Crystal Ball Gazing
January 8, 2013
of Bedlam Asset Management
Several recent government announcements are likely to impact the global economy and equity markets over the medium term. In order of importance these are: the Federal Open Market Committee pledge to target zero interest rates until unemployment reaches 6.5%; the new government in Japan, under an increasingly monetarist LDP leadership; commitments by the new Chinese leadership to boost domestic infrastructure and consumption; and finally, the softening line of the Republicans on the fiscal cliff. In every case apart from Europe, these announcements reinforce previously less overt policies of trying to promote inflation and competitive currency devaluations. In short, money printing by all major nations remains the dominant theme. The investment message is stark – buy equities and sell bonds.
What is also apparent is that throughout 2013, government policies and any shifts will continue to dominate capital markets. Given the prospect of feeble economic growth and stubbornly high unemployment, both recently elected governments and incumbents are being forced into expansionary fiscal policies, in the process squeezing private sector credit. Thus private sector investment will likely stagnate, exacerbated by excess capacity and, as a generalisation, weak domestic consumption. Excess capacity continues due to unrealistically cheap money and the reluctance of lenders, especially banks, to write off bad debts. The consequence is legions of zombie companies, whose continued existence acts as a squeeze on profits. Despite these negative headwinds, new government initiatives to prop up growth will create many investment opportunities.
The landslide victory by the LDP in Japan catapulted Shinzo Abe back in as Prime Minister. His government's blatant expansionism is the beginning of a seismic shift in the monetary policy of the third largest economy in the world. Japan has finally capitulated and joined the rest of the developed world in attempting to inflate away their debt by boosting nominal GDP growth to above the rate of interest they pay on their debt. It is worth noting that Japan has not only the highest government debt to GDP at 225% but also one of the shortest debt maturities, at under 5 years. Hence the urgent need for action. The appointment of a new Bank of Japan governor in April is likely to be accompanied by a 2% inflation target (vs. the current 1%), open-ended money printing and the buying of foreign debt - largely in order to weaken the yen but with the added benefit of helping to increase exports and profit margins. This is beggar thy neighbour competitive devaluation, already a widespread practice globally. There are suggestions too of a Y10 trillion ($122b) supplementary budget being announced in January. Banks have already started to re-price mortgage rates even lower, such as 10-year fixed rate mortgages at 1.3% with 100% financing. This is not only highly attractive to borrowers but very good news for the domestic property market. The rental yield on central Tokyo appartments is 4.5% (4.0% for prime A Tokyo office space), 3% above the cost of funding. The losers are the banks with the paltry margin on offer providing scant protection against inevitable credit and default problems.
Lower government debt levels in many emerging markets, in contrast to the industrialised world, have allowed governments to increase expenditure and prevent economic growth from slowing. For example, Thailand's government in October announced a Bt2.3 trillion ($75b) infrastructure development plan from 2012-2020, to improve internal transport connections and those with neighbouring Vietnam, Laos, Myanmar and China. 65% is being spent on land transport, the remainder going to air traffic, power and telecoms. Conveniently for the incumbent government, this expenditure plan peaks in 2014-16, coinciding nicely with the end of the government's term in office and elections in mid 2015.
The newly elected governments of China and Mexico are also changing policy. In the latter, the Institutional Revolutionary Party (PRI), headed by Enrique Pen Nieto, overthrew the previous incumbent thus resuming its "normal" stranglehold on Mexican politics. The intention is to spend 5.5% of GDP on infrastructure every year from 2013-19 - equivalent to $450bn, to be split 60% petrochemicals, 12% transportation and 10% water. The reality check on these policies is whether the government has the nerve to push through the necessary privatisation and reform of the domestic energy market. This will break up Pemex's, the long-inefficient state company, monopoly of the exploration, production and refining market. The vested interests against this are enormous; although Pemex is all but bankrupt, an estimated $20bn of oil revenues fails to reach the government's coffers year in, year out. Worse still, despite having the fourth largest natural shale gas reserves in the world, Mexico has to import gas from over the border in Texas. The necessary change in legislation is expected in the first six months of the year, opening up their gas market to private sector investment. The result will be huge infrastructure spending creating significant opportunities for companies both sides of the border.
In October, Xi Jinping was appointed as head of China's politburo, the top decision-making body. No specific reforms are due to be announced until March/April and as always, the government is likely to give with one hand and take with the other. Nevertheless, the most probable beneficiaries will be the consumer, healthcare and energy sectors. Slower growth in exports and income scares the Communist Party, where the implicit pact is "high growth for less freedom". Hence initiatives to boost consumption - particularly the number of people covered by social security payments such as health care - are likely to widen considerably. Meanwhile, banks will probably to be forced to increase their absurdly low reserves for bad debts following the credit binge of 2009 and 2011. Additional hits to bank profitability are a distinct possibility as the government continues to liberalise interest rates, leading to higher bank deposit rates. This will benefit savers to the detriment of bank margins.
The New Year sees many new and incumbent regimes bizarrely united in trying to create inflation and "reform" programmes on an unprecedented scale (having spent the previous three decades slaying the "inflation dragon"). In conjunction with corporate rationalisation and sector consolidation, this ensures that equity markets in 2013 will present many attractive opportunities. This is in contrast to the “bubble” like qualities present in much of the debt market, most notably high yield and emerging market.
© Bedlam Asset Management