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international 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 22 Superfunds December 2013 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. Superfunds December 2013 23