This post is a summary of a session from the MMI’s 2011 Annual Convention.
The moderator for this session was Richard Hoey, Chief Economist, Bank of New York Mellon. The panelists were Michael Atkin, Head of Sovereign Credit Research, Putnam Investments, David R. Bailin, Managing Director and Global Head of Managed Investments, Citi Private Bank and George Iwanicki, Jr., Global Emerging Markets Macro Strategists, J.P. Morgan Asset Management.
Michael started off by explaining that he’s concerned about short term market volatility, largely because the global economy has reached a significant inflection point. We’ve been in an environment where policy has been extremely accommodative almost everywhere. Interest rates have been kept low by central banks, accompanied by massive fiscal stimulus.
The US policy environment is changing at the same time that the recovery in the rest of the world is losing a little bit of it’s dynamism, Michael continued. These sort of inflection points in the economy, where financial conditions are being tightened a little bit, where there’s uncertainty over the shorter term trajectory of the economy, those are environments where you’d expect some volatility. “I think the short term environment is where we should expect some volatility and in most of our fixed income funds we’ve dialed down the risk somewhat,” he said.
George reminded the audience that when the financial crisis occurred, emerging markets were furthest from the epicenter. Combined with their clean public and private balance sheets meant that emerging markets were both willing and able to provide stimulus to their economies. And more importantly, they got full response from their stimulus.
There are a handful of countries where the inflation pressures are beginning to embed and place cyclical risk on economies, George observed. The good news is that these are only a few economies, but the bad news is that it is some of the larger ones. These are the larger economies that are at risk, according to George:
1) India – They have the highest risk. Inflation expectations have begun to “de-anchor” and now the central bank is starting the catch up process and becoming more aggressive. So, JPM is still cautious on India, in part because valuations are rich, but also since the inflation cycle hasn’t been halted.
2) Indonesia – To some degree it falls into the same boat, where they had a booming recovery. The exchange rate has rallied in a way that has contained some of the inflation pressures.
3) Brazil – Their central bank did about half of a tightening cycle last year and it looks like they’re finishing the job now. Inflation pressures look so far as to have been reasonably contained.
4) China – The slowdown is becoming more evident. They have been tightening the longest. They were the first out of the recession, the first into recovery, the first into the boom and the first to tighten. If you look at the import numbers that just came out, we’re starting to see an accumulation of evidence that the economy is starting to respond to tightening by slowing down. Accordingly, the inflation pressures look as though they’re poised to be reigned in.
Based on some of the dynamics that are unfolding in markets today, George’s opinion is that the strong recoveries in the emerging world combined with dollar weakness have been a very powerful tonic for commodities.
Following up on George’s comments on risk, regarding investors in general, David said, “risk is clearly back on.” However, investor’s views of asset allocation have changed, he cautioned. Their holdings of cash and liquid investments are permanently staying at significant levels. We’re seeing a very different vantage point in terms of timing. When we look at closed to venture capital and private equity alternatives, we see them diminished. Investors have a shorter term views of their portfolios, many of them are seeking to get paid now in the form of dividends. You can see that in the way that fixed income spreads have come in. When we talk about volatility, one of the reasons why we believe that volatility is real, is that we believe that there is a bit of complacency due the markets having tolerated so much incredible news, he stated.
What is going to happen with the situation in Greece?
Germany should thank the Greeks and Spaniards for contributing to the weak Euro, since it has kept their exports cheap, Dick commented.
Michael responded by listing three key issues that will determine the timeline and what is likely to happen:
1) Everything is being driven by the timetable of German politics. Their leaders know that they are going to have to pay for all this. They want to pay as little as possible, as far into the future as possible. But they also want to exact a very high price in order to discourage other countries from behaving badly.
2) Greece is insolvent. Almost everybody knows this. People are very uncertain about Portugal, Spain and Ireland also being insolvent. However, solvency is endogenous to market conditions. The Europeans want to make it possible for these countries to show themselves to be solvent. That requires a certain trajectory of interest rates and also requires that they not be too explicit as to how insolvent Greece is because they’re worried it could become contagious.
3) The EU banking system is over- exposed to peripheral countries. The EU has been very slow in responding. The banking system hasn’t improved its balance sheet as dramatically as the US and UK have. We know that Greece has to restructure, but the EU wants to put it off as long as they can since doing it quicker will hurt the European banking system and will also increase the likelihood that Portgual and Ireland will also have to restructure. Then the problem will become too big to manage.