The_Ultimate_Goal

Investment Quarterly Q2 2013 The Ultimate Goal Inside • The Ultimate Goal • Special report: ‘Abenomics’ • Market focus: frontier markets • Ask the expert: Foreign exchange rate forecasting • Navigating markets • Global data watch Overview Rapid economic growth is the Ultimate Goal for policy makers. Achieving high rates of economic growth, preferably in a low inflationary environment, is the stuff that generally keeps voters happy and gets politicians re-elected. From an investor perspective as well, strong economic growth, or its absence, can have a big influence on short-term portfolio returns, although the impact on corporate profitability and dividend payments is not always clear cut. Faltering developed world economies and rapidly expanding emerging economies have, together, already produced a dramatic shift in the centre of gravity of the global economy. Populous emerging markets have been instrumental in driving global growth in recent years with countries like China, India and Indonesia growing much more rapidly than developed world economies. We believe this is likely to continue to be the case with the developed world effectively locked into low growth for an extended period. Much of the eurozone risks a re-run of the Japanese post-1980s’ experience with a decade (maybe more) of low growth, even if structural reforms are enacted to improve competitiveness. This fate also looks to be on the cards for the UK. Despite a corresponding need for fiscal consolidation, the future for the US looks brighter. They have their own challenges but we believe emerging economies are likely to grow more rapidly than the developed world. More positive demographics and rapid urbanisation are likely to continue to support growth prospects relative to the developed world, although to be sustainable these economies will need to enact structural reforms to raise productivity. Somewhat counter-intuitively and contrary to popular opinion, there is not always a clear link from economic growth to the performance of equity markets. Strong economic growth is often good for corporate profitability because in such circumstances corporate pricing power generally improves, helping to support corporate earnings but the starting valuation for an investment is also critical to eventual long-term returns from stocks. Because of a positive growth differential as well as current undervaluation in some cases, we expect that many emerging currencies are likely to appreciate against developed world currencies over the longer term. We believe that this appreciation is likely to add to the attraction of local currency denominated equity and bond holdings in emerging markets for developed market investors. Overview (continued) Abenomics’ – a new Ask the expert – phenomenon in Japan forecasting foreign exchange rates Japan’s government strategy to overcome deflation and promote economic growth is gradually being put in place. The openended, large scale quantitative easing program announced by the Bank of Japan in early April, according to which the monetary base will be increased by about JPY140 trillion, or USD1.5 trillion, by end-2014, is meant to be the cornerstone of what is being referred to as ‘Abenomics’, after prime minister Shinzo Abe. We believe it has a reasonable chance of curbing deflation and yen appreciation expectations, which in turn will have a positive impact on expected asset returns, at least for the time being. However, ‘Abenomics’ is essentially a demand-side policy that doesn’t address the key supply-side bottlenecks in the economy, especially the very adverse demographic situation. Not only is the working age population shrinking, so is the total population. For this reason, to be successful in the longer term it needs to be accompanied by fundamental economic reforms. At HSBC Global Asset Management our interest in foreign exchange (FX) rates stems mainly from their impact on our investors’ returns when they buy assets outside their home country. For this reason our focus is on forecasting changes in spot FX rates over a 5–10 year horizon. In this article we describe our approach to forecasting changes in FX rates. The approach is based on a modified form of so-called ‘purchasing power parity’ (PPP), the idea that the same basket of goods and services should cost the same in different countries. We modify this approach to take into account the tendency for the currencies of emerging market countries to persistently trade below their PPP values. Using current estimates for PPP FX rates and GDP per capita with forecasts for inflation and economic growth we forecast future ‘fair value’ exchange rates. The best estimate of the change in the market FX rate over a multi-year horizon is that it will move from its current level to this fair value level. Focus on ‘frontier’ markets The term ‘frontier markets’ is commonly used to refer to economies that are capable of becoming the next generation of emerging markets. They are countries that have typically enjoyed high economic growth rates but have made limited progress towards either political or economic stability, or in developing liquid and efficient capital markets. Since global frontier markets have historically been among the least correlated with other equity classes, and are also lowly correlated between individual constituent countries, they can provide diversification benefits. This is appealing from an asset allocation perspective as it provides an opportunity to improve the risk/return profile of overall emerging markets portfolios. Global data watch In our global data watch section we review how economic data releases have been coming through, how consensus economic forecasts have changed and how financial markets have performed. Growth in the US came in slightly weaker in Q4 2012 and conditions in the eurozone deteriorated further. Consumer spending in much of the developed world has weakened from already low levels, being particularly anaemic in the eurozone. Although US unemployment is off its highs, it remains elevated relative to the Fed’s explicit target of 6.5%. Emerging markets growth has stabilised somewhat and a number of key economies, including China, posted higher growth rates in Q4 2012. Latest consensus forecast data shows downward revisions to economic growth expectations for the US and the eurozone in 2013. By contrast, in Japan growth rates for 2013 and 2014 have been revised up since our previous publication was released. After performing well in 2012, risk assets mostly put in a decent performance again in Q1 this year. Improving macro data out of the US coupled with Congress eventually coming to an agreement in regard to dealing with the fiscal cliff helped risk appetite. Expectations of further monetary and fiscal stimulus measures from Japan also helped market sentiment. Navigating markets Overall, global equity markets traded higher in the first quarter of 2013, as at the end of last year the US Congress eventually came to an agreement over how to deal with the ‘fiscal cliff’ and given a general improvement in global economic data. Various indications from leading central bankers that monetary policy is likely to remain extremely loose also helped to support risk appetite. However, there was divergence in performance between regions. Japan was the best performing major advanced economy stock market on expectations of aggressive policy stimulus and the US also performed well, hitting fresh all-time record highs. In Europe stock market performance was more mixed as economies in the region continue to struggle. We maintain our view that current valuations appear to bode well for long-term equity market returns, especially relative to core government bonds. In addition, the underlying fundamentals for the US economy are gradually improving and central banks are likely to continue to provide substantial liquidity, for example, with the Bank of Japan having recently announced much more aggressive monetary easing. IQ is part of a suite of investment communications produced by the Macro and Investment Strategy Unit of HSBC Global Asset Management. The views expressed herein are as at end of March 2013 and subject to change, as the macroeconomic environment evolves. 2 The Ultimate Goal Philip Poole, Global Head of Macro and Investment Strategy Rapid economic growth is the Ultimate Goal for policy makers. Achieving high rates of economic growth, preferably in a low inflationary environment, is the stuff that keeps voters happy and gets politicians re-elected. From an investor perspective as well, economic growth, or the absence of it, can have a big influence on short-term portfolio returns, although the impact on corporate profitability and dividend payments is not always clear cut. So what will determine whether economies grow or stagnate in the future and how should we deploy our portfolios in the longer-term to reflect this' In the article that follows we try to answer these questions, drawing heavily on the academic work of Robert Barro and the excellent work on modelling long-term growth trends recently undertaken by the Organisation for Economic Co-operation and Development (OECD) and featured in various publications including ‘Looking to 2060: long-term global growth prospects’. Emerging markets have been driving global growth % 4.0 3.0 2.0 1.0 0.0 1970s 1980s 1990s 2000s 2010s Global Developed markets Emerging markets Source: HSBC Global Research – The World in 2050 Report, as of January 2012 Emerging markets The near-term have been increasingly growth outlook driving global growth As the chart to the right aptly demonstrates, the relative contributions to global growth from the developed and the emerging worlds have changed dramatically since the 1970s. Faltering developed world economies and rapidly expanding emerging economies have together produced a dramatic shift in the centre of gravity of the global economy. In particular, populous emerging markets have been driving global growth in recent years with countries like China, India and Indonesia growing much more rapidly than developed world economies. And as they have outgrown the developed world, so their global influence has also increased. One of the questions we will address in this report is whether these emerging economies can remain the engines of global growth or whether they will also succumb to a lower growth dynamic as they mature and in some cases their populations begin to age rapidly. Before we move to the question of long-term sustainable growth let’s consider the outlook for growth over the next few years. We expect subdued global growth in the coming years with growth in many markets below the trend we were used to in the run up to the global financial markets crisis and the global recession that followed it. Over this period legacy effects from the crisis and the root causes that created it – particularly developed world leverage – are likely to continue to constrain global growth. In much of the developed world a nasty combination of on-going fiscal pressures, weak consumption and unemployment rates that remain stubbornly high will keep a lid on near-term growth. Indeed, it remains a moot point whether this overhang will have a more permanent, long-term impact on global growth rates. While at some point there will be a need for central banks to begin to withdraw the massive accumulated monetary accommodation injected over the last few years, we believe monetary policy is likely to remain ultra-accommodative in 2013 and into 2014. 3 US activity data has been mostly beating expectations 10 0 -10 -20 -30 -40 01/09 04/09 07/09 10/09 01/10 04/10 07/10 10/10 01/11 04/11 07/11 10/11 01/12 04/12 07/12 10/12 01/13 -50 0 -5 -10 -15 -20 -25 -30 -35 -40 -45 -50 Activity (lhs) Inflation (rhs) Source: HSBC Global Research. ‘Surprise’ Index data, Jan 2001 = 0, as of March 2013 Despite these structural headwinds to growth, there is evidence of a positive turn in the global economic cycle led by the US and China. As the chart opposite shows, activity data for the US has generally been beating expectations (surprising positively). The Purchasing Managers Indices (PMI) heat maps below also support the view that the global economic cycle is gradually improving, despite on-going problems in Europe and Japan. On the back of this incipient recovery and reflecting reduced event risk, markets have responded favourably. There has also been a normalisation of financial flows to the emerging world. International capital flows to emerging countries, which fell sharply in mid-2012, have bounced back helping to drive up stock markets and force down bond yields in these economies. Manufacturing PMI heat map Nov 12 US India South Africa Turkey Mexico Brazil Russia South Korea Global China (HSBC) Germany Taiwan Japan UK Eurozone Australia France 49.9 52.8 49.4 51.6 52.8 52.2 52.2 48.2 49.6 50.5 46.8 47.4 46.5 49.1 46.2 44.3 44.5 Dec 12 50.2 54.7 47.4 53.1 57.1 51.1 50.0 50.1 50.0 51.5 46.0 50.6 45.0 51.2 46.1 44.3 44.6 Jan 13 53.1 53.2 49.1 54.0 55.0 53.2 52.0 49.9 51.4 52.3 49.8 51.5 47.7 50.5 47.9 40.2 42.9 Feb 13 54.2 54.2 53.6 53.5 53.4 52.5 52.0 50.9 50.8 50.4 50.3 50.2 48.5 47.9 47.9 45.6 43.9 Non-manufacturing PMI heat map Nov 12 Russia US Germany India Global Mexico Brazil China (HSBC) UK Japan Australia Eurozone France > 50 + rising > 50 + falling or > 50 + unchanged Source: Markit, as of March 2013 Dec 12 55.1 56.1 52.0 55.6 54.8 54.3 53.5 51.7 48.9 51.5 43.2 47.8 45.2 Jan 13 55.7 55.2 55.7 57.5 53.4 51.5 54.5 54.0 51.5 51.5 45.4 48.6 43.6 Feb 13 56.1 56.0 54.7 54.2 53.3 53.2 52.1 52.1 51.8 51.1 48.5 47.9 43.7 57.1 54.7 49.7 52.1 54.8 53.7 52.5 52.1 50.2 51.4 47.1 46.7 45.8 < 50 + falling < 50 + rising or < 50 + unchanged GDP growth (annual % change, constant prices) % 11 10 9 8 7 6 5 4 3 2 1 US 1960s 1970s EU 1980s 1990s UK 2000s 2013–17 China India Brazil Source: World Bank, IMF (projections only), as of March 2013 In terms of consensus economic forecasts, global growth is expected to come in at a relatively weak 2.8 per cent in 2013 and gradually strengthen to 3.0 per cent in 2014. Emerging markets should continue to grow at a healthy differential relative to the developed world over the period but growth will also likely be slower than in the 2000s as a number of the larger economies begin to mature and China, in particular, struggles to grow led by consumption rather than net exports and investment. To return to pre-crisis growth rates, developing countries will need to boost productivity and this will require more than simply policy stimulus. 4 What does economic theory tell us about long-term growth prospects' Because it is such a central question, economists have given much thought to the drivers and processes that determine long-term economic growth. As in much of economic theory, there is not full agreement about the precise drivers of growth and long-term development but there is a broad consensus between competing theories about which factors are important in facilitating or retarding growth. In traditional so-called ‘neo-classical’ economic theory, growth results from three factors: 1. increases in the quantity or quality of labour (population growth and education/training); 2. increases in capital via saving and investment (which, at an individual country level, can be either domestic or external) and 3. technological progress. According to this viewpoint, over the very long-run, per capita economic growth is determined by the pace of technological progress and the rate of population growth. As a result, innovation and the way the generation of new ideas (‘intellectual capital’) is rewarded is an important determinant of long-term growth. Robert Barro, an academic expert in this area (see R J Barro, Determinants of Economic Growth, a Cross country Empirical Study, NBER, 1996) points out that theories of technological development are most pertinent in explaining why the world as a whole, particularly the most technologically advanced countries, can grow. But in this area, it is also worth emphasising that what is often referred to as the ‘diffusion of ideas’ from technologically advanced economies to emerging economies via imitation rather than innovation can also accelerate growth. This has been a key GDP growth (annual % change, constant prices) Region/Country World Developed World United States Japan Eurozone Germany France Italy Portugal Spain United Kingdom Greece Emerging World Latin America Brazil East Asia & Pacific South Asia China India Sub-Saharan Africa MENA region 5.44 6.19 8.35 4.31 4.65 4.03 4.96 9.20 5.64 8.51 4.85 3.05 6.28 3.08 3.69 8.64 1.31 1.65 5.17 5.45 9.35 5.57 1.86 1.81 4.21 9.30 5.76 n/a 5.57 5.72 6.70 7.44 3.30 7.66 3.27 4.50 3.46 2.91 3.70 3.84 4.82 3.66 1.97 4.70 3.25 4.64 2.40 2.34 2.39 2.41 3.29 2.95 2.73 0.71 1960s 5.35 1970s 3.86 1980s 3.25 element in the rapid growth of emerging economies over the last 20 years, a period where the production chain globalised, leading to significant technological transfer of know-how and production techniques from developed countries. When it comes to relative growth rates between countries – other things like the ‘quality’ of government policy and the initial stock and quality of the labour force being equal – economic theory tells us that economic growth will be higher the lower the starting level of real per capita Gross Domestic Product (GDP) (this effect is often referred to as ‘conditional convergence’). However, behind this tenet that poorer countries tend to grow faster, the assumption that ‘other things are equal’ is very important and overly simplistic. There will be cases where this income convergence process will not hold, for example because of particularly disruptive government policies or a very low savings rate which can act to keep a poor country poor. Simply put, being poor is not a sufficient condition to generate high economic growth in the future. A core conclusion from economic theory in this area is that there are so-called ‘diminishing returns’ from applying ever more capital to a stock of other factors of production in the absence of technological progress. Continuing to add more capital investment to an existing stock of labour and land, other things being equal, will result in a declining marginal contribution to output. From this it follows that prospective growth rates will normally be higher in economies where the level of capital investment per worker is low, because adding additional units of investment can significantly boost labour productivity and so growth. Combining these two effects, a country’s prospective growth rate is likely to be more sensitive to its starting level of per capita income the larger is the size of the workforce and the lower the starting per capita stock of capital. This clearly helps to explain the rapid growth of economies like China, where two decades ago the starting level of per capita income and the endowment of physical capital were very low relative to developed countries but there was lots of labour available. 1990s 2.86 2000s 2.53 2011 2.73 2012 3.28 2013-17 4.25 3.44 1.14 2.17 1.95 1.97 1.61 2.99 2.81 2.54 2.36 1.57 0.77 1.17 1.01 1.12 0.40 0.65 2.07 1.79 2.10 1.70 -0.70 1.51 3.03 1.70 0.44 -1.67 0.42 0.76 -7.10 2.17 2.22 -0.41 0.94 0.12 -2.29 -3.01 -1.54 -0.38 -6.00 3.03 1.12 1.24 1.24 1.31 0.76 1.14 0.93 2.23 1.21 3.26 2.56 3.02 5.29 10.45 5.57 2.34 4.10 3.31 3.64 3.67 6.95 10.49 7.47 4.74 4.30 4.66 2.73 3.36 6.48 9.30 6.86 4.72 5.19 3.17 1.47 n/a n/a 7.83 4.86 4.99 5.27 3.98 4.12 n/a n/a 8.46 6.59 5.70 4.16 5 Source: World Bank and IMF World Economic Outlook, as of March 2013 Forecasts are indicative only and cannot be guaranteed. Over 65s as a proportion of the population aged 15-64 % 60 50 40 30 20 10 0 Indonesia Czech Republic New Zealand Luxembourg South Korea Slovak Republic United Kingdom Saudi Arabia South Africa Argentina Netherlands Switzerland Denmark United States 2030 Source: United Nations, Eurostat, as of March 2013 2011 Demographics and savings rates really matter At a most basic level, in the future there will be a strong headwind to growth in many economies; population ageing will reduce the share of the working-age population in the total population in many countries in the coming decades with the developed world likely to be hardest hit. Fertility rates and life expectancy will play a key role in shaping the available workforce between countries, as will net migration. The exceptions to this are the countries that stand to benefit from the so-called ‘demographic dividend’ of a growing labour force combined with a falling dependency ratio. India will be by far the largest net contributor to the global labour force in the coming decades but economies like Malaysia, Indonesia and the Philippines in Asia; Turkey, Egypt and Nigeria in EEMEA and Mexico, Brazil and Peru in Latin America will also be net contributors. However, if this demographic dividend is to be realised this future workforce will need to be educated and trained to ensure they are fit for purpose. This will also involve substantial investment in health care, housing and other forms of ‘hard’ and ‘soft’ infrastructure. Beyond countries like India, for the most part in the coming decades the world will be ageing and growth will need to be driven increasingly by efficiency improvements rather than by increases in the number of workers. For this reason improvements in the combined productivity of inputs into the production process (so-called multi-factor productivity or MFP) will likely be the main driver of growth over the next 50 years and the OECD estimates that average annual global MFP growth will be in the order of 1.5 per cent. Theory suggests that, on balance, countries having comparatively low starting productivity levels, typically countries in the emerging world, should grow faster than more developed economies where productivity is already at a relatively high level. This is simply the result of the fact that in each country productivity growth is driven by the global rate of technological progress and by the rate at which countries that lag catch up. In terms of other explanatory factors, the quality of economic management and efficiency and stability of key institutions will also be important as will the enforcement of economic rights, especially property rights. The domestic savings rate or ability to attract external savings will also play a key role. In determining how rapidly individual countries grow, a higher savings rate allows for a higher investment rate and so tends to raise the level of growth for a given starting point of per capita income. When it comes to the efficiency of the growth process, the transfer of resources from low to higher productivity areas – generating what is often termed ‘intensive’ growth from the improving productivity of existing resources – should play a key role and is often facilitated by a process of urbanisation. China and Indonesia are examples where this has been the case in recent years (see next page). In this regard, a proper functioning price system to ensure efficient resource allocation can also make a huge difference to the growth outcome because domestic price distortions from subsidies or excessive taxes can lead to inefficient price signals and the misallocation of productive resources. On the negative side, economic theory also tells us that high levels of inflation tend to retard economic growth by increasing uncertainty. From the perspective of theory then, the growth scenarios for the global economy over the long-term are likely to be shaped by technological progress, education and training, and labour force participation rates against a backdrop of global population ageing. To quote a recent OECD study, “GDP per capita in each country is expected to converge to the long-run path that is consistent with its own endowments, policies and institutions”. In this process of income convergence, technological diffusion from developed to emerging economies, in particular, should help to close the income gap between the emerging and developed world. Germany Slovenia Hungary Sweden Turkey Canada Belgium Mexico Ireland Iceland Poland France Finland Portugal Russia Norway Estonia Australia Greece Austria Japan India China Brazil Chile Israel Spain Italy 6 All grown up' Has the developed world gone ex-growth' Just like a human life cycle, as economies mature they tend to grow less rapidly and at some point can stop growing altogether and even start to shrink, particularly if their populations age rapidly. One of the key questions for the coming period is whether a large part of the developed world with its existing high standard of living has gone ex-growth. The academic study by Barro referred to earlier leads to the conclusion that 2 per cent per capita economic growth “seems to be about as good as it gets in the long-run for a country that is already rich.” In the current challenged environment this may now even look optimistic. Indeed, much of the developed world seems to have acquired post-1980s Japanese-style characteristics with the risk of stagnation – a combination of low growth, persistent deflation risks and rising government indebtedness. Japanese economic performance over the last 20 years is parlous in terms of overall GDP growth. Moreover, it seems to be the case that this stagnation has additionally reduced the competitiveness of Japan’s corporate sector which was the engine of pre-crisis growth. Legacy of crisis – global output gaps 2012 % 2.0 1.0 0.0 -1.0 -2.0 -3.0 -4.0 -5.0 -6.0 widely accepted detailed medium-term fiscal plan that would be sufficient to stabilise the government debt ratio. This compares to the front-loaded consolidation being attempted in a range of eurozone economies, albeit with limited success so far. Eurozone countries that require substantial consolidation include Greece, Ireland, Portugal and Spain. The OECD estimates that to stabilise debt they require 4-7 ppts of GDP improvement in the primary fiscal balance from the 2011 position on average. The good news here is that, if existing austerity programmes are implemented and underlying economies stabilised, much of this adjustment is expected to be complete within the next few years. Getting on – global ageing (Per cent of total population 65 and over) % 25 20 15 10 5 0 US-1980 US-2010 UK-1980 UK-2010 India-1980 China-1980 Japan-1980 Japan-2010 China-2010 India-2010 Source: UN population database, as of March 2013 United States United Kingdom Russian Federation Total OECD Indonesia Germany France Mexico Total non-OECD Eurozone In addition, for a typical developed country, additional spending offsets of 3-4 ppts of GDP will have to be found over the next 20 or so years to compensate for spending pressures that will likely result from population ageing, including the implications for the cost of pension and health care provision. This combined structural fiscal overhang clearly represents a substantial headwind for prospective growth and is a key reason why we believe that developed world growth will be depressed relative to the pre-crisis period. Japan clearly faces an upward struggle to restore growth, although its experience over the last 20 years shows that even where the population is shrinking it can still be the case that per capita incomes grow. Europe risks a re-run of the Japanese post-1980s experience with a decade (maybe more) of low growth even if structural reforms are enacted to improve competitiveness. Within the bloc, Germany most likely will continue to shine while the likes of France, Italy, Spain and the smaller countries on the periphery are more likely to struggle as they seek to address the underlying malaise. This latter fate also looks to be on the cards for the UK, whether or not it stays in the EU. Despite a corresponding need for fiscal consolidation, the future for the US looks brighter. The economy remains more dynamic than most of the rest of the developed world and ageing will be less of a drag on growth, partly as a result of continued net immigration. Labour market flexibility also remains a net positive and governmental constraints on private sector activity are also less onerous. The so-called ‘shale gas revolution’ is also likely to have a positive impact on US growth prospects. UBS estimates that, all told, the impact could be a net positive 0.5 per cent annually for GDP in the five years to 2018, a positive that will not be enjoyed by Europe or Japan. As the chart overleaf shows, development of shale resources could also have a meaningful impact on the energy balance in other countries, including China. Japan Brazil Italy China Source: OECD Economic Outlook, as of March 2013 Legacy issues – ‘cleaning up the mess’ The work that the OECD has done on long-term growth rates assumes a baseline scenario of gradual structural reform and fiscal consolidation to finally stabilise government debt-to-GDP ratios in the developed world. This will have the effect of constraining developed world growth in the coming years. While the market has preferred to focus on challenges for the eurozone, in fact, globally problems are most evident in Japan and the United States. For the United States, the OECD estimates that the total required fiscal consolidation to stabilise debt is about 6.5 percentage points (ppts) of GDP improvement in the primary fiscal balance (the fiscal balance before interest payments). While significant, this required adjustment effort pales into insignificance when compared to Japan. Stabilising Japan’s debt-to-GDP ratio would eventually require a total improvement in the underlying primary balance of 13 ppts of GDP from the 2011 position. In reality, the current fiscal stimulus programme is moving the economy in the opposite direction. The United States and Japan also stand out because there is, as yet, no India 7 Global shale gas resources Estimates of recoverable shale gas resources (USD trillion cubic feet) 1400 1200 1000 800 600 400 200 0 US SA MX LIB BRZ IND AUS ALG CHL ARG CHN CAN NOR PAR PAK Growing pains – but at least emerging markets will be growing! Emerging economies are likely to grow more rapidly than the developed world but will face challenges. Growing pains are likely to include asset price bubbles from excesses that will inevitably get in the way of growth from time to time. Demographics and urbanisation are topics we come back to time and again in the context of expected future economic growth rates for emerging economies and their relative prospects versus the developed world. The urbanisation process releases latent productivity. As people relocate from rural to urban areas they cease to subsist on the land and start to work in industry and the service sector where their productivity normally increases sharply. This will continue to be a key factor driving growth in many developed economies in Asia, although the urbanisation rate in Latin America and much of emerging Europe is already high. In the case of China, the productivity increase that results will help to offset the ageing of the population. This is not a factor that will be supportive for developed Europe or Japan – ageing rapidly but where urbanisation rates are already high – and is a key reason why population ageing will be less of a drag on economic growth in China than in the developed world. In terms of the theory, because of a low starting point for per capita income frontier markets should grow most rapidly unless a low savings rate, poor government policies, or other institutional factors get in the way. Theory also tells us, more generally, that to continue to grow rapidly, emerging economies will need to enact and implement structural reforms in order to raise productivity. These reforms should focus on developing human capital, via education and vocational training, and institutional reforms to improve investment potential. As the OECD has pointed out, food security is an additional area of vulnerability that can impact long-term growth rates in emerging economies and investment to improve local storage and transportation infrastructure and reduce wastage will both help to boost growth and reduce vulnerability to global food shocks. Source: International Energy Agency, US Energy Information Administration, as of March 2013 The conclusion that the developed world is most likely locked into low growth for an extended period has far-reaching implications for developed world monetary policy. It is likely to remain very loose for a long time to come. There has been a fundamental shift in the balance of risk, from inflation to growth. This is evident in the way the Federal Reserve (Fed) is now providing forward guidance that interest rates will remain ultra low far into the future and explicitly targeting a reduction in unemployment. It is also evident in the discussion about nominal GDP targeting that has been part of the anticipation building around the appointment of Mark Carney as the next governor of the Bank of England. More generally, for central banks, targeting lower inflation seems to be out the window, at least for now. The focus is on generating growth and employment. This change is also evident in the way that governments and politicians seem to be backing away from the trend towards ever tighter governance in the financial sector in favour of measures, however tenuous, that could provide support for growth. 8 Attracted to the city – global urbanisation rates (% of total population) 1960 1980 1985 1990 1995 2000 2005 2010 2011 East Asia & Pacific (all income levels) East Asia & Pacific (developing only) Eurozone European Union Heavily indebted poor countries (HIPC) OECD members Argentina Brazil China Colombia Germany India Indonesia Japan Malaysia Mexico Philippines Poland Russian Federation South Africa South Korea Spain Thailand Turkey United Kingdom United States Vietnam 22.4 16.9 62.0 61.3 12.1 62.3 73.6 46.1 16.2 45.0 71.4 17.9 14.6 63.3 26.6 50.8 30.3 47.9 53.7 46.6 27.2 56.6 19.7 31.5 78.4 70.0 14.7 27.5 21.3 69.7 68.9 20.9 70.3 82.9 65.5 19.4 62.1 72.8 23.1 22.1 76.2 42.0 66.3 37.5 58.1 69.8 48.4 56.7 72.8 26.8 43.8 78.5 73.7 19.2 30.5 24.7 70.3 69.6 22.7 71.7 85.0 69.9 22.9 65.6 72.7 24.3 26.1 76.7 45.9 69.0 43.0 59.9 71.9 49.4 64.9 74.2 28.1 52.4 78.4 74.5 19.6 33.7 28.2 70.9 70.4 24.6 73.1 87.0 73.9 26.4 68.3 73.1 25.5 30.6 77.3 49.8 71.4 48.6 61.3 73.4 52.0 73.8 75.4 29.4 59.2 78.1 75.3 20.3 37.2 32.2 71.6 71.0 26.4 74.5 88.7 77.6 31.0 70.5 73.3 26.6 35.6 78.0 55.7 73.4 48.3 61.5 73.4 54.5 78.2 75.9 30.3 62.1 78.4 77.3 22.2 41.2 36.7 72.4 71.5 27.7 75.6 90.1 81.2 35.9 72.1 73.1 27.7 42.0 78.6 62.0 74.7 48.0 61.7 73.4 56.9 79.6 76.3 31.1 64.7 78.7 79.1 24.4 46.5 42.1 73.9 72.7 29.4 77.7 91.4 82.8 42.5 73.6 73.4 29.2 45.9 86.0 67.6 76.3 48.0 61.5 72.9 59.3 81.3 76.7 32.2 66.8 79.0 80.7 27.3 51.7 47.6 75.3 73.8 31.3 79.4 92.3 84.3 49.2 75.0 73.8 30.9 49.9 90.5 72.0 77.8 48.6 60.9 73.7 61.5 82.9 77.3 33.7 70.5 79.5 82.1 30.4 52.7 48.6 75.5 74.0 31.7 79.7 92.5 84.6 50.5 75.3 73.9 31.3 50.7 91.1 72.7 78.1 48.9 60.9 73.8 62.0 83.2 77.4 34.1 71.4 79.6 82.4 31.0 Source: World Development Indicators (WDI), World Bank, as of March 2013 9 The nature of how income is distributed will also impact growth and opportunities for investment. The distribution of income and wealth concentrations will generate alternative investment themes. For example, in China over the last decade there has been a big increase in the inequality of income distribution. This is one of the reasons why the average consumption level is relatively low in China but it also creates opportunities for us; for example in high end consumer goods where Chinese demand is progressively becoming a globally dominant force. Projecting the world There are lots of studies that look at how the world is being reshaped and predict the likely composition of GDP in 20, 30 or even 50 years’ time. We believe that the work done by the OECD is the most complete and have based the following section on their projections and the key conclusions that flow from them. The bottom line is that global growth will continue to be sustained by emerging countries but at a declining rate. Over the coming 50 years the OECD assumes that the global economy will grow by an annual average rate of around 3 per cent with the biggest contributions to growth coming from rising productivity and improvements to the quality, rather than additions to the quantity, of the workforce. In other words, ‘intensive’ rather than ‘extensive’ sources of growth. Growth in non-OECD countries is expected to continue to outpace the OECD average, though the difference is likely to narrow over the coming decades. From over 7 per cent per year over the past decade, the growth of emerging economies is forecast to decline to around 5 per cent in the 2020s and to 2-3 per cent by the 2050s. Until 2020, China is assumed to have the highest growth rate of the larger economies but in the 2020s China’s growth rate is likely to be overtaken by India and Indonesia. This is mostly on the back of the decline in the working-age population and labour force participation in China as the effect of the ‘one child policy’ from the past kicks in. Projecting these relative growth assumptions far into the future produces dramatic changes in the composition of global GDP and the size of developed versus emerging economies. The faster growth rates of China and India imply that in total their GDP will exceed that of the G7 economies by around 2025 compared to the position in 2010 where their combined GDP was less than half of that of G7 economies. The same estimates suggest that by 2060, the combined GDP of China and India will exceed the OECD as a whole, compared to around one-third of it currently. However, despite these dramatic expected changes in the size of respective economies, even 50 years out there will likely still be very large differences in living standards between developed and emerging economies. Per capita GDP in the poorest developing economies is forecast to more than quadruple by 2060, and China and India are forecast to experience more than a seven-fold increase. However, per capita incomes in these emerging countries are still only forecast to be 25-60 per cent of the level of the richest OECD countries in 2060. Potential real GDP growth rates Potential real GDP growth (annual averages, percentage change) 2001– 2007 France Germany Italy United Kingdom Russian Federation Eurozone Brazil Mexico United States China Indonesia India Japan Total OECD Total non-OECD World 1.8 1.3 1.2 2.4 5.3 1.8 3.2 2.4 2.5 10.2 4.0 7.4 0.6 2.3 6.9 2.7 2012– 2017 1.8 1.6 0.6 1.5 3.6 1.5 4.4 3.2 2.1 8.9 5.9 7.2 0.9 2.1 6.9 3.4 2018– 2030 2.1 1.1 1.6 2.1 2.7 1.8 3.9 3.5 2.4 5.5 5.1 6.5 1.3 2.3 5.1 3.3 2031– 2050 1.4 1.0 1.6 2.2 0.9 1.4 2.5 3.0 2.1 2.8 3.7 4.5 1.3 1.9 3.0 2.4 Source: OECD Economic Outlook, as of March 2013 10 Real and nominal GDP (% of global GDP) Real GDP at 2005 PPPs (% of global GDP) 2010 2010 Nominal USD GDP at market exchange rates (% of global GDP) 2010 Nominal USD GDP at market exchange rates (% of global GDP) 2010 Real GDP at 2005 PPPs (% of global GDP) Other non-OECD 12% India 6% United States 23% China 11% Other non-OECD 9% India 3% United States 26% China 16% Japan 7% Other OECD 20% Other G7 21% Japan 10% Other OECD 19% Other G7 17% 2030 2030 2030 Other non-OECD 12% India 11% 2030 United States 18% Japan 4% Other non-OECD 11% India 7% United States 20% Japan 6% China 25% Other G7 11% China 28% Other G7 14% Other OECD 17% Other OECD 16% 2050 2050 2050 Other non-OECD 12% 2050 United States 16% Japan 3% Other G7 9% India 12% Other non-OECD 10% United States 17% Japan 5% India 16% Other G7 12% Other OECD 14% China 30% Source: OECD Economic Outlook, as of March 2013. China 28% Other OECD 16% 11 Current account balances (% of global GDP) % 4.0 3.0 2.0 1.0 0.0 -1.0 -2.0 -3.0 -4.0 2000 United States Source: OECD Economic Outlook, as of March 2013. 2007 Japan Other surplus 2013 Other deficit 2020 Oil exporters China 2030 Risks – upside and downside The OECD forecasts suggest a generally benign future, albeit one where global growth slows. But we know from history that things rarely proceed in a straight line. And events over the last few years show how disruptive event risk can be. So what are the key risks to this prospective view of the world' It seems to us that there are both downside and upside risks to the way it might actually play out relative to the benign baseline described above. In terms of downside risks, a key assumption underlying these projections is that the financial market crisis that broke in 2008 has not had a permanent dampening effect on trend growth rates. In its projections, the OECD also explicitly assumes away the risk of disorderly debt defaults, increases in trade protectionism and constraints on growth from natural resource availability or environmental problems. In the event that any of these things were to happen it would likely have an additional negative impact on global growth prospects. The OECD does point to downside risks related to policy failure in the form of rising economic imbalances. Without appropriate action, government indebtedness in many developed countries could reach a level that forces up interest rates, ‘crowding out’ private sector investment, and further depressing economic growth. Global current account imbalances are projected to widen until the late 2020s and over the longer-term the negative effect of ageing populations on the savings rate will also weigh on current account performance. China’s current account surplus is projected to widen up to the late 2020s as the investment rate falls more rapidly than the savings rate. Overall, the OECD predicts that the size of current account imbalances as a proportion of global GDP could return to the 2007 pre-crisis peak by 2025-30. There are also upside risks, factors that could push up the expected rate of economic growth. Beyond hard to predict breakthroughs in productivity-enhancing technology, these factors include economic policies and structural reforms that could boost potential output and push up the level of sustainable growth. Two key areas that could deliver these upside surprises are reforms in labour and product markets. If there were to be more far-reaching reform of labour markets it could have the effect of pushing up the level of labour force participation, so adding to the total global labour force. Under one variant of this considered by the OECD, global GDP would be close to 6 per cent higher on average in 2060 as compared with the baseline. Similarly, if product markets were to be liberalised more rapidly than assumed under the central scenario, productivity gaps between developed and emerging markets could close more quickly and this would boost the level of efficiency and growth and speed up income convergence of emerging economies. One variant of this considered by the OECD would increase global GDP by an average of 10 per cent in 2060 relative to the baseline, the impact being greater in emerging countries with relatively stringent regulations, such as China and Turkey. Investment implications A focus on the long term So far this article has focused on prospects for long-term growth now it is time to turn to prospective long-term investment returns. Our approach to multi-asset investing is grounded in the analysis of such long-term return relativities. Over the very long term, equities have comfortably outperformed bonds in terms of real annualised returns. 12 But the complication for investors is that over the last 20 years (and particularly over the last decade) it has mostly been the other way round. Bonds have outperformed equities in most markets. Given current valuations we see a return to the longer-term trend of equity out-performance (so-called ‘mean reversion’) and our expected long-term return forecasts over the next 10+ years are based on this premise. The work done on this is summarised in the chart below. These long-term return forecasts are derived from extensive research on cross asset returns led by our Global Chief Investment Officer, Chris Cheetham, with contributions from Guillaume Rabault, Joe Little, Fabrizio Coai, Benoit Bellone, Adam Olive and Guy Morrell. Forecasting long-term returns is not straightforward and our estimates rely on a number of simplifying assumptions. For brevity, we present summaries of the expected return calculations (and assumptions) in the individual asset class sections below. Projections for long-term real asset class returns Prospective returns: % inflation-adjusted % 9 8 7 6 5 4 3 2 1 0 US cash US IG Credit EM Debt (USD) US Equity EM Debt (Local ccy) US Treasuries US Real Estate European Equity GEM Equity* US HY Credit -1 In thinking about future returns from bonds, in many respects our starting point is that in this ultra low interest rate and low yielding world, core government bonds (US treasuries, German bunds, UK gilts, Japanese Government Bonds etc.) are expensive. But to try to predict future returns from bonds we have to make a series of assumptions. We currently assume a real interest rate of 0.5 per cent and inflation of 2 per cent in 10 years’ time. Over the long-run, the historical additional return over cash for owning bonds (the so-called ‘bond risk premium’) has been 1.2 ppts. We make the simplifying assumption that this premium is 1.2 ppts for all developed markets and assume that bonds move to this average level of risk premium over a 10-year period. These assumptions generate a combination of bond-related returns and capital loss (as bond yields rise from the current historically depressed levels) that nets to a 2.2 per cent annual nominal return over a 10-year holding period. Subtracting the assumed 2 per cent inflation consequently generates a real annualised return of close to zero for US treasuries over this period, with corresponding real returns from other major markets potentially even negative. Clearly, this is not an attractive outcome from an investment perspective! Corporate bonds When it comes to corporate bonds, we believe current valuations offer a decent yield ‘pick-up’ relative to government bonds, especially for high yield bonds. We expect US investment grade spreads to remain stable and US high yield spreads to fall further. Corporate spreads have fallen but are still above pre-crisis levels. We also expect euro investment grade and high yield spreads to fall further. Many emerging markets bond spreads are tight, so careful selection and fund construction are necessary in this case. In terms of sectors, spreads on financial (mainly banks and insurance companies) have room to fall further as financial sector risks ease. Corporate defaults are likely to remain low for investment grade. While they are likely to rise for high yield, default rates should remain below long-term averages. The debt/ profitability ratio to corporate bond spreads is a good indicator of financial distress and return versus risk. Current levels indicate that the market is not overvalued in terms of credit fundamentals, in contrast to the 2003-07 period. Technicals also remain strong with ample market liquidity supported by ultra-low policy rates and global liquidity, courtesy of developed world central banks. Specifically, we see scope for further spread compression in Europe and in US BBB rated securities. Given current valuations, we are overweight European corporate debt. At the investment grade end, as investors continue to perceive sovereign risk as credit risk, institutional investors may prefer high quality corporate debt to government debt. This asset class has tended to be less volatile than euro sovereign debt. Currently, the correlation link between euro sovereigns, banks and corporates is strong but this should weaken once investors concentrate more closely on intrinsic credit quality. At the high yield end, the European market is growing, has better diversification compared to the sterling market and pays better premiums than the US market. This asset class has expanded because of corporate downgrades, many as automatic consequences of sovereign downgrades. For this reason, the banking sector has become the largest European high yield sector, accounting for close to a quarter of the market. The rating downgrades signal that these issuers are operating in a more fragile domestic economic environment but given that they are starting from an already weak rating position there appears to be only limited room for additional deterioration in credit quality. 13 * Emerging market bond (local) and equity returns are shown on an unhedged basis. We assume the spot rate significantly appreciates relative to current forwards. Source: HSBC Global Asset Management, Datastream, Bloomberg, as of February 2013 Forecast are indicative only and cannot be guaranteed. Because we believe in mean reversion of financial asset values, we strive to buy assets when they are cheap relative to our estimate of ‘fair value’ and sell them when they become expensive. But there will always be an economic cycle. Depending on where we are in that cycle, asset prices could either be moving towards or away from our view of their long-term fair value, arguing from time to time for tactical adjustments to positions and portfolio weights set on the basis of long-term return beliefs. In the individual asset class sections below we try to summarise where we see value, taking into account current valuations relative to longer-term fair value targets and a view, expressed above, that the economic cycle is becoming more favourable. Bonds Economic growth is a bit of a double-edged sword for government bond prices. Growth tends to be good for governments, supporting budgetary revenues, and other things being equal, can help to strengthen government finances and support sovereign credit quality. At the corporate level, if the economy is growing it should support profitability and generally help to curb default rates, the bugbear of corporate bond investors. Generally, defaults tend to be less of a problem when economies are growing. However, if growth is excessive, more often than not it generates inflation. And inflation is bad for bonds. High yield indices (Euro and US) – sector breakdown % 30 25 20 15 10 5 Basic Resources Banks Capital goods Technology Consumer non-cyclicals Telecom Energy Consumer Cyclicals Media Auto Healthcare Insurance Services Utilities Financials % 2100 1800 1500 1200 900 600 300 0 China India Peru Indonesia Russia Malaysia Philippines Morocco Egypt Turkey Chile South Korea Colombia Thailand Poland South Africa Brazil Czech Republic Mexico Hungary 0 Euro Market: % Mkt Value Source: HSBC Global Asset Management, Merrill Lynch, as of January 2012 US Market: % Mkt Value Asian fixed income markets have positive risk/return characteristics 16 14 Annualised Return (%) 12 10 8 6 4 2 0 0 5 10 15 Annualised Volatility (%) 20 25 Asian USD Bond Asian Local Currency Bonds GEM Local Currency Bonds Barclays Global Aggregate Asia Pacific ex Japan Equities GEM USD Bonds US High Yield Global Equities world stocks is that, because growth is constrained and governments are highly indebted, policy makers might be tempted to increase corporate tax rates, constraining the ability of companies to pay dividends. Because of better growth and fiscal performance, we believe this risk is lower in many emerging economies. Additionally, while cross correlations between equity markets currently remain high, significant differences in underlying fundamentals between emerging and developed economies, including long-term growth prospects, should provide valuable diversification potential over time. From the perspective of investment, it is not simply about corporate earnings but also about how those earnings are deployed, so-called corporate ‘payout ratios’ – the extent to which earnings are paid to equity holders as dividends – and the efficiency with which the retained portion of earnings is reinvested. With these caveats in mind, in terms of constructing bottom up equity portfolios, we put a lot of emphasis on starting stock valuations in addition to prospective growth (more of this later, in particular our preferred price to book versus return on equity valuation framework for discerning relative value between markets and sectors). Strong economic growth does not necessarily translate into equity market out-performance % 250 200 150 100 50 0 US Treasuries Source: HSBC Global Asset Management, as of March 2013 We also believe that a long-term position in emerging market bonds makes good sense in globally diversified portfolios. It can add diversification characteristics and should also help to boost returns. As the chart above shows for Asian fixed income, the risk/return characteristics for emerging markets debt can be attractive. Given current valuations we have a preference for emerging markets corporate exposure in US dollars and selective local currency bond markets. Equities Strong economic growth is often good for corporate profitability because in such circumstances corporate pricing power generally improves helping to support corporate earnings. However, somewhat counter-intuitively and contrary to popular opinion, there is not always a clear link from economic growth to the performance of equity markets. In fact as the chart below shows, the correspondence between economic growth and equity market returns can be low. While the link between economic growth and equity markets returns has not necessarily always been robust, in the future we do expect that higher growth economies in emerging economies will attract additional fund flows based on better growth prospects, particularly flows from indexed funds. Moreover, one of the risks for holders of developed Cum. GDP growth (LHS) Cum. stock mkt return (RHS) Source: IMF, Datastream, as of March 2013. Data for 2000-12. 14 But first, an explanation of how we reached our longterm return forecasts for equities. We adopted a so-called three-stage Dividend Discount Model (DDM) which discounts future expected dividends to generate longterm equity returns. In spite of disappointing GDP growth, dividend growth has been strong in recent years (around 5 per cent for the MSCI World composite on average over the last 10 years). This reflects a rising share of profits in GDP and, in fact, the strong dividend growth has occurred against a backdrop of falling payout ratios. We believe that underlying corporate profitability remains supportive for dividend growth in the near term. Further out, we expect dividend growth to revert back to lower levels more in line with the longer-term average but also see payout ratios, which have been low in recent years, reverting to a higher rate in most developed markets. Developed markets valuation summary (MSCI World) 30 Forward PE 25 20 15 10 5 1987 For emerging markets, we expect to see currency appreciation relative to the US dollar and other developed world currencies over time (see below). We believe this will add to the return profile of these markets in US dollar terms, boosting their prospective returns relative to those of developed markets. On these assumptions prospective long-term equity returns look attractive relative to bonds. Another way of reaching the same conclusion is to look at how markets are currently valued relative to history. The charts below show this clearly, particularly in terms of the yield gap between the equity dividend yield and US treasury yields for both developed markets and emerging markets on average. % 16 14 12 10 8 6 4 2 Yields 1990 1993 1996 1999 2002 2005 2008 2011 MSCI World forward price earnings ratio (PE) 0 1983 1987 1991 1995 1999 2003 2007 2011 MSCI World dividend yield US 10Y treasury bond yield Emerging markets valuation summary (MSCI EM) 30 Forward PE 25 20 15 10 5 1987 1990 1993 1996 1999 2002 2005 2008 2011 MSCI Emerging forward price earnings ratio (PE) Source (all): HSBC Global Asset Management, Bloomberg, as of March 2013 % 8 7 6 5 4 3 2 1 0 1996 1998 2000 2002 2004 2006 2008 2010 2012 Yields MSCI Emerging dividend yield US 10Y treasury bond yield 15 Value between equity markets and sectors As mentioned above, while we are firm believers in managing money based on long-term return expectations, there will also be a valuation cycle to take account of, normally determined by where we are in the economic cycle. Our preferred valuation metric for constructing equity portfolios, particularly in emerging markets, is price to book versus return on equity. The charts on this page show this framework on a peer group basis, for markets and sectors in developed and emerging markets. The table on page 20 also shows individual markets’ valuations relative to their own trading history using other valuation metrics. In general, and particularly for emerging markets, the price to book/ROE (return on equity) analysis highlights the fact that defensive sectors like health care and consumer staples look expensive while financials and cyclical sectors like energy and consumer discretionary look relatively cheap. Developed equity and sector valuations (price to book/ROE) 3.2 2.7 2.2 Utilities 1.7 1.2 Energy Financials 8 10 12 14 16 18 20 Materials Telecommunication services Consumer staples Consumer discretionary Industrials Information technology Health care PB/ROE valuation 3.80 3.30 Price to book 2.80 2.30 1.80 1.30 EEMEA 0.80 6.0 8.0 10.0 12.0 14.0 16.0 18.0 20.0 Japan Asia x Japan Europe x UK United Kingdom LatAm United States Return on equity (%) Emerging equity and sector valuations (price to book/ROE) 5.1 4.6 4.1 Price to book 3.6 3.1 2.6 2.1 1.6 1.1 11 Consumer staples Health care Telecommunication services Industrials Materials Energy Utilities Financials 13 15 17 19 Return on equity (%) 21 23 Information technology Price to book Consumer discretionary Return on equity (%) Note (all above): Price to book and ROE data based on HSBC Global Asset Management universe for the respective market with PB adjusted for inflation. Source (all above): HSBC Global Asset Management, as of March 2013. DM forward PE relative to own valuation history (5 year average) 1.2 1 EM forward PE relative to own valuation history (5 year average) 1.4 1.2 1 0.8 0.6 0.4 0.2 0 China 0.8 0.6 0.4 0.2 0 Europe ex UK United States Germany United Kingdom Italy France Japan Spain EM Asia Taiwan India Brazil Indonesia South Africa Thailand Turkey Source: OECD, HSBC Global Asset Management, data as of March 2013. Source: OECD, HSBC Global Asset Management, data as of March 2013. Mexico Russia 16 Comparative equity market data PE 12m fwd 5 year average Discount premium 12m fwd PB 5 year average Discount premium 12m fwd DY 5 year average Discount premium France Germany Greece Italy Japan Spain United Kingdom United States Europe ex-UK Developed Markets Russia South Africa Turkey China India Indonesia Korea Malaysia Philippines Brazil Mexico Latam EM Asia GEMs 11.1 11.0 14.9 10.1 13.7 11.1 11.1 13.2 11.9 10.2 10.5 8.5 9.3 15.4 9.3 10.1 12.8 10.7 -9.0 -5.1 -75.0 -9.2 11.0 -19.3 -9.9 -3.4 -12.1 1.2 1.3 1.9 0.8 1.1 1.1 1.6 2.0 1.4 1.2 1.3 1.1 0.9 1.0 1.3 1.6 1.9 1.4 2.7 -2.8 -74.3 9.8 -2.4 15.1 -3.1 -3.8 -2.7 4.1 3.5 3.1 4.2 2.3 5.8 4.1 2.3 3.8 4.5 3.9 5.0 5.4 2.3 6.6 4.4 2.3 4.3 10.6 11.7 37.9 22.6 1.7 11.7 6.9 -0.6 12.3 5.2 12.1 11.2 10.3 14.4 13.9 8.5 14.4 17.6 10.8 17.7 12.5 11.0 10.7 6.3 10.5 8.8 11.3 14.5 12.5 9.7 13.9 14.0 10.0 13.6 10.9 11.7 10.7 16.9 -14.9 -27.4 8.8 0.2 -11.3 12.9 -3.7 -25.8 -7.7 -30.3 -14.5 5.8 -0.1 0.7 2.1 1.7 1.5 2.3 3.0 1.1 1.9 2.7 1.3 2.0 1.5 1.5 1.5 0.9 1.8 1.4 1.8 2.4 3.0 1.3 1.9 2.2 1.6 2.5 1.8 1.7 1.6 21.3 -16.6 -21.4 17.4 4.5 0.5 12.8 -2.8 -23.2 17.9 22.5 13.5 8.4 8.1 4.1 3.8 2.9 3.1 1.6 2.8 1.2 3.5 2.2 3.8 1.7 3.1 2.5 2.9 3.0 4.0 3.9 3.2 1.5 3.4 1.6 3.7 3.5 3.7 3.1 3.7 2.9 3.2 -38.4 5.6 25.8 3.7 -5.5 16.8 24.9 6.6 36.2 -1.2 45.7 16.0 12.7 10.8 Source: Bloomberg, IBES estimates, Datastream, as of March 2013 Sector divergences in emerging Asia have big implications for investors 1.5 1.4 1.3 1.2 1.1 1.0 0.9 0.8 May-01 May-02 May-03 May-04 May-05 May-06 May-07 May-08 May-09 May-10 May-11 May-12 Cyclicals Defensives Financials Asia is a good example of equity markets where defensive sectors look expensive relative to cyclical sectors and financials. As the charts to the left and on page 16 demonstrate, at the moment defensive sectors like consumer staples and health care generally look expensive on a peer group comparative basis, whereas financials and cyclical sectors generally look cheap. This translates into conclusions for markets. Markets that are cyclically sensitive like China and Russia look cheap to peer group and also cheap to their own trading history. The chart to the left for Asia shows this pattern very clearly. As mentioned earlier we like to invest on the basis of buying assets that are cheap in their own valuation cycle. On this basis, cyclical sectors seem to offer value while defensives look set for a price correction if we are correct that the economic cycle will continue to improve. Source: MSCI, Morgan Stanley, data as of March 2013. Data is for relative 12 month forward PEs 17 Currencies Establishing fair value for a currency gives a basis for forecasting future currency movements but it is particularly difficult to get a reliable handle on currency valuations. Because currencies are relative prices (that is the value of one is expressed in terms of another) a common numeraire currency needs to be used to compare currency valuations. This is normally the US dollar. The most frequently used metric to establish fair values for currencies is ‘purchasing power parity’ (PPP) versus the US dollar. PPP measures a currency’s value in terms of the purchasing power of real goods and services. In theory, currencies should move towards their purchasing power parity exchange rate over time. However, given that a large part of economic output in many economies is not traded (and so not subject to international competition and pricing pressures) currencies of low per capita income countries can consistently trade at a big discount to their PPP rates. For this reason, when thinking about fair value or ‘equilibrium’ exchange rates we make an adjustment for relative per capita GDP (this is normally referred to as the ‘Penn Effect’). Using this framework, changes in the fair value exchange rate for a country will be driven by its rate of growth of GDP per capita relative to the US and by changes in the PPP exchange rate. Foreign exchange rate forecasts in this framework are, therefore, long-term and are determined by differential rates of growth in GDP per capita, differential inflation rates and by the assumed correction of under- or over-valuation, relative to the fair value starting PPP rate. Under and over valued currencies versus the US dollar CHF AUD JPY CAD MYR KRW INR TWD % -40 -20 0 20 40 60 80 Currencies which are at or close to fair value on this adjusted PPP rate can still be attractive for investment if the country’s inflation-adjusted growth rates are favourable relative to the baseline for the US. The fair value of such a currency will tend to appreciate against the US dollar over time. Examples of such currencies include the Chinese renminbi (RMB), Russian ruble and Mexican peso. In fact, either because of undervaluation relative to fair value, or because of a positive growth differential, many emerging currencies are likely to appreciate against developed world currencies over time. We believe that this appreciation should add to the attraction of local currency denominated equity and bond holdings in emerging markets for developed market investors. On a regional basis, we see this as more likely to be the case in Asia than in Latin America or emerging Europe. Long-term asset class conclusions In summary, the very low level of nominal and real core government bond yields relative to history implies that returns from assets such as US treasuries and UK gilts will be disappointing, even if policy rates remain relatively low. Despite recent spread compression, corporate bonds still offer value relative to government bonds, particularly in the high yield space. By contrast, prospective returns for equities look more interesting, although for a number of reasons, including our circumspect view on prospective global growth, such returns are likely to be low relative to the longer-term history. We believe developed market equities look particularly attractive relative to developed world bonds, given the view that the latter are overvalued relative to fundamentals. We are also positive on emerging markets equities where future returns should also benefit from currency appreciation relative to developed world currencies. Under/over valuation based on adjusted PPP (%) Source: Bloomberg, Penn world table, Oxford economics, HSBC Global Asset Management, as of March 2013 Currencies that look cheap relative to their fair value adjusted PPP rates include the Indian rupee, the Taiwanese dollar, the Korean won and Malaysian ringgit. Indeed, the US dollar itself looks undervalued. By contrast, some developed market currencies including the Swiss franc, the Japanese yen, the Australian dollar and the Canadian dollar look expensive on an adjusted PPP basis relative to the dollar. 18 Special report: Abenomics Hervé Lievore, Senior Macro and Investment Strategist What does ‘Abenomics’ stand for' The economic recovery strategy announced by Japan’s Prime Minister Shinzo Abe, often referred to as ‘Abenomics’, is organised around three pillars: structural reforms to unleash private investment, massive but temporary fiscal stimulation, and a commitment from the central bank to end deflation through an inflation target (set in January at 2 per cent) and open ended monetary easing. The first pillar relates to a long term, structural policy for which the government still has to come up with concrete measures. On the second pillar, the Abe administration announced in January a JPY20.2 trillion stimulus package (4.2 per cent of GDP), of which JPY10.3 trillion will come from central government spending and around JPY10 trillion from local authorities and private sector contribution. Though one of the biggest fiscal stimuli on record, the impact on GDP growth for the current fiscal year is generally estimated at around +0.5 percentage points only, partly because most of the funds will be reallocated from existing budgets and around 20 per cent of the package will be used to accelerate the reconstruction of the areas devastated by the tsunami in 2011 and maintenance work on existing infrastructure. This estimate is based on past experience but the unprecedented policy mix to be implemented this year could surprise on the upside. The fiscal effect will be reinforced by the bold measures that the Bank of Japan (BoJ) has announced. Because of entrenched deflation and stronger Japanese yen (JPY) expectations since the middle of the 1980s, Japanese households and businesses tend to hoard money in cash and deposits more than in other countries, especially the US. In other words, the velocity of money (ie the frequency with which a unit of money is spent to buy goods or services in a year) is much lower in Japan than in the US. As a result, for a similar impact, the magnitude of liquidity injections in Japan needs to be higher than in the US. This is the main reason why the BoJ’s bond buying program (‘APP’), the size of which has risen slowly, hasn’t met its objectives. Interestingly, expectations of a stepping up of quantitative easing (‘QE’) since last November had a significant impact on the yen, stocks and bonds which was strengthened by the fiscal announcement and subsequent confirmation of the measures by the BoJ. Central bank assets/money supply % 35 30 25 20 15 10 5 1996 1999 2002 2005 US 2008 Japan 2011 Source: Datastream, HSBC Global Asset Management, as of March 2013 What should Aggressive monetary we expect from easing is at the core ‘Abenomics’' of the strategy The Bank of Japan has announced an open-ended, large scale liquidity injection programme to overcome deflation. The BoJ will increase the size of its balance sheet by close to JPY140 trillion (USD1.5 trillion) in the next two years and the policy will be extended in the event of a below 2% inflation rate by end-2014. From an analytical perspective, ‘Abenomics’ is mostly a demand-side policy, which could accelerate a cyclical recovery but doesn’t really address underlying structural issues. After two decades of failed attempts to revive the economy through fiscal stimulation, Japan’s weaknesses are more on the supplyside. In growth accounting terms, the potential rate of growth of an economy is a function of 1. the quantity of labour; 2. the accumulation of capital (net of depreciation); and 3. a more efficient use of these production factors. While an 19 0.8 0.4 0.0 -0.4 -0.8 5.0 5.4 5.8 6.2 Japan is one of the rare countries where the labour force, and more generally the overall population, has already started to shrink. Moreover, the proportion of the working-age population included in the labour force has been declining since 1998. A cyclical, demand-driven recovery would likely boost this proportion and increase the number of hours worked, but the impact on long-term growth will likely continue to be undermined by the decline in the working-age population. Allowing more immigration to offset this adverse demographic trend would provide a timely solution, but it is not on the political agenda. Curbing long-term deflation expectations will be key. On that regard, the odds of success of the government shouldn’t be assessed with reference to past experience. The current round of quantitative easing differs from the previous QE episode in the sense that the primary goal of the BoJ between 2001 and 2006 wasn’t to fight deflation in the long run but to avoid an imminent systemic crisis as the whole banking system was virtually bankrupt and Japan was facing a credit crunch. In a sense, it is the first time that fiscal and monetary policies coordinate to fight deflation. -1.2 6.6 1963 1968 1973 1978 1983 1988 1993 1998 2003 2008 2013 Trade balance, constant JPY (LHS) JPY/USD (RHS) Source: Datastream, HSBC Global Asset Management, as of March 2013 The outlook for Japanese listed companies, and more specifically exporters, has improved significantly with the sudden depreciation of the yen. A weaker currency should boost exports and increase the yen value of overseas profits. Moreover, Japanese listed companies have substantially restructured their balance sheets, at least in the non-financial sector, by trimming down their leverage to global standards and increasing their asset turnover, which could contribute to maintain a certain price momentum in the future. But the low level of profit margins relative to other countries is likely to dampen market sentiment at some stage. Demand for Japan Government Bonds (‘JGBs’) has strengthened since the launch of the BoJ’s Asset Purchase Program, in October 2010, pushing yields lower. Demand for JGBs has been reinforced by the prospect of a more aggressive monetary policy, pushing yields to levels unprecedented (below 0.05 per cent for 3-year notes and below 0.6 per cent for 10-year maturities). In the near term, the BoJ’s policy will likely keep rates at extremely low levels with limited volatility but risks will arise if consumer prices finally start to rise. Implications for Japanese stocks, JGBs and the yen The JPY depreciated by 16 per cent against the USD between November 2012 and March 2013, due to the reflationary stance of the new government. As long as investors continue to expect a stepping up of monetary easing in Japan, the JPY will likely stay on a depreciation trajectory against currencies for which monetary policy shows more stability, which could be the case of the USD if the US unemployment rate continues to fall. Besides the impact of the relative monetary policy stance, the recent deterioration in Japan’s trade balance will also play a role as the external recycling of trade surpluses has been a robust driver of the yen against the USD since 1971. However, the speed of depreciation will have to be monitored to prevent possible opposition by Japan’s trading competitors like South Korea or China. Reversed scale expected long-term depreciation of the yen and a higher expected inflation would probably contribute to accelerate the accumulation of capital (through the relocation of some production capacity in Japan and higher rates of return on investment projects), with some ripple effects on technological and organisational progress, the availability of labour will remain an issue. Japanese yen and the trade balance JPY trillion 1.6 1.2 Natural log 4.2 4.6 20 Market focus: frontier markets David Wickham, Senior Product Specialist What are frontier markets' There is no strict definition of what constitutes a ‘frontier market’. They are commonly seen, however, as countries capable of becoming the next generation of emerging markets. In other words, those countries with stock markets that are ‘verging on emerging’ status either now or at some point in the future. Frontier markets are often classified as low-income, high-risk countries that have typically enjoyed high economic growth rates but have made limited progress towards either political or economic stability or in developing liquid and efficient capital markets. In addition, they are generally not represented in mainstream emerging market indices. Based on the MSCI Frontier Markets index, frontier market countries include the following 25 countries; in the Middle East and North Africa: Bahrain, Jordan, Kuwait, Lebanon, Oman, Qatar, Tunisia and the United Arab Emirates; in Latin America: Argentina; in Asia: Bangladesh, Pakistan, Sri Lanka, and Vietnam; in SubSaharan Africa: Kenya, Mauritius, and Nigeria; and in Eastern Europe: Bulgaria, Croatia, Estonia, Lithuania, Kazakhstan, Romania, Serbia, Slovenia, and Ukraine. 2. Change Just like their emerging market counterparts 20-30 years ago, frontier markets have the potential to benefit from positive change (or relative improvements) resulting in a degree of convergence with emerging markets. The specific change agents include: improved infrastructure, stronger capital markets, improved regulation and governance and deepening of the labour market to name but a few. 3. Consumers Frontier markets are notable for their large, young, fastgrowing, and rapidly urbanising base of consumers. With positive change driving productivity growth (through better technology and improved skills) and growing GDP capita, this enables a populous middle class with rising disposable incomes to consume and become an economic force. 4. Commodity Many frontier countries are naturally endowed with commodities and have been supported by the rise in commodity prices over recent years. The prevalence of commodities in frontier markets has generated strong government credit positions. This should allow governments to gradually diversify their economies away from commodity production by investing in both hard infrastructure (eg roads, bridges, airports and seaports) and soft infrastructure (such as education, healthcare and other essential services) that will drive productivity growth over time. Despite benefiting from the long-term trend in commodity prices, frontier stock markets are generally somewhat insulated from short-term commodity price movements. This is because commodity-producing companies, and oil producers in particular, tend to be government owned so they are typically unlisted. 5. Correlation Global frontier markets have historically been amongst the least correlated to other equity classes, and lowly correlated with commodities for the aforementioned reason. Frontier markets could offer additional diversification as they have low correlations with each other (in other words, they exhibit low cross-country correlations). Key growth drivers of frontier markets Global frontier markets can be characterised by seven characteristics, the so-called ‘7Cs’: 1. Comprehensive universe Global frontier markets provide investors with access to a comprehensive and eclectic universe of highly heterogeneous, inefficient pre-emerging markets. In total, using HSBC classification of frontier markets, the investment universe amounts to over 3,000 companies across more than 60 countries, representing approximately 26.5 per cent of the world’s population and a 13.8 per cent share of the world’s total GDP based on purchasing power parity. 21 These low correlations occur because each market is driven by many different and often localised factors. Overall, these low correlations surprisingly result in lower volatility for the asset class. While it may sound counterintuitive, the volatility of global frontier markets has been consistently lower than emerging and developed markets over the last five years, as illustrated in the chart below. Annualised volatility of returns in frontier markets, emerging markets, and developed markets % 60 50 40 30 20 10 0 Dec-05 May-07 Oct-08 Apr-10 Sep-11 Risks Frontier markets are prone to a number of risks that need to be carefully considered and continuously navigated. These include political, commodity, liquidity, and currency risks: • Political risks – although many frontier market countries are far more stable than a decade ago, there will always be political risks. • Commodity risks – some frontier countries, like Nigeria and the oil producing Gulf Cooperation Council (GCC) states, and indeed some emerging markets like Russia for that matter, are sensitive to the oil price. • Liquidity risks – as many stock markets in frontier countries are in the process of developing, trading volumes are lower than emerging and developed markets and they are also often fraught with operational issues. These include trading restrictions, complex custodial arrangements, and poor regulation. • Currency risks – in comparison to mainstream emerging market currencies, frontier market currencies generally have less liquid and deep foreign exchange markets. Wider bid-ask spreads, larger commissions, higher currency volatility and even restrictive regulations also tend to define these markets. MSCI Emerging Markets *FEM- Frontier Emerging Markets MSCI World MSCI FEM* Capped Source: Bloomberg, as of December 2012 6. Cash Returns Dividend yields in global frontier markets have been consistently higher than both developed and emerging markets, as seen in the chart below. This has been due to the fact that while the stock exchanges of frontier market countries may be relatively young, the companies themselves are not as they are typically well established, formerly government or family controlled businesses that are often highly cash generative. 12-month trailling dividend yield at year end % 7.5 6.5 5.5 4.5 3.5 2.5 1.5 2008 2009 DM 2010 EM 2011 FM 2012 Conclusion Since global frontier markets have historically been among the least correlated to other equity classes, and are also lowly correlated across individual constituent countries they provide diversification benefits. This is appealing to us from an asset allocation perspective as it provides an opportunity to improve the risk/return profile of emerging market portfolios and any allocation to global frontier markets can provide meaningful diversification benefits in the form of reduced portfolio volatility and enhanced returns. Source: Bloomberg, as of March 2013 7. Cheap Valuations At present, we believe the valuation opportunity looks attractive, with frontier markets trading on cheap valuations but with higher levels of return-on-equity. At present frontier markets are trading on a price-to-book value of 1.6x compared to 1.7x in emerging markets and 1.9x in developed markets. 22 Ask the expert: Foreign exchange rate forecasting Adam Olive, Senior Investment Strategist What is your approach to FX forecasting' At HSBC Global Asset Management our interest in foreign exchange (FX) rates stems mainly from their impact on our investors’ returns when they buy assets outside their home country. For this reason our focus is on forecasting changes in spot FX rates over a 5-10 year horizon. Over these long horizons we believe that FX rate changes will be driven by a reversion to equilibrium or ‘fair’ value. We estimate this fair value using a modified form of so-called Purchasing Power Parity (PPP). This is the idea that the same basket of goods and services should cost the same in different countries. For example if the reference basket of goods and services costs GBP1,200 in the UK and USD1,920 in the USA, then the PPP FX rate that makes the two baskets cost the same is GBP1 = 1,920/1,200 = USD1.60. How good is purchasing power parity as an estimate of fair value for an FX rate' If the Purchasing Power Parity FX rate is a good approximation to fair value then the ratio of the market FX rate to the PPP FX rate should fluctuate around 1.00. For the major developed countries’ currencies in the modern era of floating FX rates this is in fact the case. Ratio of market FX rate to PPP FX rate for major developed currencies 1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 0.2 Unfortunately PPP is not a good estimate of fair value for emerging market currencies: their market values against the USD and other developed currencies are permanently cheap when measured relative to PPP: Ratio of market FX rate to PPP FX rate for major emerging currencies 1.6 1.4 1.2 1 0.8 0.6 0.4 0.2 Source: Bloomberg, Penn world table, Oxford economics, HSBC Global Asset Management, as of March 2013 As in the case of the developed currencies the ratio of the market FX rate to the PPP FX rate appears to revert to a ‘mean’ (or average) level, but around a much lower level than 1.0. It seems that the equilibrium or fair value FX rate is below the PPP value. This is normally referred to as the ‘Penn Effect’. GBP DEM FRF AUD CAD IPY Source: Bloomberg, Penn world table, Oxford economics, HSBC Global Asset Management, as of March 2013 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 INR ZAR BRL CNY MXN IDR 23 What is the explanation for the Penn Effect' The main theoretical explanation for the Penn Effect is that in rich countries non-traded goods and services (think of fresh bread and taxis) are expensive relative to poorer countries. Bakers and taxi drivers are probably not much more productive in Stuttgart than in Cape Town but they are paid more in Germany than in South Africa. This is because workers who make or provide these things could potentially work in the highly productive and highly paid traded sector in richer countries and this pulls up their wages. It is because non-traded goods and services go into the baskets used for estimating PPP rates and because these items are cheap in developing countries that the equilibrium FX rates are below the PPP value. If this explanation is correct, then the fair value (or equilibrium real exchange rate) of a currency (the ratio of the Market FX Rate vs the US dollar (USD) to the PPP FX rate which we plotted below) should be an increasing function of the relative GDP per capita of the country (that is the GDP per capita of the country, divided by the GDP per capita of the US). To a reasonable approximation that is what one sees. Current real FX rate vs GDP per capita (13 March 2013) 1.8000 1.6000 1.4000 DKK CHF NOK How can one forecast currency changes using the PPP corrected for the Penn Effect' Because we are interested in long-term (multi-year) forecasts for market FX rates we can’t simply assume that the market FX rate will change so that the real exchange rate moves vertically up or down to its theoretical fair value represented by the red diamonds. The theoretical real exchange rate for a country’s currency will change over the forecasting horizon. For example, we expect that GDP per capita in China will grow faster than GDP per capita in the USA by about 5 per cent per year. This means that over the next 10 years GDP per capita will go from its current level of about 20 per cent of the US level to about 33 per cent of the US level. This means that the fair value price of China’s currency should go from about 60 per cent of the PPP value to about 70 per cent of the PPP value. Now this could happen in one of two ways. Firstly the market FX rate could stay at its current level of CNY 1 = USD 0.1608 and the PPP exchange rate move down from CNY 1 = USD 0.2668 to CNY 1 = USD 0.2299 because of higher inflation in China than in the US. Alternatively, if inflation rates were the same in the US and in China, then the market FX rate could move up from CNY 1 = USD 0.1609 to CNY 1 = USD 0.1868. This shows that there are three components to long-term forecasting of FX rates. There is the correction of pricing errors, there is the effect of differential growth in GDP per capita and there are inflation rate differentials. By estimating these three quantities and summing them appropriately we believe we can produce a serviceable forecast for long-term changes in spot FX rates. SFK AUD Real FX rate 1.2000 1.0000 0.8000 0.6000 0.4000 0.2000 JOD RRI COP CLP CZK NZD JPY ILS EUR GBP KRW TWD CAD USD HKD SGD TRY ZAP MXN RUB MAR PEN HUF NDD CNY MYR PLN PHP ARS LKR THB EGP PKR INR 0.0000 0.2000 0.4000 0.6000 0.8000 1.0000 1.2000 Per capita GDP at PPP/US per capita GDP Actual real FX rates Source: Bloomberg, Penn world table, Oxford economics, HSBC Global Asset Management, as of March 2013 1.4000 24 Navigating Markets Julien Seetharamdoo, Senior Macro and Investment Strategist Equity market rally continues, but with greater divergence between markets Global equity markets traded higher in the first quarter of 2013 overall, as the US Congress eventually came to an agreement over how to deal with the ‘fiscal cliff’ and pushed back various other fiscal deadlines and amid a general improvement in global economic data. Indications from various leading central bankers that monetary policy is likely to remain extremely loose also helped support investor sentiment. However, there was divergence in performance by region. Japan was the best-performing major advanced economy stock market with the Nikkei 225 index advancing 19.9 per cent year-to-date (in yen terms, all figures as of 20 March) amid increased expectation of further monetary and fiscal stimulus measures. The US S&P500 was up 9.3 per cent so far this year with the Dow Jones Industrial Average up 10.7 per cent and hitting a fresh all-time record high in the process. However, in Europe, the Euro Stoxx 50 was up just 2.8 per cent year-to-date as of 20 March (with Germany outperforming other major eurozone bourses). Equity market performance in Asia Pacific ex-Japan has also been mixed, with the overall MSCI Asia Pacific ex-Japan index up just 1.1 per cent year-to-date (in local currency), with the Indian Sensex down 2.8 per cent and the Korean Kospi down 1.9 per cent, Shanghai Composite index up 2.1 per cent, but Hong Kong Hang Seng index down 1.8 per cent. However, many of these Asian stock markets had rallied sharply towards the end of last year. The US is still the world’s largest economy and the outlook for its economy a key factor in the performance of so called ‘risk assets’ (equities, commodities, high yielding corporate debt and emerging market (EM) currencies). We think the underlying fundamentals for the US economy are gradually improving. The US banking system has largely recapitalised and recovered from the credit crisis, and is able to support the wider economy, the housing market is rebounding and jobs continue to be created at a decent pace. This should help offset various tax increases and government spending cuts this year worth around 1.5 per cent of GDP (most notably so-called ‘sequestration’ or automatic spending cuts and the payroll tax increase agreed for 2013 as part of the fiscal cliff deal). Overall, we expect the US economy will be able to manage growth of at least 2 per cent in 2013, which should represent a favourable backdrop for risk assets. In Europe, recent economic data continues to expose a clear divergence between Germany and the rest of the eurozone but overall the pace of economic contraction in the region appears to be slowing. However, an uncertain general election result in Italy and a messy Cypriot bailout deal led to an increase in risk aversion towards the end of the quarter. In Italy, any new government formed may be unstable and a fresh round of elections in a few months time is a distinct possibility. However, last year’s European Central Bank (ECB) commitment to do ‘whatever it takes’ to preserve the euro and the announcement of the Outright Monetary Transactions (‘OMT’) government bond buying programme for countries that apply for it, in our view, is still an important underlying positive for the region reducing the degree of ‘tail risk’. Overall, as we have said previously, we expect the eurozone situation to be a source of volatility for risk assets from time to time this year, but probably not to the same extent as in 2012. In Asia, the evidence of a soft landing for the Chinese economy continues, as we argued would be the case last year. Economic reforms and liberalisation are expected to continue with a focus on boosting domestic consumption with the new leadership now in place. In the short term, the bias of monetary policy is probably slightly more restrictive than it was a few months ago given that inflation has ticked up, but is not in our view enough to derail growth. In Japan, new Prime Minister Shinzo Abe has committed to do whatever it takes to end deflation. On 28 February Abe nominated a long time advocate of more aggressive antideflation policies, Haruhiko Kuroda, next Governor of the Bank of Japan. His appointment caused the JPY to decline further against the USD, while Japanese equities rallied and business and consumer confidence indicators have also improved in Q1. Indeed, on April 4th the BoJ announced a substantial increase in its asset purchase program (see separate article in this edition). 25 Monetary policy is likely to be kept loose in the US as well. In particular, in Q1 we had several important Fed comments worth noting. Fed vice-Chair Janet Yellen suggested that the current highly accommodative nature of monetary policy is justified and that labour market slack can be attributed to cyclical rather than structural factors. Chairman Ben Bernanke has also committed the Fed to maintain stimulus “until it observes a substantial improvement in the outlook for the labour market”. Overall, in our view global equity valuations still look attractive particularly on a relative basis. With the gap between dividend yields and bond yields for many markets close to the highest level in decades, we maintain our view that current valuations appear to bode well for long-term equity market returns, especially relative to core government bonds. Corporate balance sheets and cash levels are also generally healthy and the economic cycle supportive. Central bank policy remains extremely accommodative suggesting liquidity is also positive for risk assets. Therefore, in terms of asset classes, we continue to favour corporate assets such as equities and corporate bonds over core government bonds. Indeed, over the long-term equities are even more attractive relative to corporate credit, in our view. Year-to-date MSCI equity performance for key markets (% YTD, in USD terms) 12 10 8 6 4 2 0 US Europe Japan Asia ex Japan Source: Datastream, as of March 2013 26 Global data watch Paras Patel, Associate, Macro and Investment Strategy Key highlights • Growth: GDP growth for the US was weaker in Q4 while the growth rate in Japan stabilised, albeit at a very low level. However, eurozone Q4 GDP growth showed a fourth consecutive decline with nearly every country registering additional weakness. Latest quarterly data for EM now shows a modest pick up in growth for key economies. • Inflation: The slowdown in the global economy helped to reduce inflationary pressures in the last quarter for the US, eurozone, China and Brazil while in Russia and in the UK, inflation started to pick up. Annual global real GDP growth % 8 6 4 2 0 -2 -4 -6 -8 -10 % 8 6 4 2 0 -2 -4 -6 -8 -10 • Industrial production: Industrial production growth has continued to soften in both developed and emerging markets with key economies in both blocs registering a contraction in industrial production. • Labour market: Although the unemployment rate in the US has fallen, it remains at a high level while eurozone unemployment rates continue to rise. However, in key EM economies labour markets remain relatively healthy. Real GDP growth, BRIC economies % 15 10 5 0 -5 -10 % 15 10 5 0 -5 -10 May-11 Sep-11 Jan-12 May-12 May-07 May-08 May-09 May-10 Sep-12 Dec-12 Sep-07 Jan-08 Sep-08 Jan-09 Sep-09 Jan-10 Sep-10 Sep-06 Jan-07 Jan-11 May-11 Sep-11 Jan-12 May-12 May-07 May-08 May-09 May-10 US UK Eurozone Japan China Brazil Russia India Year-on-year GDP growth for the US was weaker in Q4 while the growth rate in Japan stabilised, albeit at a very low level. However, eurozone Q4 GDP growth showed a fourth consecutive decline with nearly every country registering additional weakness. Developed markets headline inflation % 6 5 4 3 2 1 0 -1 -2 -3 % 6 5 4 3 2 1 0 -1 -2 -3 GDP growth rates in the BRIC economies have somewhat stabilised with Indian growth bouncing back in the last quarter. Although the Chinese economy has cooled, growth still remains at a high level relative to the other BRIC economies. Headline inflation in the BRIC economies % 16 14 12 10 8 6 4 2 0 -2 -4 % 16 14 12 10 8 6 4 2 0 -2 -4 Jan-12 May-12 May-07 May-08 May-09 May-10 May-11 Sep-06 May-07 Sep-07 May-08 Sep-08 May-09 Sep-09 May-10 Sep-10 May-11 Sep-11 May-12 Sep-12 Dec-12 US UK Eurozone Japan China Brazil Russia India (WPI) Inflation for the US and the eurozone has fallen in the last quarter while inflation for the UK is slowly creeping up. Japan remains in deflationary territory. Source (all): Bloomberg, Datastream, ThomsonReuters, as of March 2013 Inflation in Brazil and China has continued to fall, while in Russia it has started to pick up. The WPI series for India remains at elevated levels relative to other BRIC economies. 27 Sep-12 Dec-12 Sep-06 Jan-07 Sep-07 Jan-08 Sep-08 Jan-09 Sep-09 Jan-10 Sep-10 Jan-11 Sep-11 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11 Jan-12 Sep-12 Dec-12 Sep-07 Jan-08 Sep-08 Jan-09 Sep-09 Jan-10 Sep-10 Sep-06 Jan-11 Jan-07 -15 -15 Industrial production – developed markets % 40 30 20 10 0 -10 -20 -30 -40 % 40 30 20 10 0 -10 -20 -30 -40 Industrial production – BRIC markets % 25 20 15 10 5 0 -5 -10 -15 -20 % 25 20 15 10 5 0 -5 -10 -15 -20 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Dec-12 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 US UK Eurozone Japan China Brazil Russia India Industrial production (IP) growth for the developed world has been mixed with growth for the US, Japan and UK relatively unchanged in the last quarter. Japanese IP continues to contract while eurozone’s IP growth slightly picked up in the last quarter. Developed markets retail sales % 12 10 8 6 4 2 0 -2 -4 -6 -8 -10 % 12 10 8 6 4 2 0 -2 -4 -6 -8 -10 Industrial production for most of the BRIC economies stabilised in the last quarter, with China now posting double digit growth. However, IP for Brazil and India weakened. In Russia, IP growth also weakened. Emerging markets retail sales % 25 20 15 10 5 0 -5 -10 -15 % 25 20 15 10 5 0 -5 -10 -15 May-11 Sep-11 Jan-12 May-12 May-07 May-08 May-09 May-10 Sep-12 Dec-12 Sep-07 Jan-08 Sep-08 Jan-09 Sep-09 Jan-10 Sep-10 Sep-06 Jan-07 Jan-11 May-11 Sep-11 Jan-12 May-12 May-07 May-08 May-09 May-10 US UK Eurozone Japan China Brazil Russia Taiwan Retail sales growth in much of the developed world was weaker during the last quarter. Eurozone retail sales remained in contractionary territory in Q4 on a year-on-year basis but the disparity between the countries was large. UK retail sales also came in weaker in Q4. Unemployment rates in the developed world % 14 12 10 8 6 4 2 0 % 14 12 10 8 6 4 2 0 Consumer spending has started to turn for key emerging economies. China, Russia and Taiwan saw retail sales growth pick up in Q4. By contrast, in Brazil retail sales growth has continued to fall. Unemployment rates in emerging markets % 11 10 9 8 7 6 5 4 3 2 % 11 10 9 8 7 6 5 4 3 2 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 Sep-12 Dec-12 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 May-11 Sep-11 Jan-12 May-12 May-07 US UK Eurozone Japan China Brazil Russia Labour markets in the US have shown further signs of stabilisation and improvement with latest monthly data showing unemployment down to 7.6%. Unemployment rates in the UK and Japan have remained relatively stable while in the eurozone, unemployment rates continues to rise. Source (all): Bloomberg, Datastream, ThomsonReuters, as of March 2013 Labour markets in Asia remain relatively healthy despite slowing growth reflecting stronger economic fundamentals and better sentiment when compared to their developed world counterparts. Unemployment rates in Brazil continue to fall while in China and Russia they have remained relatively stable. Sep-12 Dec-12 Sep-06 Jan-07 Sep-07 Jan-08 Sep-12 Dec-12 Sep-07 Jan-08 Sep-08 Jan-09 Sep-09 Jan-10 Sep-10 Sep-06 Jan-07 Jan-11 Sep-12 Dec-12 28 Economic forecasts for 2013 and 2014 • Growth: Consensus global growth forecasts through 2013 have been revised modestly lower from 2.6 per cent in January to 2.5 per cent in March, while global growth forecasts for 2014 are unchanged at 3.2 per cent. The most notable changes over the past three months have come in Italy and Japan. Italian forecasts through 2013 have been revised down from -0.9 per cent to -1.2 per cent, while Japan’s 2013 forecast growth has almost doubled to 1.2 per cent. Consensus GDP growth forecasts January 2013 Consensus 2013F Developed markets Canada Eurozone France Germany Italy Japan Spain United Kingdom United States Emerging markets Brazil China India Mexico Russia South Africa South Korea Turkey World Source: Consensus Economics as of March 2013 • Inflation: Consensus global inflation forecasts through 2013 and 2014 remain unchanged over the past three months at 2.8 per cent and 3.0 per cent, respectively. The most notable changes to inflation forecasts for 2013 and 2014 include Japan and the UK, where inflation is expected to tick higher by 0.2 per cent in both 2013 and 2014. Inflation forecasts across the eurozone for 2013 have also been increased from 1.7 per cent to 1.9 per cent. March 2013 Consensus 2013F 1.6 -0.3 0.0 0.7 -1.2 1.2 -1.6 0.9 1.8 2014F 2.4 1.0 0.8 1.7 0.5 1.2 0.3 1.6 2.8 2014F 2.4 0.9 0.8 1.7 0.5 1.0 0.3 1.7 2.8 1.8 -0.1 0.1 0.7 -0.9 0.7 -1.6 1.0 2.0 3.3 8.1 6.5 3.6 3.3 2.9 3.2 3.8 2.6 3.9 8.0 7.4 4.0 3.8 3.4 3.7 4.9 3.2 3.1 8.2 6.3 3.5 3.3 2.9 3.0 3.9 2.5 3.7 8.0 7.4 3.9 3.8 3.4 3.7 4.8 3.2 29 Consensus Economics inflation forecasts January 2013 Consensus 2013F Developed markets Canada Eurozone France Germany Italy Japan Spain United Kingdom United States Emerging markets Brazil China India Mexico Russia South Africa South Korea Turkey World Source: Consensus Economics as of March 2013 March 2013 Consensus 2013F 1.3 1.7 1.3 1.8 1.9 0.0 2.0 2.8 1.8 2014F 2.0 1.7 1.7 2.0 1.7 1.8 1.5 2.5 2.1 2014F 2.0 1.7 1.8 2.0 1.8 1.6 1.5 2.3 2.1 1.8 1.9 1.5 1.9 2.0 -0.2 2.3 2.6 1.9 5.5 3.2 7.6 3.7 5.9 5.8 2.6 6.7 2.8 5.6 3.4 6.8 3.6 5.6 5.5 2.9 6.0 3.0 5.6 3.2 7.8 3.7 5.9 5.9 2.5 6.9 2.8 5.5 3.5 6.8 3.8 5.5 5.7 2.8 6.3 3.0 30 Policy rates • Monetary policy: Consensus forecasts for interest rates in the US, UK and Japan indicate that policy rates are likely to be on hold for at least 12 months. While in the eurozone there is a bias towards a 25bp cut over this time frame. Consensus policy rates Current (%) Developed markets US Eurozone UK Japan 0-0.25 0.75 0.50 0-0.1 0-0.25 0.75 0.5 0-0.1 0-0.25 0.5/0.75 0.5 0-0.1 3 months (%) 12 months (%) Consensus policy rates suggest further easing is likely in India but rates are now expected to move higher in Brazil, Mexico and Taiwan from current levels within the next 12 months. Emerging markets Brazil India Mexico South Africa South Korea Taiwan Turkey 7.25 7.50 4.00 5.00 2.75 1.875 5.50 7.25 7.50 4.25/4.5 4.75/5 2.5/2.75 1.75/2 5.25/5.5 7.5/7.75 7.25 4.25/4.5 4.75/5.0 2.75/3.0 2.00 5.25/5.5 Sources : Merrill Lynch, JP Morgan, Barclays, Deutsche Bank, Danske, Westpac, HSBC, Nomura, Credit Agricole, Société Générale, UBS, Citigroup, as of March 2013 Central Bank interest rate setting meetings Date 04-Apr 04-Apr 04-Apr 26-Apr 01-May 02-May 09-May 22-May 06-Jun 06-Jun 11-Jun 19-Jun Country UK Japan Europe Japan US Europe UK Japan UK Europe Japan US Event BoE MPC interest rate decision BoJ interest rate decision ECB interest rate decision BoJ interest rate decision US Federal Reserve's FOMC interest rate decision ECB interest rate decision BoE holds MPC meeting BoJ monetary policy meeting BoE MPC interest rate decision ECB interest rate decision BoJ interest rate decision US Federal Reserve's FOMC interest rate decision Source: HSBC Global Asset Management, Bloomberg as of March 2013 31 Currency expectations (quoted vs. USD) Spot Developed world Australia (AUD) Canada (CAD) Eurozone (EUR) Japan (JPY) New Zealand (NZD) Norway (NOK) Sweden (SEK) Switzerland (CHF) United Kingdom (GBP) Asia China (CNY) Hong Kong (HKD) India (INR) Indonesia (IDR) Malaysia (MYR) Philippines (PHP) Singapore (SGD) South Korea (KRW) Taiwan (TWD) Thailand (THB) EEMEA Czech Republic (CZK) Hungary (HUF) Poland (PLN) Russia (RUB) South Africa (ZAR) Turkey (TRY) 19.92 230.2 3.18 31.65 9.23 1.80 19.23 220.9 3.13 30.18 9.06 1.77 19.19 216.8 3.18 31.42 8.77 1.80 19.01 227.0 3.20 29.54 7.85 1.79 19.91 232.1 3.20 32.12 9.34 1.82 19.89 233.6 3.21 32.58 9.45 1.84 19.87 234.8 3.23 33.02 9.56 1.86 19.85 235.8 3.24 33.44 9.67 1.88 6.18 7.76 54.39 9731 3.06 41.38 1.24 1121 29.82 28.84 6.22 7.75 53.67 9625 3.04 40.63 1.23 1066 29.00 29.78 6.25 7.75 53.74 9617 3.05 41.34 1.23 1103 29.27 30.76 6.31 7.76 52.53 9187 3.07 42.69 1.25 1140 29.51 30.99 6.24 7.76 55.13 9810 3.07 41.35 1.24 1125 29.74 30.89 6.24 7.76 56.02 9933 3.09 41.36 1.24 1129 29.65 28.98 6.25 7.76 56.90 10040 3.10 41.32 1.24 1132 29.56 29.22 6.25 7.76 57.74 10198 3.11 41.31 1.24 1135 29.47 29.33 1.02 1.03 1.30 99.43 0.84 5.91 6.63 0.94 1.53 1.06 1.00 1.33 88.61 0.84 5.56 6.52 0.93 1.58 1.03 0.99 1.30 79.85 0.81 5.73 6.65 0.93 1.60 1.03 0.99 1.32 81.18 0.81 5.74 6.76 0.91 1.61 1.02 1.03 1.30 99.38 0.83 5.93 6.64 0.94 1.53 1.01 1.03 1.30 99.30 0.83 5.95 6.65 0.94 1.52 1.00 1.03 1.30 99.20 0.82 5.96 6.66 0.94 1.52 1.00 1.03 1.31 99.09 0.82 5.98 6.67 0.94 1.52 3 months ago 6 months ago 12 months ago 2-month forward 6-month forward 9-month forward 12-month forward LatAm Argentina (ARS) Brazil (BRL) Mexico (MXN) 5.17 2.02 12.25 4.96 2.04 12.69 4.74 2.03 12.98 4.41 1.88 13.18 5.68 2.04 12.35 6.31 2.07 12.44 6.98 2.10 12.54 7.61 2.13 12.64 Source: Forward currency rates sourced from Bloomberg as of March 2013 32 Global equity market performance (MSCI indices) Total return (% in USD terms) – MSCI indices Asia Pacific ex Japan Developed World Emerging World Europe Europe ex UK Eurozone North America Australia Austria Belgium Brazil Canada Chile China Colombia Czech Republic Denmark Egypt Finland France Germany Greece Hong Kong Hungary India Indonesia Ireland Israel Italy Japan Malaysia Mexico Morocco Netherlands New Zealand Norway Peru Philippines Poland Portugal Russia Singapore South Africa South Korea Spain Sweden -1M -1.6 0.7 -3.5 -1.3 -1.6 -2.3 1.1 -1.1 -2.1 0.6 -2.0 -1.7 -3.8 -6.8 -5.3 -9.6 -1.8 -7.9 -4.6 -2.3 -1.3 1.3 -3.0 -15.2 -3.5 3.9 7.7 3.4 -8.8 6.9 0.9 -3.7 -2.2 -1.8 -1.9 -4.1 0.2 -2.7 -4.9 -3.8 -6.1 -1.7 -5.1 -3.6 -2.7 -2.1 -1Q 6.1 6.4 -2.3 2.4 3.0 0.5 7.7 8.7 -2.7 4.9 0.2 -0.5 3.3 -5.5 -4.8 -13.8 5.9 -12.3 1.4 0.8 1.2 25.3 1.9 -5.6 -2.7 11.6 12.2 3.7 -8.2 11.0 -3.1 -1.7 -8.3 2.0 4.6 0.4 -5.8 13.6 -10.4 1.3 -1.5 0.8 -8.2 -4.4 -0.8 9.2 -1Y 17.4 10.8 -0.6 9.3 10.7 6.9 11.3 20.8 3.9 25.7 -15.6 1.5 -4.9 2.8 8.9 -20.8 16.5 -6.2 2.1 8.0 9.3 5.3 11.4 -10.0 2.6 14.5 6.5 -2.7 -9.2 8.4 1.5 14.3 -18.7 12.2 19.6 4.1 2.6 34.6 6.8 6.3 -10.7 11.6 -4.8 -1.6 1.3 15.3 YTD 6.2 7.1 -2.6 3.7 4.4 1.8 8.3 8.9 -0.7 7.0 -0.1 0.0 3.9 -5.9 -7.3 -14.6 6.0 -10.3 4.2 2.2 2.4 22.6 1.8 -5.6 -1.9 10.9 13.0 8.1 -7.2 11.0 -4.5 0.2 -4.0 3.3 5.9 2.0 -6.5 12.0 -9.2 2.8 -2.3 0.8 -9.6 -4.6 0.3 9.1 33 Global equity market performance (MSCI indices) - continued Total return (% in USD terms) – MSCI indices Switzerland Taiwan Thailand Turkey United Kingdom United States -1M 1.4 -2.4 2.7 2.7 -0.9 1.3 -1Q 9.0 -0.4 10.9 4.3 1.1 8.5 -1Y 21.6 1.4 22.5 34.2 6.8 12.2 YTD 11.4 -0.5 10.6 2.7 2.3 9.1 GEMs equity valuations End year PE (x) 2012 Argentina Brazil Chile China Colombia Czech Republic Egypt Hungary India Indonesia Malaysia Mexico Peru Philippines Poland Russia South Africa South Korea Taiwan Thailand Turkey GEMs 4.5 11.1 17.7 9.8 14.8 10.1 7.2 8.3 13.8 15.6 14.8 17.9 12.4 20.2 12.0 5.1 13.4 8.8 14.9 13.0 11.2 10.9 2013e 4.4 10.0 15.7 8.8 15.7 10.3 6.3 7.4 12.0 13.5 13.5 16.0 11.6 18.9 11.5 4.9 11.6 7.7 13.3 11.6 10.3 9.8 2014e 3.2 9.1 14.1 8.2 14.4 11.0 6.1 5.8 9.2 11.9 12.6 14.3 11.1 17.6 10.9 4.9 10.5 7.0 11.2 10.6 9.4 8.9 End year EPSg (%) 2012 10.2 25.4 25.7 10.5 12.3 -1.8 32.8 7.8 15.1 11.5 1.8 10.8 11.8 7.9 -15.3 0.8 14.0 28.7 29.9 19.7 9.2 15.4 2013e 4.1 10.6 13.2 11.4 -5.8 -2.3 14.8 11.8 14.9 15.9 9.6 12.2 6.5 6.6 4.8 3.5 15.1 14.3 11.9 12.1 9.6 11.1 2014e 35.4 9.5 10.8 7.6 9.4 -6.2 2.3 27.5 30.4 12.8 6.9 11.7 4.4 7.6 5.8 0.6 10.0 10.4 18.7 9.9 8.6 9.7 PEG 2013e 0.1 1.0 1.4 1.2 1.7 -1.7 2.7 0.3 0.4 1.1 2.0 1.4 2.7 2.5 2.0 7.7 1.2 0.7 0.7 1.2 1.2 1.0 PE – price earnings, EPSg – earnings per share growth, PEG – price/earnings to growth ratio. Data is for end year. Source: IBES estimates, MSCI, Thomson Reuters Datastream, HSBC Global Research, as of March 2013 34 Contributors Philip Poole Global Head of Macro and Investment Strategy Hervé Lievore Senior Macro and Investment Strategist David Wickham Senior Product Specialist Adam Olive Senior Investment Strategist Julien Seetharamdoo Senior Macro and Investment Strategist Paras Patel Associate, Macro and Investment Strategy 35 This document has been written by HSBC Global Asset Management (UK) Limited for distribution to HSBC Premier customers. HSBC Global Asset Management is a part of HSBC Group. The views expressed are those of HSBC Global Asset Management and do not constitute investment advice. No liability is accepted to recipients acting independently on its contents. Past performance should not be seen as an indication of future returns. The value of investments and any income from them can go down as well as up. Any forecast, projection or target where provided is indicative only and is not guaranteed in any way. HSBC Global Asset Management accepts no liability for any failure to meet such forecast, projection or target. This material is distributed by HSBC Bank Middle East Limited. Regulated by the Jersey Financial Services Commission. Accounts, facilities and services are subject to Bank’s terms and conditions. CRN 130513 Copyright © HSBC Global Asset Management Limited 2013. ALL RIGHTS RESERVED. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, on any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of HSBC Global Asset Management Limited.