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Beyond
brinkmanship
If Wall Street sneezes, does the rest of the world still catch a cold?
Carl hess identifies what Australian super funds need to know
about the US economy and politics.
S
hutdowns. Fiscal cliffs. Political
brinkmanship. The United States (US)
economy, the world’s largest economy,
has weathered some serious storms in
recent times, while the rest of the planet
has watched with varying degrees of
frustration, hope and relief.
Throughout history, when economic
conditions shattered in the US, the rest of
the world was left to pick up the pieces.
While the political impasse, culminating in
the US Government shutdown, was resolved
in the nick of time, another deadline for
the US government’s debt ceiling looms
in January. What is the state of play in
the US now, and what should Australian
institutional investors be most aware of?
As it stands
Compared to the European Union, the
US economy is in a relatively good place.
It’s chugging along, albeit with sub-par
growth. Recovery from the great recession
has not been as robust as one might
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have hoped, but there have been a few
drivers – a revival in real estate values,
the US Federal Reserve’s (Fed) continued
easy monetary policy, the potential for
fracking to dramatically change America’s
reliance on external energy supply, and
the relatively minor cuts imposed by the
sequester budget cuts – have not had the
negative impact some feared. Another
encouraging sign is recent increases in
manufacturing employment. While
modest, it has reversed what had been
a strong negative trend for much of the
past decade.
The recent shutdown had a limited
impact on the US economy and markets.
Most people were betting on a short-term
accommodation between the Republicans
and Democrats, and that’s what occurred.
So what will happen in early 2014?
We could see a repeat of the bandaid
solution or some sort of grand agreement.
Politically, we all know which is easier.
Provided none of our big worries
materialise: some sort of Eurozone
meltdown, a prolonged US Government
shutdown when negotiations resume
in early 2014, an ill-executed end to
quantitative easing, currency wars or some
sort of terrorist attack, our central forecast
calls for continued moderate growth in
the US. Everyone is grappling with how to
achieve returns in a low-yield world. The
stresses in the macro environment have
been papered over, rather than solved.
Other issues
Another issue is the knock-on effects of
the recent increase in US Treasury yields,
particularly in some parts of the developing
world that have grown accustomed to large
inflows of foreign capital to finance their
current account deficits (think Turkey,
India, and South Africa). As capital
inflows slow, due to the higher yields
and other factors, home currencies have
been falling and local inflation rising.
Time will tell if this tension causes a full-
fledged balance of payments crisis for
some of these countries.
Will the Fed introduce ‘tapering’ at the
end of this year and are we likely to see any
great changes when Janet Yellen takes over
from Ben Bernanke as Fed chairman in early
2014? Yellen has been around for some time
so I believe it will be business as usual when
she takes the helm. In terms of tapering,
the Fed has hinted it may ‘taper off’ and
see what the market does. If the reaction is
reasonable, then we may see more tapering.
A major factor that the Fed considers is the
outlook on the fiscal side of things. Federal
spending today is at reduced ‘sequestration’
levels – so we have a bit of ‘tight’ fiscal and
‘loose’ monetary policy fighting each other,
which may well motivate the Fed to push
tapering out further than some expect.
Some market commentators have
suggested that the Yuan will become
the world’s new reserve currency. It’s an
interesting notion, but not without some
potential stresses. Today, China is a lender
not a borrower, and a reserve currency is
far more effective when you have lots of
that currency ‘sloshing’ around. It’s unclear
whether China has any desire to take this
position and I think the more probable
outcome is multiple reserve currencies,
where investors can invest or hedge
or speculate.
We don’t hear much noise about a
strong US dollar any more, and there’s a
good reason for that. If you owe a lot to
external creditors devaluing that debt is a
good way to lower your burden, although
you’d best do it quietly to avoid a ‘run on
the bank’. The more interesting issue is
that we can’t all devalue our currencies,
so who is willing to let their currency
appreciate?
Investment objectives for the future
If I were the chief investment officer of
an Australian fund at the moment, I’d take
the time to flesh out my team’s investment
objectives and beliefs. Changes that lead
to better decision making and increased
operational efficiency may be just as
productive as those regarding investment
strategy. I’d then look at maximising riskadjusted return.
In a world where asset prices gyrate
as fast as they have of late, and where
greatly influential players with different
motives exist (central banks, I’m looking at
you), do we have what it takes to monitor
developments and react accordingly? This
may demand re-focusing energy toward
activities like dynamic asset allocation
and construction of better benchmarks,
and a move away from manager selection.
Particularly, I think there’s an increasing
role for smart betas such as commodities,
reinsurance and other strategies in
institutional portfolios.
Carl Hess is Global Head of Investment,
Towers Watson.
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