As the World Turns: From Goldilocks to the New Investment Landscape
Over the last few years, the Goldilocks children's story was a common analogy in financial commentary - a reference to a global economy that was not too hot and not too cold. Indeed, monetary policy around the world was accommodative, official inflation figures were low, and worldwide growth was strong, but not too strong. The little bear's porridge tasted just right.
After several years of buoyant worldwide growth, Goldilocks has vanished from financial observations. With the US consumption juggernaut running on empty, world commerce is slowing noticeably. Many imbalances that have existed during this period are experiencing their first systemic shock. And while the current credit crisis has its epicenter in the US housing market, reverberations are being felt around the world. Major indices have fallen significantly and risk is being rapidly re-priced. The iShares Xinhua China 25 ETF (NYSE:FXI) is down over 40% since its October 2007 high. Paradoxically, sovereign bond yields continue to linger near multi-decade lows while many commodity prices are flirting with new record highs.
With this backdrop to the international financial marketplace, a growing number of analysts suggest that the global economy has entered a period of realignment in search of a new form of stability. In a commentary in the Financial Times, George Soros declared that this crisis "marks the end of an era of credit expansion based on the dollar as the international reserve currency." The latest annual report from the Bank for International Settlements states that "we should not expect a quick and spontaneous return to normalcy", calling for a "deeper and more protracted" economic downturn than generally expected.
Our own house view is that the global economy is indeed experiencing a sweeping transformation ... one with a central feature of shifting economic power. While we anticipate a global "economic intermission" -- a period where the US economic slowdown spreads to other parts of the world, temporarily easing inflationary pressures -- the world is experiencing a longer running structural change. Among many changes, the United States (and other parts of the high-income world) will face a weaning-off of surplus capital flows that were running uphill (from the emerging, newly industrialized world to the high-income countries). That means slow growth, stagflation and higher interest rates in the former, and more bubbly, inflationary conditions in the latter.
Timeless Portfolio Principles. Consistent with this rapidly changing global economy, the exchange-traded fund space is transforming the investing landscape in its own way. International ETFs of all types have proliferated. Different "asset classes" have been made available, challenging conventional portfolio construction methods and calling into question long-recommended strategic asset mixes. Foreign currency has not traditionally been an active component of a core asset mix strategy. But there are now 19 exchange-traded products tracking international currencies in the US alone. While commodities have traditionally been labeled "flow" items versus "investment" assets, there are now 41 US commodity exchange-traded products with assets of over USD 41 billion. While previous issues of ETFocus have cautioned against some of the potential pitfalls associated with these new listings, each new offering has expanded the investors' toolkit and better prepared investors to thrive in the new investment landscape. We've come a long way. The ETF Timeline on page 1 shows the first ETF as Canada's TIP 35 in 1989, followed in the US 4 years later by SPDRs (S&P 500 Depositary Receipts). All types of asset classes have been launched since then. Today, the industry has over 1,909 listings on 41 exchanges with assets of USD 796.6 billion (Morgan Stanley figures as of year-end 2007).
Global Rebalancing and Strategic Investment Stances. Below, we outline some of the major world shifts investors should incorporate into strategic asset mixes. The contours of this new landscape point our investment strategy to the following broadbased themes:
• Rise of Emerging Economies. In the year 2000, the U.S. economy accounted for over 30% of world gross domestic product (GDP). By 2007, that figure had fallen by more than 5%. On the other hand, emerging economies' GDPs have moved up substantially. With higher growth rates and lowered risks (see ETFocus April/May 2008), it's evident that this trend is set to continue and is in its early stages. Emerging Asia still accounts for less than 5% of S&P/Citigroup's entire world market capitalization (in USD terms), despite a continuing migration of wealth to Asia. Brazil's sovereign credit just received the international seal of approval by Standard & Poor's (its score rising from BB+ to BBB-). Cost of capital will fall significantly, putting the booming country on track to expand even faster.
How should investors react to these trends? Consider that in recent years many domestic model portfolios recommended US equity weightings of up to 50% and much higher. That was then. But where are the world's most favourable growth prospects now? Increasing domestic consumption, infrastructure spending and maturing capital markets will only serve to reinforce this growth. To be sure, volatility should still be expected. Boom and bust cycles have not been repealed. With the global slowdown, emerging markets are facing their first cyclical adjustment since the expansion started in the earlier part of this decade. From a fundamental basis however, developing countries' balance sheets are in much better shape than the recent past. Although global asset allocators will need to become more selective in the emerging environment, a secular overweight exposure is recommended in these asset classes - in stocks, bonds and the local currency money markets.
• Realigning the Financial Sector. Since the early 1980s, the financial sector -- certainly in the much of the developed world -- has benefited from an unprecedented credit expansion. According to the Federal Reserve's Flow of Funds Report, US credit market debt as a percentage of GDP increased from 162.1% in 1977 to 352.6% as of year-end 2007. During that period, the financial sector market capitalization of the S&P 500 had a dramatic run up - from a low of 4.5% in 1980 to its recent peak in late 2006 of 22.7%.
Today, market conditions are much different. Banks are deleveraging their balance sheets, while a contraction in Wall Street "structured finance" is under way. State Street's US financial sector ETF (AMEX:XLF) is down almost 50% since early 2007. Many dividend-weighted ETFs -- with large financial biases presently -- have also taken large losses. Damage of this magnitude will take some time to repair. In an environment of declining collateral values, financial institutions are extremely vulnerable (particularly when copious amounts of leverage are being used). Financial companies in the industrialized world will struggle for an extended period as the "financialization" boom is unlikely to be repeated soon. An avoidance of Western financials and an emphasis on the highest quality debt issues is appropriate during this transitional period.
• Divided World: Deflation or Inflation? It's a dichotomous pricing environment. On the one hand, "asset deflation" is accelerating. S&P's Case-Shiller index of home prices is falling faster than at any time in its 20-year history. Many home values elsewhere in the world have also started their descent. In the UK, prices have already plummeted 7.3% from October's market peak. Activity in the US banking system has also decelerated ... slowing to a trickle as evidenced by recent credit figures. While the Federal Reserve has administered draconian rate cutes, the banking sector is not commensurately expanding. Credit is still being rationed. These are hardly inflationary trends. On the other hand, US headline inflation running at over 4% (a 15-year high) and many commodity prices continue to reach stratospheric levels.
Which is the more threatening danger? Inflation or deflation? Actually, both. Asset price deflation is firmly entrenched and will continue for some time. But following unprecedented credit creation in the Anglo Saxon world, there can be little doubt of a secular period of global inflation and currency debasement as debt levels are inflated away. Policymakers around the world can be expected to respond with extraordinary stimulus packages. Emerging economies will contribute to inflationary pressures as production capacities are expanded and the multi-decade infrastructure boom intensifies and domestic consumption ignites. Shorter-term cyclical considerations aside, price pressures will therefore prevail in production structures and consumer basics for some time. Having exposure to real return assets and inflationprotected investments is mandatory in this environment.
Outlook Conclusion. As we write, markets are facing a difficult period. The bears are back and Goldilocks has left the building. Long-running imbalances in the global economy have begun their first steps toward a necessary rebalancing. While the world economy will look much different in the coming years, the principles of successful portfolio management remain unchanged. Hardwiring a disciplined investment process that identifies opportunities and manages risk and emotion will be critical - as it always has been. The advent of ETFs covering all types of asset classes has allowed managers to build lower cost and more tax efficient investment portfolios that are able to adapt to this new investment landscape.