2013 International Outlook
January 18, 2013
by Colin Moore
of Columbia Management
We continue our outlook for 2013 with a review of select international economies and financial markets. Similar to the U.S. the road to recovery will be bumpy and we expect financial markets to continue being affected by macroeconomic uncertainties. While the overall environment remains uncertain, some of the significant headwinds in 2012, e.g. the Chinese leadership transition and a complete disintegration of the eurozone, are perhaps less concerning for markets than they were a year ago. Moreover, in the eurozone, there is now at least a recognition that very tough decisions lie ahead. Several European politicians have indicated they know how to address the debt crisis, but not how to get re-elected if they do. Sound familiar?
Interest rates will remain low indefinitely and the search for yield will continue. However, fixed income investors should not expect a re-run of the easy ride they had in 2012. Active management will play an important role given the strong returns from many fixed income assets over the past 12 months. In a low growth world, we expect strong companies to get stronger. Businesses that can deliver sustainable growth should be able to command premium valuations, given that overall rates of economic growth will remain subdued. Developed world government balance sheets are likely to remain under pressure, and investors will continue to question the sustainability of current policy.
The eurozone is likely to remain in recession, with gross domestic product (GDP) contracting by 0.5%. Japan is likely to see a slowdown in growth unless the new prime minister can create new stimulus while the UK will see a modest recovery in GDP growth to 1% for 2013. Growth in the emerging world will be considerably better. The rebalancing of China’s economy is likely to result in GDP growth of just below 8%. At a minimum the news from China shows signs of the economic slowdown having bottomed, which is a clear plus for equity markets and risk assets generally, as the emerging world remains the primary motor of global economic growth. The easing of tail risks in Europe and China leads us to be more positive on equities than we have been for some time. We expect the strong to continue to get stronger in the equity space and M&A activity to remain an important driver in a number of markets as companies put their excess cash to work. In fixed income, we continue to question the appeal of so-called safe haven core government bonds such as UK gilts and German bunds — yields remain at historically low levels (and are particularly unattractive in real terms) — and the risk of capital losses down the road is significant. Higher-yielding areas of fixed income such as emerging market debt and high yield look more appealing to us, although strong returns from these asset classes over 2012 and significant spread tightening mean that it is much more difficult to make a strong valuation case for these areas than it was a year ago.
We expect commodity markets to be pulled in different directions in 2013, with the latest round of quantitative easing (QE) most likely to benefit precious metals. We see tight supply conditions in the oil market, and a shock to production cannot be ruled out given Middle East tensions. However, buoyant agricultural markets should lead to heavy planting, which may limit future gains. Furthermore, the sluggish global economy and the shift in China from investment-led growth towards greater emphasis on consumption are negative for industrial metals. However, even with these caveats, commodities are likely to remain very popular with investors looking for a hedge against the longer-term inflation risks posed by QE. Moreover, commodities, while volatile, can provide significant diversification benefits as part of a multi-asset portfolio.
Since 1990, one of the easiest annual strategy calls has been to dismiss investing in Japanese equities as a broad asset class. Although our long-term view on Japan remains bearish, there is a chance that Japanese equities will perform well this year. Japan has suffered years of weak economic growth and deflation. Prime Minister Abe seems to favor a reflationary policy and has pushed the Bank of Japan (BOJ) to increase its inflation target to 2% from a 1%. Perhaps more importantly, the BOJ is likely to introduce a nominal GDP growth target of 3%. While both the equity market and the yen have quickly priced in a meaningful probability that some of the “Abe-nomics” will be effective in increasing economic growth, the scale of the anticipated measures may not be fully discounted:
1) There will be a significant adrenaline shot to stimulate activity and attempt to defeat the lethargy which has resulted in deflationary pressure for decades. A stimulatory package of ¥12 trillion, or 2.5% of GDP, is already planned but a supplementary budget is also likely. In particular, the revival of infrastructure spending is likely. The new government has encouraged the nations’ public pension fund to move $1.12 trillion dollars into equities.
2) The BOJ’s new leader, to be appointed in April, is likely to end the bank’s long-term hawkish bias. If the BOJ adopts a new policy stance, it is critical that they stick with it. Past experience is they tighten at the first sign of growth and snuff out the nascent recovery. Debasing the currency has begun with a 15% drop against the U.S. dollar and a 20% drop against the euro and Korean won in just the past three months. However, a global race to the bottom is underway. Every developed country government wants a weaker currency. Consequently, further JPY debasement will be countered by other central banks. Further declines may occur, but at much more gradual pace. Investors need to be aware of the currency wars. Guessing which global market will outperform may be rewarding, but it can hugely frustrating if the investor benefits from the market gain only to have that gain diminished by currency devaluation.
3) While Japan may match Italy in terms of political instability, recent history has been a little volatile. However, the Liberal Democratic Party’s expected victory in the upper house elections in the summer 2013 should lead to more unity between upper house, lower house and the prime minister.
4) Prime Minister Abe’s rhetoric around closer ties with Russia may provide better access to stable energy natural resources and reduced geopolitical risk.
5) The corporate sector is sitting on huge cash surpluses. Similar to the U.S., Japanese corporate balance sheets are basically the mirror image of massive government deficits. The economic climate has lead to low real (and nominal) returns on capital so there is no huge incentive to put the excess cash to work. Forcing that cash to be put to work, through stimulating demand, inflation and tax policy (incentives on spending), could have a massive impact on the economy .While details are not yet available, effective corporate tax cuts are expected from the current level of 40%.
6) If corporate return on capital grows, then equity valuations should improve. The current price to book ratio of approximately 1 is undemanding, especially if when comparing an improved return versus the 10-year Japanese government bond yield.
However, there are several boxes to check off to make us optimistic on Japan strategically. The aging population and shrinking workforce appears to be an intractable demographic problem. Without substantial changes to immigration policy we are struggling to see any meaningful solution. A declining workforce needs to be supported by significant scientific/technological research and the highest education standards. We have visited with the management of Japanese companies for 25 years. They have many fine qualities, but if they want to attract and retain foreign capital they must change their view toward shareholder friendly capital management.
Japan’s current government debt problem is massive. Therefore, the pressure to be successful with deficit stimulus over a relatively short time scale will be high. Otherwise, this causes more problems than it solves. Many believe that the fact that current deficits are largely financed by private sector savings mitigates this issue compared to the U.S. While true historically, we believe the aging demographic will pressure that relationship. If the BOJ doesn’t stick with the reflationary policy, all hope will be lost and the yen could strengthen materially and suddenly. If Abe gets his 2+% inflation and the BOJ raises rates as a result, the debt math becomes untenable very quickly. Obviously, the debt burden is a time bomb as it is, but ironically this inflation target could end up being the match that sets it off.
Asia & Global Emerging Markets (GEM)
Broadly, the GEM structural growth story is still intact. The 2008 global financial crises found a rapid response from policy makers in emerging markets. We saw swift and large fiscal and monetary stimulus from central banks throughout the GEM universe. With looser monetary policy, credit boomed, consumer spending surged and infrastructure projects were pulled forward. The consequences of this, particularly in the larger GEM countries such as China, Brazil and India, was the return of domestic inflation and a deterioration in asset quality at many banks by the time we moved into 2011. Policymakers responded accordingly and tightened policy across the GEM universe though out 2011, causing their economies to slow considerably; this proved too large a headwind for GEM equity markets causing them to underperform versus developed market peers in 2011. The policy cycle slowly started to turn at the beginning of 2012, and monetary policy was gradually loosened. The magnitude of the easing however has disappointed some market observers as it has been much less than what was seen in 2008/2009. Policymakers were wary not to make the same mistakes that would result in a return of inflation and heightened asset quality concerns. In that regard they have been successful; we have seen a slow stabilization in the major GEM economies without the return of inflation. Since we have merely seen a stabilization of growth rather than a strong rebound, there are some who believe the slowdown is more structural than cyclical. We are not in that camp. We believe the structural advantages for GEM are still intact, and while the growth rate may not return to what it was during the last decade, it may very well be growth of higher quality, i.e. more of a consumption-led growth driven by a strong sustainable middle class rather than growth driven by fixed asset investment. We would also highlight, when considering emerging markets, it is important to look beyond the major markets we have become accustomed to discussing.
Much has been written about the slowdown in emerging markets over the last year. It is important to remember that approximately 70% of the world’s incremental global growth is coming from emerging markets —even with the big markets of China and Brazil slowing down materially. Economic growth in GEM seems to have stabilized albeit at a lower rate than before. We don’t expect a return to the high growth rates of last decade, particularly in China, but we would argue that this will perhaps be a higher quality more sustainable type of growth moving forward, led by the rise of a powerful middle class and perhaps less fixed asset investment.
Asian economic growth has entered a transformational phase where the strong export-led model will continue to adjust to a model based on domestic demand. We have argued that this may produce lower growth but less volatile growth. However, this is a long-term trend and for 2013, Asian economic growth will depend on exports. Consequently, our assumed second half recovery in the U.S. and the renewed interest in risk assets due to the reduction of tail risks thanks to aggressive central bank policies will be important for the Asian economies and markets.
We expect inflation to head modestly higher in most Asian countries, given our anticipation of a recovery of global trade. Asian inflation risk is mostly food related. We do not expect that to be a major source of inflation given additional planting. There are always wildcard possibilities. Tensions in the Middle East inducing an oil price shock and/or a potential rebound in coal prices are clearly a threat especially to those countries where their retail fuel prices are still heavily subsidized by their government.
However, major competitive advantages remain in place. Asia and the emerging markets suffered crisis after crisis from the 1980’s till the early 2000’s. The process of recovering from these crises and attempting to setup a system that would prevent them from happening again saw many countries imposing new regulations and fiscal disciplines that have left them in a much healthier place today. The factors that led them on their growth trajectory are still in place today. The cost advantage in manufacturing, that initially took developed companies overseas is still in place, but now perhaps sits in different countries and certainly in different industries. The corporate balance sheets which allow companies in emerging markets to take on this capacity are still very strong — they have continued to de-lever, having learned many of the painful lessons of carrying too much debt. This is also true at the government level and for households.
GEM demographics should also not be ignored; they are a very powerful driver of economic growth and markets over time. Due to the long lead times, demographics are easy to analyze and to predict. Having a young, growing workforce certainly increases the potential GDP of a country. Overall demographics in emerging markets are much healthier than the developed world, which will continue to act as tailwind over time.
Keep in mind that there are stark differences between GEM countries which helps guide us in our country allocations. When you can combine a strong demographic profile with an economy that allows for social mobility, that is when the demographic dividend is truly captured. Demographic “winners” include Indonesia, the Philippines, Turkey and Brazil. India should also be highlighted; JP Morgan estimates that 250 million people will enter the working age population between 2005-2025. This is a staggering number and could turn out to be extremely powerful. Demographic “losers” include Russia and China. China’s one child policy, in place since the 1970s, has had a major impact on demographics. It looks like the Chinese workforce will peak sometime in the next few years in terms of sheer size; the Chinese government is well aware of this phenomenon, perhaps helping explain why they have dedicated so many resources to improving education levels and moving up the value chain. Other areas that we have concerns regarding demographics are South Africa and parts of the Middle East, where the populations are young but lack social mobility due to poor education levels and structural unemployment, often a recipe for social unrest.
China’s communist government is going through a period of leadership transition. However, outgoing and incoming leadership have consistently reiterated their priority of sustainable economic growth with urbanization, infrastructure investment and accommodative monetary policies being the main pillars to achieve their GDP growth target. We will be keen to see more progress made by the government in several areas including banking sector regulation, exchange rate policy, the development of domestic bond markets and new initiatives to push consumption demand further as a sustainable source of growth. The macro economic data in China has stabilized and continues to point to a soft landing. We don’t expect an immediate change in policy; we believe the new leaders, like the previous ones view the magnitude of the 2009 stimulus as a mistake with the ensuing overcapacity in many industries still being felt today. We believe the key metric the government is focused on is employment. As long as employment stays strong, we do not expect another round of big stimulus but rather a continuation along this gradual transformation to a more consumption lead economy. We do have some concern that China is becoming less competitive, particularly on the low end of the value chain. The cost of doing business has been rising rapidly due to the peaking of the workforce and the steady increase in wages which has really hurt the return on invested capital of the export sector. Over the long term, we believe they will be successful in moving up the value chain but it can be a bumpy transition due to the weak external demand environment particularly from the developed markets. Our other concern on China has been the deterioration in the return on invested capital and earnings of the listed companies. Many sectors are in a state of overcapacity and the earnings downgrades have felt much more like a hard landing than the macro numbers indicate. Part of the problem is that Chinese companies have historically managed for maximum growth in output, managing in a constrained environment has been a new experience for many management teams and the stress is showing. One silver lining is the housing market. Since the policy restrictions were lifted last March, there has been a significant pickup in transaction volumes, hence inventories have started to come down and new starts have begun to pickup. The pickup in investment will have a good effect on the economy. It is important to keep in mind the positive and negative crosscurrents when looking at a complex market like China. Our expectation is the macro numbers will muddle along and we will continue to look for opportunities at the stock level.
For India, investors remain concerned about fiscal slippage. S&P revised India’s outlook of its BBB- rating from stable to negative in early 2012, highlighting the lower GDP growth prospect, risk of external liquidity and eroding fiscal flexibility. There are now heavy economic and political pressures for the Indian government to deliver on the reform front, but the political reality in India will continue to make reform impractical. Getting agreement by both the lower and upper houses may be even harder than getting agreement between the House and Senate in the U.S. Separately, due to the inelastic demand for gold and oil, appreciation by these commodities would put more pressure on the current account deficit. We continue to be enthusiastic about the opportunity suggested by India, but we remain frustrated by the political and bureaucratic quagmire that inhibits its realization.
Beyond the BRICs
It is important to remember that the emerging markets are not just about the big four countries of Brazil, Russia, India and China. It is true that all four have faced some sort of cyclical or even structural issues in the last 24 months which has held back the overall performance of the index, but that has masked the stellar performance of some of the smaller index constituents. Markets such as the Philippines, Thailand, Turkey and Mexico have continued to post very strong returns supported by very strong fundamentals. It is important that when investing in emerging markets you have the flexibility to position around an often inefficient index to take advantage of these opportunities. As of end of October 2012, constituents of the energy, financials and materials sector made up a little more than 50% of the weight of the overall index. This is why it behaves in such a cyclical manner and does not truly capture the secular opportunity associated with the emerging market universe. Consumer and services sectors have been leading the market’s performance over the past few years; given the secular trends with strong middle class formation in many of these countries, we feel they should continue to do so. The same point can be made on the stock level, where the top end of the index is dominated by state owned enterprises, whose primary purpose is to provide employment for the people of the nation rather than to maximize shareholder value. Over time a distinct focus on companies who create shareholder value should also add to returns.
During this economic slowdown, it has been hard to separate the cyclical versus the secular issues but the long-term drivers for emerging market growth are still in place. Earnings have been consistently revised down and multiples have compressed. Expectations for emerging market equities are low, but with the help of accommodative monetary policy, growth seems to have stabilized. In the current environment, one may need to dig a little deeper and work a little harder to find great investment opportunities in the GEM equity markets — but they are there.
The aftermath of the 2008 global financial crisis has given the fixed-income market not only a new interpretation in terms of its risk-reward profiling versus equities, but more importantly a much higher percentage of core portfolio allocation, in the hearts of many global investors. Asian fixed income, which has grown sizeable enough in terms of market capitalization, geographic and industries coverage, is now a distinctive choice of an investment asset class for global investors. 2012 was a defining year for Asian fixed income. Not only did we experience the highest amount of new issuance within a single year, the diversity of industry groups from new issues was also unprecedented. In Asian sovereign, we had Sri Lanka returning with a 10-year new issue, and Mongolia’s debut issuance of two USD benchmark bonds. These new sovereign issues, together with the supply from their quasi-sovereign peers (Bank of Ceylon from Sri Lanka, Vietnam Joint Stock Commercial Bank, Development Bank of Mongolia) open up a brand new arena for Asian sovereign and quasi-sovereign bonds.
Asian high-yield corporate bonds delivered volatile but strong total return performance for 2012 (JPMorgan Asian Credit High-Yield Corporate Index returned 25.4% in 2012), when event risks from developed market subsided and credit fundamentals remerged. Consequently, we may only receive the higher carry currently available but credit fundamentals remain strong.
The love-hate relationship between investors and Asian benchmark high-yield sovereigns (Philippines and Indonesia) has deepened further in 2012. They are everything to love in terms of liquidity, but everything to hate in terms of valuation (especially the Philippines sovereign debts). Tight valuation aside, we believe the Philippines earned a well-deserved upgrade by rating agencies this year with its better public finances, sustained growth of overseas remittances, and disciplined government budgeting. Philippines sovereign bonds appear to have earned a relative “safe-haven” status. Valuations appear more attractive in Indonesia and “frontier” markets such as Sri Lanka, Mongolia, and Vietnam. Of course, there is a reason why they are referred to as “frontier” markets; there are significant risks.
There was a big jump in the amount of high-grade corporate new issuances in 2012, up 189% on a year-over-year basis in terms of total amount issued. Valuations have risen but Asian high-grade spreads still offer 50-90 basis points pick-up from similarly rated bonds in the U.S. Our favorable outlook on Asian high-grade corporate bonds is also an expression of our view that market volatility will be less detrimental to Asian high-grade compared to high-yield when people are still generally cautious about the heightened risk of global growth and politics.
Various actions by the European Central Bank (ECB) have reduced tail risks. Risk premiums in the periphery markets have eased since the ECB announced further programs to maintain/improve liquidity and reduce interest rates. Similar to Federal Reserve (Fed) actions in the U.S., the ECB will buy government bonds of countries that are under financial stress as long as the government is under an “adjustment program” approved by the eurozone. This is in addition to the Long-Term Refinancing Operations (LTRO) which provided money at reduced rates eurozone banks. Importantly, the ECB has put these measures in place with the grudging acceptance of Germany. We should be under no illusion that these measures address the key structural issues confronting Europe. Indeed the ECB’s initiatives to contain financial stress/contagion may have weakened the pressure on the political process and thereby slowed progress towards resolution.
Large divergences remain between core and periphery economies. Goldman Sachs note in their 2013 outlook “Such divergence is expected (given the public-sector austerity and private-sector deleveraging required to correct, in several cases, severe imbalances in periphery balance sheets) and necessary (as reducing intra-Euro area imbalances is required to make the single currency workable). Peripheral governments must spend less and generate more revenue (through taxation, etc.) in order to reduce government debt, budget deficits, or both. All of the above has continued to weigh heavily on the economic growth of the peripheral economies.”
It is noteworthy that some of the periphery countries such as Spain and Ireland appear to be making the necessary structural adjustments as painful as they are. Greece, through a series of measures has made progress on refinancing itself, but we are not comfortable they are really dealing with the structural issues. 2013 will have its political dramas and comedies including upcoming elections in Italy (given the resignation of technocrat PM Mario Monti and the possible re-emergence of Silvio Berlusconi) and Germany. We suspect Chancellor Angela Merkel will be reelected but her ability to maneuver the competing interests and passions of the German political class and voters relative to the other eurozone politicians and voters should not be under estimated.
We see 2013 as a broadly sideways to modestly firmer year for the U.S. dollar, at least against the major currencies. The trade-weighted U.S. dollar against a simple model based on a composite 2-year sovereign bond yield differential looks slightly undervalued. An expanded model based on 2-year differentials and the VIX, which looks at the market’s expected volatility, to capture risk on/off swings in market sentiment and the dollar’s tendency to outperform cyclical explanations alone during periods of risk aversion shows the dollar looks fairly valued against the other major currencies, in aggregate. With 2-year yield differentials likely to remain very low and differentials fairly static this year, we do not see a sustained move in the dollar higher or lower.
We see the U.S. dollar modestly softer in the first half of the year as the impact of fiscal drag on U.S. growth and political rancor over the debt ceiling take a toll. But we expect the dollar to recoup these losses plus some in the second half if U.S. economic growth starts accelerate. Indeed, looking forward a year, we think it will be increasingly clear the U.S. economy is crawling out of the post-financial crisis mud faster than Europe or Japan, and this companies with strong balance
sheets, robust cash flow generation and proven capital allocation strategies are also likely to remain in demand, particularly as the shares in such companies often provide a higher yield than equivalent bonds. Poor management, flawed business models and weak franchises are very likely to struggle in the tough economic environment. We continue to favor companies that offer growth in a low-growth world. These include:
- Companies selling into emerging markets.
- Businesses with access to a secular theme such as providing cost-effective healthcare services to aging populations in developed countries or new affordable healthcare in developing countries.
In emerging market sovereign debt, there will be an increasing realization that certain sovereign issuers are more deserving of safe haven status than developed peers.
The views expressed are as of 1/14/12, may change as market or other conditions change, and may differ from views expressed by other Columbia Management Investment Advisers, LLC (CMIA) associates or affiliates. Actual investments or investment decisions made by CMIA and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance. Asset classes described may not be suitable for all investors. Past performance does not guarantee future results and no forecast should be considered a guarantee either. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts are accurate.
This material may contain certain statements that may be deemed forward-looking. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those discussed. There is no guarantee that investment objectives will be achieved or that any particular investment will be profitable.
Investment products are not federally or FDIC-insured, are not deposits or obligations of, or guaranteed by any financial institution, and involve investment risks including possible loss of principal and fluctuation in value.
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