The year ahead may be one of the most difficult for investors in recent memory. Although the economic recovery has gained a solid foothold in several countries, the global financial system has reached a crossroads: will the fragile, if somewhat erratic progress continue? Or will one or more of the many current political and financial question marks hanging over global economies blow up into a recovery-killing crisis?
Those potential landmines range from the recovery of the battered American consumer and the fiscal policies of the government-controlled economy in China to the debt contagion spreading through Europe.
Reflecting those uncertainties, there is remarkably little agreement among economic forecasters about what is to come — and how to deal with those unknowns. If there is one point of consensus, however, it may be the crucial importance of the unemployment rate in the U.S., closely followed by the consuming habits of the ordinary American.
If the U.S. unemployment rate drops significantly, American shoppers will almost certainly return to the malls in force and the global economy could well be out of the woods — at least, for the time being. If U.S. unemployment remains at the current level of around 10%, financial markets will be nervous and jittery, overreacting to each piece of data that comes out. And that could mean that the shares of even solid companies would suffer, even though their fundamentals are sound.
Seven of 13 global strategists interviewed by Investment Executive believe that U.S. growth will surprise on the upside, coming in at 3.5%-4.5%. That would be sufficient to get the jobless rate below 9% by yearend — and perhaps even as low as 8%.
Three forecasters are in the pessimist camp; they believe U.S. debt problems are so significant that it will take years to resolve them. They predict the U.S. economy and unemployment rate will move sideways in the months ahead.
The other three are somewhere in the middle, forecasting growth of 2.5%-3%. This is murky territory, in which the jobless rate may move down significantly or it may stay high. The situation depends on whether U.S. companies can increase output without hiring significantly more staff. It also depends on how many more people start looking for work and thus begin being counted as unemployed.
That’s the short-term picture. But when it comes to the medium term, there’s much less difference between the optimists and pessimists. Everyone is worried about the mountains of government debt in the three major industrialized regions — the U.S., Europe and Japan. Dealing with that debt will require tax increases and/or cuts in program spending, which will dampen growth. But not dealing with it could result in new fiscal crises.
From this perspective, the difference between the optimists and pessimists is only a matter of degree. Both camps think that the quantitative easing that the U.S. Federal Reserve Board is currently undertaking will prevent the U.S. — and, thus, the global economy — from falling back into recession this year. But they differ only on how much growth there will be, which will affect how far the jobless rate will drop. But neither group believes that this year’s momentum will be enough to produce sustainable medium growth unless the fiscal situations of world governments improve.
Financial markets are sensitive to this fiscal issue. If credible government plans for fiscal restraint aren’t developed soon, fears about economic prospects in 2012 and beyond could dampen share valuations.
So, how do you give investment advice in this environment?
If you are in the optimist or consensus camp, the current, very low interest rates in the industrialized world argue against overweighting fixed-income: when rates start to climb, as they inevitably will at some point, existing bonds will lose value. This is particularly so for safe government bonds because they don’t have the potential for rating upgrades to increase their prices. Corporate bonds, especially those rated BBB to A, are a better bet; they may well be upgraded if the issuing company performs well.
That means overweighting equities, which is not a hard sell for most clients if you stick with the dividend-paying stocks of companies that have pricing power over their products or services — large U.S. multinationals, for example — or the stocks of emerging markets, resources and industrial companies that benefit from infrastructure spending, all of which have strong prospects.
There are, however, a few contrarians on resources prices, particularly for oil. Lloyd Atkinson, an independent financial and economic consultant in Toronto, believes that resources prices are now primarily being driven by investor sentiment. While this has long been the case for gold, he says, the proliferation of newer investment vehicles, such as exchange-traded funds, have helped extend this influence to oil and key base-metals equities. If he’s right, prices for these commodities could start dropping if investors decide to start buying fewer futures contracts.
John Arnold, portfolio manager with AGF International Advisors Co. Ltd. in Dublin, is also concerned about how much oil prices are supported by speculation. He also thinks surging supply from Iran and Iraq could pull prices down significantly in the next five years.
Nevertheless, the majority view is for strong oil and base metals prices over the medium term. This group includes a couple pessimists, although Nandu Narayanan, chief investment officer at Trident Invest-ment Management LLC in New York and manager of several funds sponsored by Toronto-based CI Financial Corp., would hold off buying emerging markets and resource stocks until after the big global stock market correction he’s expecting this year. In the meantime, he suggests being invested in defensive stocks, such as those in the consumer staples, defence and pipelines sectors.
Other pessimists would take a different route to minimize the downside risks from a major market correction caused by: less than expected declines in the U.S. unemployment rate; a U.S./China currency or trade war; or the need for a bailout in Spain. Worst of all would be the failure of the U.S. to produce a credible fiscal plan.
David Rosenberg, chief economist and strategist with Gluskin Sheff & Associates Inc. in Toronto, recommends that both equities and fixed-income be underweighted. He recommends that a substantial 33% of clients’ portfolios be placed in hedge funds to ensure that capital is preserved. The rest should be divided equally between fixed-income and emerging markets and dividend-paying growth equities, plus hard assets (mainly precious metals). He thinks it will be six to 10 years before U.S. consumer debt levels are under control.
Jean-Guy Desjardins, chairman, CEO and CIO of Fiera Sceptre Inc. in Montreal, is also recommending hedge funds. Although not a pessimist — his base case is 3%-3.5% U.S. growth — he puts the odds of a global currency/trade war involving the U.S. and China or a flight from U.S. Treasuries by investors who think that country is insolvent at 30%-40%. If either of those events occur, he predicts a stock market correction of 20% or more. In a client portfolio that has a 50% fixed-income/50% equities target asset mix, Desjardins recommends 20% of investments be in North American or Canadian market-neutral long/short funds, which would have half the risk of the equivalent weighting of equities. The rest of the portfolio would be 35% equities and 45% fixed-income, with the latter primarily in high-yield vehicles such as real estate investment trusts and infrastructure bonds.
Pessimist Ross Healy, president of Strategic Analysis Corp. in Toronto, believes there’s so much risk for equities in the current environment that retail inves-tors are better off with mostly fixed-income and cash. The rest of the portfolio should be in gold stocks but not in other resources, which he thinks are very risky at the moment. He recommends a few other individual equities — some income trusts; perhaps a company such as Microsoft Corp. that will benefit from the current renewal cycle in the computer industry; some U.S. health-care stocks; or a Canadian bank that’s trading at a particularly low valuation. Most holdings, including those in fixed-income, would be viewed as short-term investments to be sold when the price is right. However, U.S. health-care holdings would be long-term, given the increasing demand as Americans age.@page_break@Emerging markets and resources offer another set of risks. One possibility is a significant slowdown in China and other emerging countries caused by the need to quell fast-rising inflation. The other is a substantial drop in resource prices and/or emerging markets stocks, not because of slower growth or demand but because investor sentiment toward them cools.
Most strategists assign a low probability to both these situations. They believe China will slow its economy enough to stop an inflationary spiral without braking sufficiently to threaten global growth. They also believe that economic fundamentals support high resources prices and that investor sentiment won’t quickly turn against that sector.
But both Rosenberg and Stéphane Marion, chief economist and strategist with National Bank Financial Ltd. in Montreal, believe that inflation is becoming embedded in China due to higher wages. If they’re correct, it’s possible China’s government may inadvertently brake their economy too hard. As Peter O’Reilly, global money manager for I.G. Investment Management Ltd. in Dublin, points out: just because China hasn’t made a mistake in the past doesn’t mean that it won’t do so in the future.
Exchange rates are another question mark. Most economists expect the Canadian dollar to remain near par against the U.S. dollar. But, Atkinson thinks the loonie will fall to around US90¢. This would be positive for your clients with U.S. investments, as their return would be enhanced when turned into C$. Alternatively, if the loonie goes appreciably above par, returns on U.S. investments would be negatively affected. Your clients can hedge their foreign investments, either through currency ETFs or with mutual funds that are fully hedged.
Here’s a look at what strategists say about the key regions and sectors:
> The U.S. There are two factors to consider when investing in the U.S. The first is that there are two broad categories of U.S. equities: those that depend on U.S. growth and those that depend on global growth. You will want to suggest only the first if you think that U.S. growth will surprise on the upside. The second category should provide sound investments unless the global economy shows signs of slowing significantly. This group is composed of U.S. multinationals that tend to be dominant in their markets, have pricing power because of the popularity of their brands and that sell all over the world, including in emerging markets.
The second factor is the resiliency of the U.S. economy. U.S. companies have a long history of being able to increase their productivity, and they have continued to do so in the past year. It’s also hard to keep American consumers from spending. They take pauses during recessions, but as soon as they feel the economy — and, particularly, the job situation — is improving, they return to the stores.
Some economists, including Atkinson, believe this flexibility and resiliency will continue. But the pessimists think the country and its residents have been overextending themselves for years and will finally pay the price.
One risk to keep in mind is the possibility the U.S. will decide to monetize its debt by encouraging inflation. As inflation rises, debt is repaid in less valuable dollars and is therefore easier to pay off. This situation won’t occur overnight, but your clients should be aware of the possibility. Fortunately, many of the investments that are currently recommended, such as resources and companies with pricing power, have built-in hedges that should protect your clients’ purchasing power from the erosion that comes with inflation.
> Europe. No one is very enthusiastic about this region, although O’Reilly says Europe’s growth could surprise on the upside, just as he expects U.S. growth to do.
Arnold’s portfolios are overweighted in Europe, based on his long-held belief that European valuations are unreasonably below compared with U.S. stocks.
But even among other strategists, there isn’t a huge underweighting of Europe. Many portfolio managers are avoiding the periphery — Greece and Ireland, which have already been bailed out; and Portugal, Spain and Italy that may also have to be rescued. But the core countries and the northern economies are in good shape.
All the portfolio managers and strategists are assuming that any further sovereign debt problems within Europe will be solved. Despite Germany’s clear unhappiness about having to help out those in trouble, it can’t afford to abandon the euro, which is its only other option. Should Germany do that, the value of its replacement currency — presumably, a resurrected deutsche mark — would immediately rise by at least 20%, making German exporters much less competitive and potentially strangling the economic growth being driven by those exporters.
> Japan. Although Japan is still a very large economy, it hasn’t grown much in almost 20 years and isn’t expected to do much better in the near future. This economy has two pluses — major, competitive exporters and geographical nearness to emerging Asia. But Japan also has an aging population and uncompetitive domestic companies. Also on the positive side, valuations are very low, so there is a good deal of upside potential.
> China. Everyone is counting on China continuing to grow at 8% or more annually. Inflation remains the big question, including whether curbing it will significantly slow the economy. Marion and Rosenberg both believe inflation is becoming embedded through wage increases. If they’re correct, then China’s economy needs to slow significantly through higher interest rates, higher bank reserve requirements and/or a higher exchange rate.
O’Reilly thinks the current inflation rate is the result of a one-time catch-up in wages, which were held back in 2008-09. If he’s correct, then inflation will fall once the adjustment phase is over.
Most other analysts believe China will solve any inflation problem without slowing its economy down enough to be a serious threat to global growth.
Then there is the possibility of a China/U.S. currency and trade war. Desjardins puts the odds of this happening at 30%-40%. However, most think this is a minor risk because the U.S. and China know how much they need each other.
> Other Emerging Markets. India’s population of 1.2 billion and Brazil’s and Russia’s rich resources bases make these countries economic powerhouses. All are expected to do well in 2011 if efforts to contain inflation, a potential problem in India and Brazil, do not slow them down too much.
Other Asian countries are also expected to perform well — as long as China does, as much of their exports go to China. IE
Steering through uncertainty
The global economy has made some recent gains but is now facing new problems, ranging from inflation to trade wars. Strategists suggest options for your clients in 2011
- By: Catherine Harris
- January 24, 2011 November 5, 2019
- 12:21