Economic challenges and oportunities in 2011

Michael Hasenstab

The global recovery in 2010 has been characterised by pronounced differences between economies.

Many emerging markets and select developed ones that were not overly reliant on leverage before the financial crisis have experienced robust recoveries.

These recoveries have contrasted sharply with the anemic rebounds observed in the G-3 (i.e., the US, the eurozone and Japan).

As a result, the policy responses throughout the world have differed significantly, ranging from unprecedented monetary easing in the G-3 to gradual tightening of fiscal and monetary policy in countries from China and Australia to Sweden and Peru.

Going forward, we believe the two- speed recovery will continue, although investors need to remain selective as asset and currency trends are unlikely to be uniform. Rising interest rates and fiscal uncertainties can further challenge many traditional fixed income investors, and historically large capital flows pose a challenge to policymakers.

In emerging markets, stimulative policies enacted during the crisis are now being tightened in an attempt to avoid economic overheating, asset price bubbles and inflationary pressure.

Complicating this effort, though, is the tremendous amount of liquidity present in the global financial system, which is getting a further boost from the latest stimulus measures, especially in the US and Europe.

Abundant liquidity, combined with what have been the relatively higher historical returns of emerging market investments, has resulted in very large capital inflows to emerging economies.

Emerging markets have thus far absorbed this capital productively, and we do not see evidence of a bubble in these economies at this time. Still, while these investments should help rebalance the global economy over the long term, over the short term they pose a challenge to emerging market policymakers.

Emerging markets, in general, are characterised by a relative lack of capital, leading to lower productivity among their workers and, consequently, lower wages.

The large capital inflows are responding to this imbalance as investments have generally been flowing to the economies with the highest rates of return.

By increasing the supply, these inflows have lowered the cost of capital within emerging markets, thereby encouraging investment and consumption.

The currency appreciation that accompanies the flows should also, in our view, help reduce global imbalances over the medium term.

However, unwinding these imbalances will likely take time and require more than just currency appreciation. Tensions over currency valuations have been rising, and we expect that trend to continue in 2011.

However, grandstanding by politicians aside, we expect more currency appreciation for emerging markets against the Japanese yen, euro and US dollar because it appears to be in the developing economies’ self-interest.

Political considerations can make this a very noisy process, and we are likely to see increased use of unconventional measures to help limit or at least control the pace of currency appreciation.

But ultimately, policymakers will likely opt for a gradual and balanced approach to tightening domestic financial conditions, including through currency appreciation, in our view.

We have been encouraged by the prudent tightening undertaken thus far by many economies around the world.

This tightening has taken a variety of forms, including raising interest rates, tightening fiscal policy, increasing reserve requirements, implementing measures to limit loan growth, tightening regulations on real estate and other investments, allowing currency appreciation, and increasing restrictions or taxes on foreign capital inflows.

Despite these encouraging steps to tighten policy, we continue to see the greatest risk to emerging markets over the next several years as not enough tightening.

This can be a politically sensitive issue, but we believe it is crucial in order to help avoid overheating economies and asset price bubbles over the next several years.
 
Economic policy must remain forward-looking, and policymakers must not become complacent due to temporarily contained price pressures.

Such tightening can also increase the ability of policymakers to enact counter- cyclical policies if growth should unexpectedly slow at some point.

In contrast, risks to the biggest developed economies remain skewed toward below-trend growth over the short to medium term. Financial sectors in the U.S., the UK, the eurozone and Japan remain cautious as balance sheet repair continues and excess reserves remain elevated.

Concerns regarding highly indebted public sectors and what we would consider to be the unsustainable path of fiscal policy in many of these countries threaten to force public sectors to become a drag on these still weak economies through fiscal consolidation or risk higher interest rates. Despite these weaknesses, the recoveries in developed markets have been ongoing, albeit at a modest and uneven pace.

We believe this trend will continue in 2011. In the US, corporate profitability and healthy corporate balance sheets should underpin gradual job creation as well as improvement in private consumption and investment.

Additionally, the Federal Reserve’s (Fed’s) latest asset purchase programme may help keep interest rates low over the short term.
However, over the medium term, concerns regarding an eventual end to quantitative easing measures and the Fed’s ability to reduce its balance sheet in a timely manner to try to avoid inflationary pressure should put further upward pressure on US Treasury yields, in our view.

While the prospect of higher interest rates is a challenge for many fixed income investors, the global bond portfolios managed by my investment team have been cushioned from rising yields, with average durations that were significantly reduced in 2010, no exposure to US Treasuries or Japanese government bonds, and minimal exposure to eurozone government bonds as of September-end.

Additionally, we believe there can be opportunities to potentially capitalize on rising yields in the US by positioning long the dollar against the Japanese yen, a strategy that we believe could benefit from an increase in interest-rate differentials between the U.S. and Japan.

Actively managed global fixed income investing in a rising interest-rate environment can, in our view, also offer the opportunity to pursue relatively high yields without taking what we would consider much duration or credit risk.

We have continued to favor short maturity bonds in places like Australia, Israel and South Korea. These positions are exposed to currency risk, but we think that exposure could further enhance return potential.

We expect that the currencies of economies with relatively strong growth, where policy is likely to be tightened over the short term, should appreciate against the currencies of the G-3, where monetary policy is likely to remain loose over an extended period.
We believe the multi speed global recovery can create attractive fixed income opportunities beyond currencies as well.
 
Strong relative fundamentals also support select sovereign credits and even some duration exposures in economies where the extent of likely monetary tightening has already been priced in and long-term government bond yields are likely to benefit from improved policymaking and lower risk premiums over the medium term.

The writer is a Ph.D. and Co-Director of the International Bond Department and Portfolio Manager, Franklin Templeton Fixed Income Group

 

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