Pictet’s Christophe Donay unrolls his map of the current financial landscape and identifies areas of relative safety and others of mystery and possible danger
IN 2010, THE dark clouds of deflation gathered over Western economies, threatening the fragile recovery. Recent moves by the Fed (QE2) and the solid showing by government bonds have thus far averted the storm. In 2011, the economic environment should be characterised by double decoupling in a global economy set in a context of ever-increasing inflationary risk in the emerging economies.
First, the US and Europe are likely to grow at a sluggish 2 per cent compared to the 5.5 per cent expected growth in emerging economies. Second, the policy-mix responses of the US and EU are totally different in regards to both monetary and fiscal policy. On the monetary-policy side, the Fed’s QE2 confirms its desire to do whatever is necessary to hit inflation and employment targets. The ECB, however, has begun its exit strategy, continuing to try to banish the spectre of inflation. On the fiscal front, the US government is expected to extend household tax rebates, while the EMU countries have opted for the German austerity model: shrinking of public debt/GDP ratio over the next five years and public-deficit reduction from 2011.
The policy-mix responses of developed economies and emerging economies show that there is patently no cooperation, no co-ordination and no concerted action among the community of central bankers. These policies are clearly domestically focused and the source of both global disequilibrium in currency markets and inflationary pressures. This is compounded by the renminbi. Were China to accept a 30 per cent one-off fair-value revaluation, the pressures on the monetary system would ease, though this tail-event seems very unlikely in 2011. On the contrary, the risk of a renewed sovereign European crisis remains high.
In this difficult context, here are some of our views for asset allocation in the year ahead…
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Opportunity in AAA sovereign money markets… As central banks in the eurozone, Japan, the UK and the US maintain interest rates close to zero, the return of cash will remain very low, especially in developed markets. On the other hand, China, India, South Korea, Taiwan, Malaysia and Thailand have increased interest rates in the second half of 2010 and we expect other Asian central banks to join this trend in 2011. Therefore one of the key investment opportunities in the coming year lies in sovereign money market domestic currency funds benefiting from AAA rating.
Dollar likely to remain weak… Economic climate, risk aversion and structural factors: these three factors have driven currency exchange rates. A fundamental change is that exchange rates are now increasingly used as an economic and geopolitical policy tool. This is why we now expect all three factors to have a significant impact on this asset class.
The Fed’s quantitative easing policy has, and will continue to, put downward pressure on the US dollar and cause the appreciation of defensive currencies, most notably the Swiss franc. As growth in Asia ex-Japan is enhanced and inflationary pressures increase, yields are likely to rise there and attract capital flows, which would, in turn, strengthen Asian currencies. A weakening US dollar and strong growth in Asia are supportive for commodity currencies (eg AUD, CAN). This is further compounded by the low level of solidarity witnessed between eurozone members, which implies that most of the adjustment will be borne by the weak peripheral countries and confidence in the single currency is likely to be shaken.
Developed market blue-chips offer upside… The effects of economic decoupling has led to the development of two types of equity markets. In developed markets, after three years of deflationary pressure, the compression of the valuation ratios is done while in emerging markets, valuations are stretched for some, but not for others, such as Chinese equities. If the US policy-mix succeeds thanks to the extension of household tax rebates, the upside potential for equity markets in 2011 is more or less equal to the earnings growth ranging from 12 per cent to 15 per cent.
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Alternatively, in case of inflation surge, the price-earnings expansion could trigger an additional upside of 10 per cent. A portfolio recommendation would thus be to invest in developed domestic equity markets (blue-chips).
Little to go for in sovereign bonds… In the US bond market, the level of long-term interest rates is no longer determined by market mechanisms but rather by the Fed’s policy of quantitative easing. One of the targets of this policy is to maintain the financing cost of the economy below the real economic growth rate. As long as the Fed’s abundance of liquidity prevails, the return on bonds as an asset class is likely to remain unattractive as the volatility of interest rates could erode the return delivered by the low coupon. Interest-rate risks are tilted toward the upside, therefore, and the day economic growth accelerates or inflation pressures loom, the rates could adjust to fundamentals, creating a disruption in the bond markets.
High-yield corporates promise good returns… Corporate-bond interest rates fell by 100bp in 2010. As the narrowing of spreads is becoming increasingly dependent on developed market economic growth, corporate bonds remain a more attractive investment. Several factors contribute to this trend. Coupons remain more attractive than those paid in cash and government bonds, particularly in the high-yield segment. Returns are also safer than those delivered by sovereign bonds. If the pace of nominal economic growth were to accelerate, the rise in risk-free interest rates would be offset by narrowing spreads. The expected return in high yield is higher than for investment grade. In a typical portfolio it is interesting to keep investment-grade bonds while investing in euro and dollar high-yield bonds hedged in the domestic currency.
Gold remains appealing… In 2010, the gold price topped its historical record in dollar terms due to the QE2 announcement. Gold is historically correlated both to the US dollar’s weakness and to risk aversion and again shows a strong positive correlation. This confirms gold as the perfect anti-paper currency asset. It also plays a broader role for international investors in its extreme form, in the case of dollar debasement.
Even if deflation is not the core scenario, monetary policy response to deflationary pressures is good for the price of gold. Alternatively, even if there is a switch to an inflation scenario, it is a strategic asset to hold. As an insurance-like asset, investing in physical gold is the play to avoid counter-party risk. Structured products or gold-mining stocks should be avoided.
Illustration by Vince Fraser (vincefraser.com)
