment plan and effective "tail risk" management.
A thought provoking note and drives home the key theme of an uncertain world with unpredictable outcomes. This type of environment makes it even more critical to construct a well diversified portfolios, which provide upside potential while protecting against principal impairment. That is portfolios weighted towards EM equities, energy and natural resources, high quality multinationals, EM government and corporate debt, cash and gold. Gold has historically done well under a negative real rate environment (i.e. financial repression-see chart below) and hedges against the risk that the central banks overstay their welcome!
On EM equities, last week I had made the case for taking a contrarian exposure to Indian equities which are at historically attractive valuation levels. The chart below (from BCA research) extends the theme to the EM universe and looks at both relative equity valuations (y-axis) and currency valuations (x-axis). From that perspective, China, Taiwan, and Emerging Europe looks cheap (India is very cheap from a currency viewpoint and close to being cheap from an equity viewpoint) while Indonesia, South Korea and Latin America look expensive.
-Looking at the whole EM universe, the chart below (from Morgan Stanley) illustrates the cheapness of EM equities, which at 1.6x book value are 1 standard deviation (16%) below their 20 year historical average. So attractive valuations, combined with the secular theme in favour of emerging markets as outlined in the PIMCO note, make it a compelling case!
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