Global Investing

Big Fish, Small Pond?

It’s the scenario that Bank of England economist Andrew Haldane last year termed the Big Fish Small Pond problem — the prospect of rising global investor allocations swamping the relatively small emerging markets asset class.

But as of now, the picture is better described as a Small Fish in a Big Pond, Morgan Stanley says in a recent study, because emerging markets still receive a tiny share of asset allocations from the giant investment funds in the developed world.

These currently stand at under 10% of diversified portfolios from G4 countries even though emerging markets make up almost a fifth of the market capitalisation of world equity and debt capital markets.  In the case of Japan, just 4% of cross-border investments are in emerging markets, MS estimates.

But change is on its way. MS surveys show most classes of global institutional investors intend to boost allocations to emerging markets, including the more conservative investor groups – Japan’s $1.3 trillion government pension insurance fund, for instance, plans to start buying emerging equities later this year.  MS analysts calculate allocations to emerging markets could rise 3.5% over the next five years.

That may not sound like much until one realises the true scale of the global pool of investable institutional assets and compares them with current market cap values in developing countries . These assets currently exceed $212 trillion, meaning a 3.5 % allocation increase will bring over $2 trillion into emerging markets. That’s over half the capitalisation of EM equity market, more than 80% of bond markets and a third of the combined market cap of both sectors.

The “least worst” option?

Western governments saddled with mountainous debts will “repress” creditors and savers via banking regulation, capital controls, central bank bond buying and currency depreciation that effectively puts sovereign borrowers at the top of the credit queue while simultaneously wiping out real returns for their bond holders. So says HSBC chief economist Stephen King in his latest report this week called “From Depression to repression”.

Building on the work of U.S. economist Carmen Reinhardt and others, King’s focus on the history of heavily indebted governments applying “financial repression” to creditors arrives at several interesting conclusions. First, even though western governments appeared successful in using these tactics to reduce massive World War Two debts alongside brisk economic growth during the 1950s and 1960s, King argues that the debt was cut mainly by the impressive economic growth and tax revenues during that “Golden Age” – and this was mostly down to the once-in-a-century period of relative peace that involved unprecedented integration and cooperation among western governments also engaged in a Cold War with the Soviet Union. Compared to this boost, the financial repression was a “sideshow”, he reckons.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           To show that, he applies the interest rate and inflation conditions of the 1950s and 1960s to the current US government debt trajectory and then compares the growth scenario back then with the one faced now. The graphic is revealing. So, for repression to work, it needs to generate higher growth first. And despite lower real rates today than in the days of Mad Men, that seems not to be the case.

Instead, King says governments will adopt this repression tactic anyway just to stave off draconian austerity now and prevent a destabilising surge in economy-wide borrowing rates. This will effectively reduce the amount of credit to the rest of the private sector, or at least elevating its cost, while reducing the pressure on governments to cut the debt levels quickly. The net result, then will likely be “persistently lower growth”, whatever your conclusion about the desirability of  state or the market allocation of resources.

Japanization of euro zone bonds?

Fear of many years of stagnation in the major western economies has everyone fretting about a repeat of  the “lost decades” that Japan suffered after its banking and real estate bubble burst in the early 1990s. Indeed HSBC economists were recently keen to point out that U.S. per capita growth over the noughties was already actually weaker than either of Japan’s lost decades.

But in a detailed presentation on the impact of two years of soveriegn debt crisis on euro zone government bond holdings, Barclays  economist Laurent Fransolet asks whether that market too is turning into the Japanese government bond market — where years of slow growth, zero interest rates, current account surpluses and captive local buyers have depressed borrowing rates for years and turned JGBs into an increasingly domestic market dominated by local banks, pension funds and insurers. Non-residents hold less than 10 percent of JGBs, compared to more than 50 percent for the EGB as a whole, and Japanese banks hold up to 35 percent of their own government bond market.

But is the euro government market heading in that direction after successive crises have seen foreign investors flee many of the peripheral markets of Greece, Portugal, Ireland and even Italy and Spain? Fransolet argues that the seniority of substantial European Central Bank holdings built up in the interim (now about 15 percent of each of the five peripheral markets) may be one reason why these foreign investors will be wary of returning. Meantime, euro zone banks, who have traditionally held a high 20-25 percentage point share of euro government markets, withdrew sharply late last year amid balance sheet repair pressures but have  rebuilt holdings again sharply in early 2012 after the ECB’s liquidity injections — particularly in Italy and Spain.

Japan… tide finally turning?

Until recently, when you mentioned  ”Japan” in the investment context, you could almost hear a collective sigh of disappointment — it was all about recession, deflation and poor investment returns.

However, sentiment does seem to be finally changing, not least because Tokyo stocks have rallied almost 20 percent since the start of the year, outperforming benchmark world and emerging indexes.

The yen has also been on a (rare) declining trend since the start of February, with the selling momentum accelerating since the Bank of Japan set an inflation goal of 1 percent in a surprise move and boosted its asset buying programme by $130 billion on Feb 14.

Fresh skirmishes in global currency war

Amid all the furious G7 money printing of recent years, Brazil was the first to sound the air raid siren in the “international currency war”  back in 2010 and it continues to cry foul over the past week. With its finance ministry issuing fresh warnings last night over hot-money flows being dropped by western economies on its unsuspecting exporters via currency speculation,  Brazil’s central bank then set off its own defensive anti aircraft battery with a surprisingly deep interest rate cut late Wednesday. Having tried everything from taxes on hot foreign inflows to currency market intervention, they are braced for a long war and there’s little sign of the flood of cheap money from the United States, Europe and Japan ending anytime soon. So, if  you can’t beat them, do you simply join them?

The prospect of  a deepening of this currency conflict — essentially beggar-thy-neighbour devaluation policies designed to keep countries’ share of ebbing world growth intact — was a hot topic this week for Societe Generale’s long-standing global markets bear Albert Edwards. Edwards, who represent’s SG’s “Alternative View”, reckons the biggest development in the currency battle this year has been the sharp retreat of Japan’s yen and this could well drag China into the fray if global growth continues to wither later this year. He highlighted the Japan/China standoff with the following graphic of yen and yuan nominal trade-weighted exchange rates.

Edwards goes on to say that this could, in turn, create another explosive FX standoff between China and the United States if Beijing were to consider devaluation — the opposite of what the protectionist U.S. lobby has been screaming for for years.

Being chic and not saving

Japanese people are generally regarded as saving a lot and not spending much, but in olden times when Tokyo was called Edo (until the mid-19th century), it was considered iki (chic or sophisticated) not to keep one’s earnings overnight.

The latest survey from the Central Council for Financial Services Information (part of the Bank of Japan) may suggest that people are going back to that tradition — although perhaps not for style reasons.

The survey, only available in Japanese so far, showed more than one in four households (consisting of at least two people) said they have no savings, the highest level since the survey started in 1963.

Emerging market local bond rally has more legs

Just a month and half into 2012, emerging local currency bonds have already returned 9 percent, one of best performing asset classes. But the rally has further to go, says J.P. Morgan which runs the most widely used emerging debt indices. The bank is now predicting its benchmark local currency debt index, the GBI-EM, to end the year with returns of 16 percent, upping its original expectation for 11.9 percent.

There are several reasons for this bullishnesss. JPM’s latest client survey reveals investors’ positioning is still neutral, meaning there is potential for more gains. Cash inflows to EM local debt have been dwarfed this year by investments into dollar bonds, considered a safer, albeit lower-yielding asset than locally issued bonds. So when (and if) euro zone uncertainties abate, some of this cash is likely to make the switch.

Many emerging countries are still cutting interest rates, which will push down yields on short-dated bonds. Other countries may tolerate some more currency appreciation to dampen inflation, benefiting the currency side of the EM local bond trade. Above all, with all developed central banks intent on quantitative easing (Japan announced a surprise $130 billion worth of extra QE this week), the yield premium offered by emerging markets — the carry — is irresistible. On average the GBI-EM index offers a 4.5 percent yield pick up on U.S. Treasuries, JPM notes:

from MacroScope:

Are Treasuries the new JGBs?

Anemic economic growth in the United States has sparked fears the country was entering a Japan-style “lost decade.” The comparison also has implications for government bond markets. Some traders see the U.S. Treasury market’s new, lower-yielding structure as eerily reminiscent of trading patterns seen in JGBs (Japanese government bonds). Says George Goncalves at Nomura:

There has been much debate since the start of the '08 credit crisis over whether the US is turning into Japan and if so how to trade it. We have spent a fair deal of time over the last two years developing a framework for how US rates investors can leverage these insights to "Trading USTs like JGBs.” […] One thing is clear: momentum trading starts to wane and narrower ranges will become the norm in a low yielding world with the Fed on perma hold meanwhile a lack of alternative fixed income products is still forcing investors to buy USTs.

This does not mean that investors can remain permanently bullish on Treasuries, however, Goncalves warns.

from Funds Hub:

Gerard Fitzpatrick: Positive on global growth

Guest blogger Gerard Fitzpatrick is portfolio manager at Russell Investments, where he runs a $5 billion global bond fund.

The views expressed here are entirely the author's own and do not constitute Reuters point of view.

The global economic outlook is positive overall, currently powered by China and America's twin engines of growth. Questions have been asked about the level to which the Japanese disaster may slow down the world's economic recovery, but in reality, it's expected to have only a small negative effect on global growth this year.

from MacroScope:

APEC’s robots stealing the show

robot

A guide at the "Japanese Experience" exhibition talks to Miim, the Karaoke pal robot, on the sidelines of the APEC meetings in Yokohama, Japan on Nov. 10. REUTERS/Yuriko Nakao

    Miim is one of the more popular delegates at the APEC meetings in Yokohama Japan. She sings. She dances. She tosses her shoulder length hair. She may not be able to spout an alphabet soup of APEC acronyms like the other Asia-Pacific delegates. But she's still pretty lively. For a robot.

    This week's meetings of the Asia-Pacific Economic Cooperation forum have been earnest and most comprehensive . Foreign and trade ministers issued a 20-page statement about all the things they talked about -- a giant free trade zone, protectionism, the Doha round, easing restrictions on businesses, simplifying customs procedures, promoting green industries, cooperating on health and security, you name it. They also have been, and pardon my French here, excruciatingly dull. So far, the meetings and their stupefying statements have been a testimonial to Japan's skill at stating the ambiguous. Call it the opaque meetings. Journalists from around the Pacific rim have been desperately trying to find news as the 21 APEC leaders gather for their annual pow-wow this weekend.