Decline and fall?
The credit downgrade has been seen as the first sign of the end of the US’s economic power. Paul Farrow investigates whether asset allocation should change to reflect that
Stock markets across the globe have been in turmoil. The US may have stepped back from the brink of default in early August but congressional approval of a last-gasp deficit-cutting plan failed to dispel fears of a credit downgrade and future tax and spending feuds.
President Barack Obama and lawmakers from across the political divide expressed relief over the hard-won compromise to raise US borrowing authority. Nevertheless, US stocks fell sharply as investors fretted over persistent economic and political uncertainties dogging the world’s largest economy.
It wasn’t the only market to fall sharply the FTSE plunged below the 5,000 level amid fears of a double-dip recession, while European bourses couldn’t halt the slide either as Italy and Spain get dragged into the sovereign debt crisis.
On the flip side, investors have rushed to buy gold in droves, so much so that the gold prices hurtled towards the $2,000 barrier.
Pension funds are in an interesting position. They follow traditional benchmarks and, as such, their asset allocation is heavily skewed towards western markets. But will the downgrading of the US and the indebtedness of many developed nations mark a sea change in strategy?
Ryan Hughes, portfolio manager, Skandia Investment Group, is adamant that recent events have shown that it’s time to change the way investors view the world.
He says: “With the dust having settled just a little from the wild markets, history may well show that the summer of 2011 proved to be the point in history when the thinking of investors shifted from the west to the east.”
Hughes points out that one of most long standing habits of investors is the cult of the ’home bias’. That “alluring pull” that drives investors from almost any country to put huge amounts of their investment portfolio into shares or funds that are exposed to their own country.
He adds: “Granted, we live in a globalist world where stock markets are no longer representative of local economies, but our small island in the Atlantic Ocean now represents less than 4 per cent of world GDP China is five times bigger and will soon be overtaken by Brazil.”
Robert Talbut, chief investment officer at RLAM is not surprised by the changing shift. After all, he says, events in the US and Europe indicates that the continual leveraging up that has occurred in the west over the last 30 years must come to an end. He said: “This implies structurally lower growth in the west, which I believe is the crux of current market concerns.”
Emerging market nations already account for 50 per cent of global GDP and this is likely to get larger. The arguments in favour of emerging markets are compelling particularly if you believe that India and China are suffering nothing more than a temporary dip due to the global recession. Plus emerging markets are not saddled with the huge deficits holding Western nations back.
History may well show that the summer of 2011 proved to be the point in history when the thinking of investors shifted from the west to the east
Julian Webb, head of DC and workplace savings at Fidelity, says: “The US downgrade is a symptom of the broader malaise of Western economies a massive debt overhang, across both the private and public sector. The deleveraging required to cure this overhang is likely to hamper growth in the medium term in the main developed economies.
“Contrasting this, emerging and developing countries continue to show strong growth and expansion, and as a result of their export-led growth models are sitting on huge current account surpluses 80 per cent of the world’s reserves are sitting in developing economy central banks.
According to the latest World Energy Report, the emerging nations notably China and India are going to continue to support and fuel energy prices for the next two decades.
And only last week, the Asian Development Bank has said that emerging middle classes in India and China could become the next leading global consumers. Developing Asia could account for 43 per cent of worldwide consumption by 2030, it argues.
According to the multilateral agency, the demand for consumer goods in the developed world, such as Europe, Japan and the US, is likely to be sluggish.
“The emerging middle class consumers of Asia, especially in the PRC (People’s Republic of China) and India, can become the next leading global consumers, and assume the role that the American and European middle classes have traditionally played in the world order,” the report said.
The US downgrade is a symptom of the broader malaise of Western economies - a massive debt overhang, across both the private and public sector
Andrew Gillan, who heads the Asian equities desk at Aberdeen Asset Management, says: “Inflation in Asia might have been a problem over the past two years, but for the past decade Asia has had double-digit wage inflation. This has outstripped the recent rate of inflation and so the consumer story is still strong. Developed stock markets also have lower growth prospects, and the companies are more expensive.”
But the east versus west debate is far from cut and dry and many UK, or global heavy schemes have been benefiting from emerging market growth as plenty of multinational companies listed in developed markets derive considerable part of their revenues from emerging markets.
British-Dutch Unilever, for example, gets over a half of its business from emerging markets. A large share of Colgate’s sales is in the developing world and that is likely to increase over time. Nestle, a Swiss-headquartered company, also has a considerable part of their business in global emerging markets.
So what next for pensions schemes? Economies and equity markets rarely sing the same tune and many experts warn investors not to get too carried away with the merging market growth story. “There is no empirical evidence that faster growing economies produce greater equity returns,” said Talbut. “I’m not sure it’s as simple as to say that because emerging markets are growing quicker that we should be increasing our allocation. It appears that we have increasingly integrated financial markets, so that recent worries have sent all markets down.
Interestingly, one of the best performing markets has been Japan, which is anything but emerging.”
With debt laden western chickens coming home to roost, the prosperous east is finally flexing its muscles, and it is time for investors to realise that risk comes in many forms, and some of them are very close to home indeed
John Lawson at Standard Life agrees with Talbut. “I’m not sure that this is a tipping point, the increasing importance and size of the BRIC (Brazil, India, Russia and China) economies is a trend that has been underway for 30 years.”
Emerging markets, for all their aspirations, still have their risks. They may not have the debt levels of their Western counterparts, but they have political, cultural and governance risks too. And that is not all.
“Another issue is currency risk. Pensions are paid in sterling, and the pound is relatively weak compared to where it has been for the last decade,” said Lawson. “If our austerity plan works and the economy begins to pick up, the pound may strengthen against other currencies or looking at it the other way around, the value of investments in foreign denominated investments may weaken. Currency risk can of course be hedged but that comes at a cost, which can put a drag on investment returns.”
But Hughes counters that Asian and emerging markets have been viewed with suspicion by western investors for many years with fears over corporate governance, yet they “conveniently” forget Enron and, Parmalat, corruption, authoritarian regimes and currency defaults.
“With debt laden western chickens coming home to roost, the prosperous east is finally flexing its muscles, and it is time for investors to realise that risk comes in many forms, and some of them are very close to home indeed,” said Hughes. “If investors learn nothing else from the past few weeks, they should recognise that it is time to put past prejudices behind them and acknowledge that the world has changed. There is no longer any reason why investors should have so little exposure to the future drivers of our world economy.”
As with in 2008, communication is the key during times of uncertainty. Mercer is in the process of sending notes out to clients to update them on recent events.
Brian Henderson, European head of DC at Mercer, says that he and colleagues have been working over the past fortnight to check that arrangements are in place the company has made a concerted effort to learn lessons from the financial crisis.
“We have strong views on diversified growth and they have done a reasonable job in protecting clients from the worst of the stock market falls,” said Henderson. “I’m sure that recent events have been a wake-up call for some schemes.”
Mercer favours off-the-shelf diversified growth funds offered by the likes of Baillie Gifford, Standard Life. JPMorgan, BlackRock and Schroders.
Unlike the last crisis, workers have been hit with a double whammy falling share prices and falling gilt yields. It has advocated the lifestyle approach but emphasises the need for care.
“The difference this is that bond yields have come in and annuity prices have gone up it reaffirms that you should be de-risking as you approaching retirement and pound-cost averaging your bond purchases on the where there. If you have sat in equities until you are 65 you get a double hit. You have not dealt with the equity risk or the bond/annuity conversion risk,” adds Henderson.
And when it comes to bond yields many schemes have taken a greater interest in emerging market bonds in the past couple of years. Aon said that it used to focus on dollar denominated bonds, but not anymore.
Colin Robertson, global head of asset allocation at Aon Hewitt, says: “There has been huge interest in emerging market bonds as well as equities. They tend to be rated B+, so middle ranking corporate debt that is regarded safer than high yield.”
Fraser Smart, managing director of Buck Consultants, admits that downgrade of the US economy on other markets will undoubtedly give trustees and sponsors a lot to think about for planning their long term strategies. But he does think that there will be any significant shift in asset allocation because of the downgrade, in the short-term.
“Logic dictates that the downgrade, along with the general weakness currently being seen in developed economies, will lead some investors to diversify their assets in order to reduce the dependence on these markets. As a result we may see a shift in the options available to a typical UK DC investor in future, with fund choices likely to include products with a higher weighting to emerging economies,” he says.
Many already are. Mercer has been introducing new funds on its platform that have specific exposure to emerging markets.
Meanwhile, Fidelity is seeing trustees and plan sponsors change their default fund strategies to include a higher percentage of emerging market equities. Increasingly this is being achieved through single global equity funds that have access to emerging market equities, it said.
“For DC investors, depending on their risk appetite and investment goals, developing markets equity can provide long-term opportunities for growth and diversification away from domestically biased portfolios,” says Webb. “Investing in emerging and developing economies is not without risk and the long road to global rebalancing will have speed bumps, but from a long-term perspective the opportunities are plentiful. In support of this view we are also seeing.”
The market volatility is unnerving for all investors yet any significant shift from developed nation assets to emerging markets is some way away.
Some consultants are happy with their current asset allocation and are happy to let it run.
“Emerging markets is a theme that has been on the go for sometime now, but it is not new and its emphasis should not change because of recent events,” says Robertson, who still believes that everyone needs some “strategic exposure” to developing countries over the longer-term.
In many respects emerging market economies are better managed than their developed counterparts, but that doesn’t mean that they are not high risk they can be,” he continues. “Remember that emerging markets shares led the rout when the problems first arose this summer.”