Investment Week – Asset Allocator’s Soapbox
Living in a world of debt: The investment implications
Investors have a long list of questions at the moment, many of them relate to how they should invest given that many parts of the developed economy are saddled with a high level of sovereign and consumer debt. This concern is being manifested in the on-going Euro crisis as well as concerns about the level of US debt and how to control it. Helpfully for investors, corporate sector balance sheets are under leveraged and profits are set to grow robustly in the years ahead, ameliorating some of the concerns.
Debt problems remain paramount at present. In the Eurozone the major refinancing and issuance of debt increasingly comes at a higher price for nations as confidence periodically wanes. In some cases the natural buyers of these assets are disappearing as sovereign nation rating downgrades force such debt out of traditional benchmarks. Large bank exposures to peripheral debts mean “hair cuts” will eat into capital bases and heighten worries about the cost of debt restructuring. Finally, the stock of debt is too high, the consequence of which is that deleveraging and the crowding-out of the private sector will decrease the growth potential of economies, hitting consumption. We expect GDP in this cycle to be up to 2% lower per year than the last, albeit, very robust one making it more likely that recessions are more frequent.
A resolution to the debt problem is needed. Eurozone leaders agreed to provide a short-term financial solution for Greece - in effect enabling an orderly default through maturity extension and private sector write-down of existing debt, plus a further asset injection. The result is potentially a reduction of Greece’s debt-to-GDP ratio from around 160% to 135%, if reform expectations are fulfilled. However, this is still a precarious position and does not offer a longer-term solution. This agreement, in effect, signals a further step towards a European Monetary Fund and ultimately a form of fiscal union for the Euro area.
However, longer-term uncertainties remain, and investors will need further reassurance. Other more substantive policy responses for Greece, the highly indebted Eurozone nations, plus the UK and US require a series of long-term policy responses. Firstly, fiscal austerity is needed to crowd-out the public sector and crowd-in the private sector via a reliance on spending cuts rather than tax rises. This should be accompanied by loose monetary policy. Longer-term economic adjustments are also vital to counter the disinflationary forces of deleveraging. Competitive tax rates that attract outside investment are helpful, while exchange rate depreciation, to fuel trade surpluses, and lower unit labour costs, to enhance economic productivity, are both important. The alternative outcome is that some Euro nations break away, which would be expensive and risky. For other countries the currency potentially takes the strain of adjustment.
Despite all these sovereign uncertainties, the corporate sector remains an engine of growth, as it is highly exposed to emerging markets growth, buoyant energy prices and the technology sector. Markets are hence pricing in around 15% earnings growth for 2011-2012, largely driven by revenues from these buoyant parts of the global economy. The market currently benefitting most from these drivers is the US, which has the advantage of a weak currency which is boosting overseas earnings when translated into US dollars. Hence, the Q2 earnings season has started well for US companies with earnings up around 15% p.a. and the vast majority of companies’ earnings surprising positively. Strong areas are business-to-business expenditure in OECD and business-to-consumer/government revenues in emerging markets. However, corporate margins are vulnerable due to higher raw materials and intermediate goods costs, though revenue growth continues to surprise to the upside, helping drive profits growth.
In conclusion, the global financial crisis has evolved into a sovereign crisis, creating systemic risks. The economic adjustment process to avoid a systemic outcome is long and complicated. On the upside, the corporate sector is performing well with profits growth set to continue robustly in the years ahead. The investment implications are to favour assets that provide high and sustainable income rather than relying on capital growth. Hence, we favour corporate bonds and commercial property. However, we remain cautious of the Eurozone and have moderate risk in portfolios.
Richard Batty, Global Investment Strategist, Standard Life Investments