Comment: Underlying economic trends are deteriorating
Baring Asset Management (Barings), the international asset management firm, believes that even as the headlines focus on debt negotiations in Europe and the US, the underlying economic trends are deteriorating. Percival Stanion, Head of Asset Allocation at Barings, explains...
Global economic data continues to be both broadly weak and disappointing. The manufacturing strength that had powered the global economy out of recession appears to be petering out across north America, Europe and, most worryingly, Asia.
Barings believes the global weakness will continue for several months due to rising inventory levels, the continued fiscal retrenchment of governments, and anaemic job creation. Short term deals in Europe and the US may stabilise markets temporarily but lack of a substantial solution to both problems is undermining business and consumer confidence.
Recent activities in Europe have seen a deal to successfully ring-fence a Greek default from the rest of the Eurozone financial system agreed, but it offered no substantive debt relief to reduce the likelihood of a future default. It furthermore gives few clues as to how a market run on Italy might be approached. However, by transforming the European Financial Stability Fund (EFSF) into a multi-purpose slush fund, the guardians of the Eurozone appear to have done enough to cause investors to close down shorts and reduce underweights. While this half-baked deal may result in a temporary reduction in Eurozone risk premia, its ability to put an end to the sovereign crisis remains unproven and unlikely.
In the United States widespread contingency planning is in train to deal with different flavours of policy failure. We take the view that a deal will get done to lift the debt-ceiling, but it is unlikely that there might emerge a deal of sufficient ambition to avoid the loss of the United States’ AAA rating. We believe the response on the part of foreign public sector money to the possible loss of the US AAA rating is the most crucial unknown factor for financial markets and the path of the global economy.
In light of the uncertainty, Barings highlights the importance of a process driven approach to asset allocation.
At times like this process is everything. To ignore the seismic policy developments that are dominating markets would be a dereliction of duty. But the dangers of being caught in the latest headline that will determine this week’s outsized market gain or loss are meaningful. And so we focus on the question as to whether our estimates of risk premia available in markets are sufficient to account for all of these risks. Broadly, we find them wanting not only in equity markets but also in bond markets. As such we took the unusual step of upgrading cash despite the derisory deposit rates available. We liken cash to a call option on uncertainty. Like any option it will be expensive to hold for long. But if uncertainty continues we hope for better entry points to risk markets.
In light of the uncertainty, Barings made no changes within developed market country ratings or sectors this month. Within emerging markets, Barings upgraded Indonesia on the basis of its strong secular developments, but downgraded South Korea given the more worrisome global cyclical developments. Malaysia was also upgraded given its defensive characteristics.
Within bonds, Barings’ preference for the Australian government market persists given its strong debt dynamics, weak domestic economy, active and independent central bank and its reliance on continued economic strength in Asia. German Bunds were downgraded, as Barings believes every Eurozone government bond yield is probably wrong, with German bond yields unsustainable low.
Today Bunds enjoy a safe-haven status within the Eurozone that may be challenged by an ultimate commingling of fiscal burdens should the situation deteriorate in a manner still consistent with the Eurozone as a single entity. If, however, the crisis dissipates we would expect yields to move to levels more consistent with fundamentals and as such lose this ‘flight-to-quality’ premium.”
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