Comment: Baring Asset Management's chief investment officer looks to Asia as he warns of global instability
Baring Asset Management (BAM) says that while global economies face a period of instability, Asian markets are set for sustained relative out performance.
This theme of global economic instability is central to BAM's investment management thinking for 2006. According to BAM, it will have significance not just for asset allocation, but also for the types of investment risks that people are prepared to take.
Michael Hughes, chief investment officer at Baring Asset Management, explains: "We are at a stage where low real yields have encouraged a degree of leverage in the system, a degree of risk taking with credit, and a degree of false safety in both company and individual planning,' says Michael Hughes, chief investment officer at Baring Asset Management. "We have to ask the question: 'What's coming next?', and at BAM we believe the answer is an era of economic and investment instability."
Hughes believes there are three key economic conditions that are likely to bring about this volatility.
Firstly, policy priorities are set to change and cause divergence. Hughes predicts that economies will no longer have the commonality of simply fighting inflation, but are likely to have different agendas when implementing policy change.
"In the United States there will be a much greater focus on infrastructure spending,' he explains. "In Japan the priority is to get consumer growth back on track. In Europe the policy is simply to try and keep it all together. In China the reindustrialisation of that economy is a very strong and powerful theme."
Secondly, competitive pressures are set to become greater, impacting heavily on currencies. "With the level of debt overhanging the US economy now exceeding its previous peak in 1929, there is a limit on how far you can raise interest rates without going into a debt spiral," continues Hughes. "Increasingly, therefore, currencies will take the strain and currency risk will form a greater component of the risk budget."
Finally, in this environment debt replaces inflation as a major driver, not only of economic policy but also in terms of market ratings and valuations. This change in environment has some very broad positive implications for Asia, a market which will react to this instability in its own unique way. BAM has identified three key drivers for the regions expected out-performance; these are the exchange rate, bond yields and commodities.
According to Hughes, "Looking into 2006, if we have an environment where bond yields rise, we would expect the Pacific Basin to relatively outperform," says Hughes. "If global commodities rise, emerging markets and Asia would outperform since they are the major producers. And if the US dollar were to fall, then the relative performance of Europe would suffer by comparison with Asia and Japan.
"But Asia is special not just in a relative sense, but in an absolute sense. The Asian economies have in the last year overtaken the United States in terms of their share of the world economy, even if you exclude Japan. However, they have not overtaken the United States in terms of market capitalisation. This major imbalance between the value of the economy and the value that's currently placed on the region is set to close as more Asian reserves get rediversified into the local markets."
In Asia more than 70 per cent of all bonds are being upgraded, compared with a figure that's well under 50 per cent of bonds in the West. The return on equity has begun to consistently exceed the return on capital, and in 2005 the return on equity in Asia has exceeded the return on equity in the West. BAM expects this to be the case throughout 2006 and 2007.
"While there will always be short periods of underperformance within a long-term period of out-performance, we strongly believe that the Asian equity story is robust and presents the most viable opportunities for growth for investors in the long-term," concludes Hughes. "We expect this Asian period of relative strength to last for the better part of the next 10 to 15 years."
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