Politicians and Policy Mistakes Obscure Economic Growth

(October 28, 2013) — Despite an overall positive outlook for global markets, Russell Investments announced “short-sighted politicians” could stir market volatility and even decelerate growth.

In Russell’s fourth quarter “Strategists’ outlook and barometer,” economists, strategists, and analysts found the US Federal Reserve’s quantitative easing (QE) tapering to have minimal impact on asset prices.

“QE has more closely resembled pushing on a string than an irresponsible act of market distortion,” the report said. “The eventual winding down of QE will generate volatility, but there is little evidence that the Fed has significantly distorted asset prices.” It also stated stable economic growth, low inflation, and deleveraging by the private sector had helped avoid a devastating effect on the markets.

However, a US political tug-of-war remains a great threat to economic recovery, Russell said.

“The eleventh-hour deal we have just witnessed is just another round of Congressional ‘kick the can,’” said Mike Dueker, chief economist at Russell.

According to the report, policy mistakes could cause anxiety in the bond markets as well as a decline in confidence in the US economy. But the biggest problem of all was a possible halt in the “momentum” of the economy.

If politicians could reach a reasonable fiscal deal, Russell said the US could expect to see almost 3% growth and an average of 200,000 more jobs per month next year. It also predicted 10-year US treasury yields would reach 2.8% in the first quarter of 2014 and 3.2% by the end of the year.

Russell also said it preferred US equities over fixed income, and European equities over US equities.

Looking outside of the US, Russell said relatively positive projections for the Eurozone. Successfully exiting the recession last quarter, the Eurozone is expected to experience growth between 0.5% to 1% in 2014. The less-than-great figure may be due to the political muddle of Greek and Portuguese bailouts as well as difficulties facing the adaptation of a European banking union, the report said.

But vigilance is necessary, Russell concluded. “We warn against being complacent, as none of the region’s key long-term problems have been solved: The periphery is still stuck in its debt trap, the banking sector is week and not lending, growth is insufficient to lower debt burdens and/or unemployment rates, and structural reforms are largely nonexistent.”

The outlook was slightly better for Japan, with money growth at 3% year-on-year at the end of the third quarter and a real GDP growth at 4%. Asia-Pacific is in good shape, Russell added, in both balance sheet and current accounts: “The region as a whole (both economies and markets) would, in our view, respond well to any acceleration in US and/or European growth in 2014.”

Emerging markets are expected to perform well—at the end of September this year, they were trading at a 25% discount to developed markets. While they might experience mild turbulence as the Fed resumes talks of tapering, Russell projected their growth to be in the low double-digits in 2014.

“The impact of the political fireworks in the United States and geopolitical risks have meant buying opportunities in the US equity markets for those nimble enough to capitalize on the resulting volatility, though our recommendation to the less agile and more risk averse remains equity overweight,” said Doug Gordon, senior investment strategist for North America at Russell.

Large amounts of assets in emerging market consumer-friendly brands is putting too much risk on investors’ portfolios, an asset manager has claimed.

(October 29, 2013) — Investors are taking on too much risk with their emerging market equity allocations by skewing them towards consumer-focused companies, according to Bank of America Merrill Lynch (BoAML).

The fund manager found that most investors were too heavily weighted in consumer sectors such as retail, internet, and telecoms, placing substantial risk on their overall portfolio.

These assets, typically described as “growth-orientated” assets, are also now worse value for money, according to Ajay Kapur, BoAML’s Asia Pacific and global emerging market strategist—a price/earnings valuation of 31 x PE, compared to 20 x PE for developed market growth assets.

Investors should be looking to the exceptionally underweight, unpopular state capitalist sector instead, Kapur argued in a BoAML global research report entitled “The Unbearable Heaviness of Investor Portfolio”.

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And all of the things which have traditionally turned investors off that sector—higher financial vulnerability, worsening external/fiscal accounts, corruption perceptions and forthcoming elections and their impact—should be the reasons for investing in these assets.

Why? Because these countries have every incentive to change, taking their state-owned assets values up as they do so, Kapur argued.

“China, Malaysia, Indonesia, India, South Africa, Brazil, and Chile have had or will have elections/ political change in 2013/14. New leadership could start sweeping with a new broom,” he stressed.

The young demographic in these regions will drive their governments into a new direction, Kapur continued. These countries populations—mostly young and increasingly middle class—are concerned about perceived corruption and wealth inequality, and the state-owned assets are often at the heart of this frustration.

“The potent mix of a Chinese boom, QE, and strong economic fundamentals that allowed the State capitalism model to thrive is evaporating,” said Kapur. “Privatization, and/or significant reform is demanded by disgruntled populations, is made imperative by worsening fiscal (and current accounts), and is made possible by political change.”

Reforming these state-owned assets to raise their return on equity and ultimately privatizing them will bring in much needed revenues, lessening the burden to the government balance sheet.

There is a rising external constraint too: countries with the highest state-owned company concentration also have the most serious deterioration in their current account balances. “As quantitative easing wanes, potential withdrawal of foreign capital could be a potent threat for pre-emptive reform,” said Kapur.

There are of course risks associated with this new direction. The first big one is that momentum investing continues for longer than BoAML thinks it will, as successful emerging market growth investors raise more assets under management and then deploy it.

The second, Kapur said, was that consumer-friendly drivers like high property prices, nominal wage growth, low gas prices, and consumer lending growth stay strong. The third, that growth names deliver earnings per share surprises, and fourth, that Chinese nominal growth disappoints and so raises the premium for growth stocks.

Kapur’s pick of the crop were: Oriental Bank of Commerce, Petrobras, Huadian Power, SABESP, ONGC, Kunlun Energy, Sberbank, Bharat Electronics, Cia Energetica Minas, China Unicom, China Construction Bank, PetroChina, China Agri Inds, Rosneft, and Gazprom.