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Tipping points: Global perspectives on navigating “The Great Divergence”
Tipping points: Global perspectives on navigating “The Great Divergence”
Tipping points: Global perspectives on navigating “The Great Divergence”
Tipping points: Global perspectives on navigating “The Great Divergence”
Tipping points: Global perspectives on navigating “The Great Divergence”
Tipping points: Global perspectives on navigating “The Great Divergence”
Tipping points: Global perspectives on navigating “The Great Divergence”
Tipping points: Global perspectives on navigating “The Great Divergence”
Tipping points: Global perspectives on navigating “The Great Divergence”
Tipping points: Global perspectives on navigating “The Great Divergence”
Tipping points: Global perspectives on navigating “The Great Divergence”
Tipping points: Global perspectives on navigating “The Great Divergence”
Tipping points: Global perspectives on navigating “The Great Divergence”
Tipping points: Global perspectives on navigating “The Great Divergence”
Tipping points: Global perspectives on navigating “The Great Divergence”
Tipping points: Global perspectives on navigating “The Great Divergence”
Tipping points: Global perspectives on navigating “The Great Divergence”
Tipping points: Global perspectives on navigating “The Great Divergence”
Tipping points: Global perspectives on navigating “The Great Divergence”
Tipping points: Global perspectives on navigating “The Great Divergence”
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Tipping points: Global perspectives on navigating “The Great Divergence”

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This white paper is the result of the partneship between RBC Capital Markets and the Economist Intelligence Unit. The survey work conducted at the turn of the New Year. It reveals interesting insights …

This white paper is the result of the partneship between RBC Capital Markets and the Economist Intelligence Unit. The survey work conducted at the turn of the New Year. It reveals interesting insights into a “Great Divergence” in our global economy, fundamentally driven by opposing scenarios in economic growth, sovereign debt, currencies and fiscal policy. By capturing market sentiment via survey results and interviews, this report illuminates the intricacies of these issues and their implications for investors, providing the most
relevant information and insightful perspectives to help them navigate the markets and find opportunity.

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  • 1. Tipping PointsGlobal perspectives on navigating “The Great Divergence”A survey and report created with
  • 2. Printed January 2011Table of ContentsForeword 1Executive Summary 2Introduction 4 + About the survey 4The Great Divergence: Economic growth 5The Great Divergence: Sovereign debt 7The Great Divergence: Currencies 9The Great Divergence: Fiscal policy 10Sovereign wealth funds 11Implications for investors 12 + Emerging markets and their risks 12 + New skill sets are required 13 + Sharper pricing of risk 13 + The impact of fiduciary frameworks 14 + Assigning a value to liquidity 15Conclusion 16About RBC Capital MarketsRBC Capital Markets is a Premier Investment Bank that provides a focused set of products and services to institutions,corporations, governments and high net worth clients around the world. With over 3,300 professional and support staff,we operate out of 75 offices in 15 countries and deliver our products and services through operations in Asia andAustralasia, the U.K. and Europe, and in every major North American city.We work with clients in over 100 countries around the world to help them raise capital, access markets, mitigate risk, andacquire or dispose of assets. According to Bloomberg, we are consistently ranked among the top 20 global investment banks.RBC Capital Markets is part of a leading provider of financial services, Royal Bank of Canada (RBC). Operating since 1869,RBC has more than USD711 billion in assets and one of the highest credit ratings of any financial institution – Moody’s Aa1and Standard & Poor’s AA-.About The Economist Intelligence UnitThe Economist Intelligence Unit is the business information and research arm of The Economist Group, publisher ofThe Economist. Through its global network of 650 analysts, it continuously assesses and forecasts political, economicand business conditions in more than 200 countries. As the world’s leading provider of country intelligence, it helpsexecutives make better business decisions by providing timely, reliable and impartial analysis on worldwide market trendsand business strategies.
  • 3. ForewordOur economic landscape has been evolving at a rapid pace over the last three years. As the global community becomesmore intertwined, institutional investors and corporate executives must address the increasingly complex implicationsof local and regional challenges around the world. At RBC Capital Markets, we strive to provide our clients with the mostrelevant information and insightful perspectives to help them navigate the markets and find opportunity.With this goal in mind, we partnered with the Economist Intelligence Unit for our third survey of more than 400 capital marketsparticipants to gather sentiment as the industry moves away from the legacy mindset of the past 30 years. The purposeof our poll was to gauge the consensus outlook, examine deviations from the consensus and discover how investors planto turn these expectations into action.This white paper is the result of survey work conducted at the turn of the New Year. It reveals interesting insights intoa “Great Divergence” in our global economy, fundamentally driven by opposing scenarios in economic growth, sovereign debt,currencies and fiscal policy. By capturing market sentiment via survey results and interviews, this report illuminatesthe intricacies of these issues and their implications for investors.We would like to thank the individuals who are quoted in this report for their valuable time and insights:Michael Ben-Gad, Professor of Economics, City University LondonQuentin Fitzsimmons, Executive Director and Head of Government Bonds and Foreign Exchange, ThreadneedleLena Komileva, Head of G7 Market Economics, Tullet PrebonJonathan Lemco, Principal, VanguardPippa Malmgren, President and Founder, Canonbury Group and Principalis Asset ManagementArvind Rajan, Managing Director and Head of Quantitative Research and Risk Management, Prudential FinancialAndrew Rozanov, Managing Director and Head of Sovereign Advisory, PermalRobert Talbut, Chief Investment Officer, Royal London Asset ManagementWe hope you will find the report insightful.Marc Harris Richard TalbotCo-Head of Global Research Co-Head of Global ResearchRBC Capital Markets RBC Capital Markets January 2011 TIPPING POINTS | 01
  • 4. Executive Summary It is a truism that the planet’s economy has become more connected even as global imbalances have grown more severe. In today’s volatile world – which combines abundant liquidity with extreme and potentially long-lasting divergences across markets – investors are pondering both the outlook for the coming year and the intermediate-term end-game. They are specifically questioning: • what extent will the large gap in growth between emerging and To developed markets – with its attendant effects on capital flows and asset prices – continue? • Sovereign debt restructuring on the European periphery and elsewhere appears inevitable. When will it occur and what market fallout will it generate? • Looking out five years or more, a large proportion of market participants expect the dollar to relinquish its role as the primary global reserve currency. Will the euro’s problems enable the dollar to retain its primacy beyond this horizon? • Can the U.S. continue to borrow and spend while almost all other developed countries embrace austerity? If so, for how long? What would be the effect of another economic downturn on deficits in developed countries? All of these questions are unresolved, but one thing is certain: Building a portfolio that generates excess returns requires stepping outside the legacy mindset of the past 30 years. Two previous RBC Capital Markets white papers examined the transition from the “great moderation” that began in the 1980s through the financial crisis to the post-crisis world of today.1 To discover how institutional investors, financial institutions and large corporations are emerging from the old and adapting to the new, RBC Capital Markets enlisted the Economist Intelligence Unit to interview a range of investors and survey 461 financial market participants. The objective was to gauge the consensus outlook, examine deviations from the consensus, and discover how investors intend to turn these expectations into action. Key findings are as follows:1. aising Capital in a New Era R (September 2009) and Emerging markets and their risks. In both the survey and the interviews, The New “Normal”: Implications of Sovereign Debt and the Competition location predicts sentiment. Optimism abounds on prospects for emerging for Capital (June 2010). and resource-rich economies, with the highest hopes focused on the non-BRIC02 | TIPPING POINTS January 2011
  • 5. frontier markets. The consensus is so strong that it lends credence to the idea In today’s volatileof an emerging markets bubble, with a fire hose of capital aimed at a limited world – which combinespool of financial assets. If the emerging markets are flooded with more capitalthan they can immediately use, valuations will outrun fundamentals and the abundant liquiditymarkets will eventually drop. with extreme and potentially long-lastingNew skill sets are required. In contrast to the situation a year ago, much oftoday’s portfolio risk is driven by sovereign risk. Prudential Financial Managing divergences acrossDirector Arvind Rajan points out that as sovereign risk rises, it tends to become markets – investorsthe common factor that drives all other portfolio risks. Therefore, the ability are pondering bothto analyze sovereign risk is essential – and it requires a broader base of skillsthan many portfolio management firms currently possess. The skill set includes the outlook forexpertise in government financing strategies, multilateral lending agencies, the the coming year andbanking sector, the CDS market and political scenarios. In addition, the loss of the intermediate-termcredibility by rating agencies has contributed to a trend of bringing more creditanalysis in-house. end-game.Sharper pricing of risk. Risk has not been priced accurately in the past, to putit mildly, and skepticism has grown around traditional methods of evaluatingrisk, including snapshots of fundamentals, rating agency judgments, confidenceintervals and assumptions about government backstops. Capital preservationrequires a more conservative approach to the potential for extreme events.The impact of fiduciary frameworks. Downgrades could limit the ability tohold sovereign debt among large institutional investors facing investmentmandates. On the other hand, the new Basel III accord will require banksto hold more capital and liquidity buffers, which will result in a mandate tohold more asset classes that have historically presented low risks, such assovereign debt. This change would boost the demand for bank holdings ofgovernment debt, even if the credit quality is below that of sovereigns.Assigning a value to liquidity. The dollar may not be the best measure of value,but it is undeniably the most liquid medium of exchange. This liquidity hasa higher value than it used to, which explains the reluctance of many sovereignwealth funds to dramatically scale back their holdings of the dollar andU.S. Treasuries. Portfolios are judged to be more volatile than they used tobe, with a wider range of scenarios on either side of the expected value.The funds also face a wider range of potential calls on their liquidity – forinstance, to bail out local banks, companies or governments. Fund managersare building in more diversification to stabilize values, and they are placingmore weight on liquidity. January 2011 TIPPING POINTS | 03
  • 6. IntroductionAlthough the economic crisis appears to have passed, Another is the skepticism around notions such as confidencethe nations of the world are diverging on multiple levels. intervals and mean reversion, which offer the promise ofFrom the dynamic BRIC economies to the debt-burdened mitigating risk but become difficult to apply in the face ofnations of the European periphery, economies are diverging fundamental shifts in market conditions. Also under fire is thein terms of economic growth, creditworthiness and fiscal notion of – in the words of a fixed-income executive at a largepolicies. And in this two-track global economy, it is the London asset manager – “a world where friendly, big-brotherslower-growing developed nations that are the most fiscally style bailouts always happen.”constrained, have the greatest need for austerity and face themost difficult prospects for regaining their economic health. The fuel for financial markets is confidence, an ingredient in short supply when asset values are diverging. By assessingAs a result, investors are breaking free of past orthodoxy the fundamental factors driving this Great Divergence,and viewing alternatives in light of new realities. One and taking the pulse of the market via survey results andmanifestation is capital chasing higher yields, rising asset interviews, this report aims to clarify the decisions faced byvalues and appreciating currencies of emerging markets. global investors. About the Survey The Economist Intelligence Unit polled 461 capital markets participants on behalf of RBC Capital Markets in a survey that closed in January of 2011. Of the respondents, 211 come from the financial services industry and 250 from non-financial organizations. • ithin financial W • he top industries T • he executives polled T • espondents came R services, 31% are among non-financial are quite senior, with primarily from from commercial respondents are 36% coming from the North America and banks, 26% from asset manufacturing, C-suite and another Western Europe, management firms the public sector, 58% at or above the with 38% from each or institutional professional services, VP/Director level. region. 14% reside investors and energy and technology. in the Asia/Pacific 18% from investment Average annual region, and 9% banks; the rest work revenues are US$3-4bn, came from Eastern at hedge funds or with a range of Europe, Latin America, private equity funds. US$750m to over the Middle East The average asset US$100bn. and Africa. size is US$275bn.04 | TIPPING POINTS January 2011
  • 7. The Great Divergence: Economic growthThe most obvious divergence is in economic growth rates. In its December 2010Global Outlook, the Economist Intelligence Unit highlighted the varying pace ofthe recovery. Although global growth is forecast at 3.8% in 2011, stark underlyingdifferences between developed and developing markets are expected to persist.While the advanced (OECD)2 economies are forecast to expand by 1.8% in 2011,growth outside the OECD is projected to be 6.3% in the same period.3Among respondents to the survey, a greater proportion expects conditions toimprove rather than deteriorate in major regions of the world – with the exceptionof Japan (see Chart 1). But it is clear that the recovery will proceed at multiplespeeds. While respondents are in strong agreement that the prospects for China,India and developed Asia remain bright, there is much greater ambiguity aboutthe outlook for the rest of the world.Survey respondents are less sanguine with respect to the developed world. 2. rganisation for Economic OWith the exception of Japan, pluralities – not majorities – expect better prospects Co-operation and Developmentfor 2011 in the developed world. In Japan, a plurality expects no change, and 3. conomist Intelligence Unit Emore think that the economy will deteriorate than improve. forecasts as of January 2011Chart 1 Over the next year, what change do you expect to the prospects for economic growth in the following regions? Chart shows the proportion of respondents who expect an improvement in prospects minus those who expect a deterioration Other developed Asia 71%(Hong Kong, Singapore, South Korea) India 70% China 65% Russia 32% Africa 31% Middle East 30% North America 19% Europe 4% Japan –3% 10% 0% 10% 20% 30% 40% 50% 60% 70% 80% Proportion of respondents that expects an improvement in prospects minus respondents that expect a deterioration January 2011 TIPPING POINTS | 05
  • 8. Chart 2 From 1998 to 2008, the U.S. economy grew in real terms at an average rate of about 2.7% per year. Over the next decade, how do you expect this rate to change, if at all? Much higher 2% Higher 14% No change 18% Lower 53% Much lower 12% Don’t know 1% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Percentage of respondentsThere is also a clear bifurcation between developed and expectation of below-trend growth rates in the U.S., as welldeveloping economies. Chart 2 shows that most market as the European periphery and the rest of Western Europe.participants think that U.S. growth in the coming decade The reverse is true for Asia-Pacific, Canada, the BRICs andwill be below that of the last decade. Chart 3 confirms the other emerging markets.Chart 3 How do you expect the real growth rate in your country over the next decade to compare with the rate from 1998 to 2008? Chart shows the proportion of respondents who expect a higher than average rate minus those who expect a lower than average rate Lower growth Higher growth Asia/Pacific excluding India and China 41% BRICs 27% Other (MEA, Latin America, Eastern Europe) 16% Canada 7% 16% European periphery 35% Europe ex-periphery 37% U.S. 53% U.K. 60% 40% 20% 0% 20% 40% 60% Proportion of respondents that expects a higher than average rate minus respondents that expect a lower than average rate06 | TIPPING POINTS January 2011
  • 9. The Great Divergence: Sovereign debt The imposition of fiscal austerity measures, of the scale required to service debt “While [Greek] debt in Greece and Ireland, means that it will be difficult for those countries to grow restructuring may their way out of the crisis. The concern is a persistent downward spiral of higher levels of debt leading to slower growth and a further withdrawal of assets, be more painful resulting in more losses on bank balance sheets. initially for existing bondholders, it is “What these EU and IMF bail-outs are essentially asking those countries to do is to put their economies into permafrost for a very long period of time,” says perhaps an outcome Robert Talbut, Chief Investment Officer at Royal London Asset Management. that, combined “What’s more, there is no guarantee that, in three years’ time, those economies with the budget will be in a position whereby their citizens will be able to say that it was worth taking the pain. Ultimately it’s inevitable that some form of debt forgiveness will consolidation in have to occur.” progress, provides a more definitive Even in countries less severely affected by debt problems, the poor state of public finances means that the role of government is changing. “The social solution to the contract between the public and government is being renegotiated,” says long-term problem.” Pippa Malmgren, President and Founder of the Canonbury Group and Principalis Asset Management. “The scale of the problem means that many people will be Arvind Rajan, forced to retire later than they expected for a lower standard of living than they Prudential Financial ever anticipated. Public services and benefits that people have come to expect will no longer be available.” The confrontations involving trade union and public sector workers in Greece, Portugal, Spain and Ireland may be just the beginning. Flat growth, or a tumble back into recession, will dramatically accelerate the prospects of debt restructuring in these economies. “Many people consider a potential restructuring in the coming years to be inevitable, simply because they don’t believe that Greece can grow its way out of such a large debt, particularly with the fiscal austerity measures that have been forced upon it,” says Arvind Rajan, Managing Director and Head of Quantitative Research and Risk Management for the U.S.-based fixed income business of insurance and investment management giant, Prudential Financial. “While debt restructuring may be more painful initially for existing bondholders, it is perhaps an outcome that, combined with the budget consolidation in progress, provides a more definitive solution to the long-term problem.” So if debt restructuring is the inevitable outcome of crisis in the Eurozone, why not embark on the process now, given that we don’t have a sustainable position? The problem essentially comes down to an unwillingness to accept the inevitable and the consequences that debt restructuring is likely to entail in terms of further recapitalisation of the European banking system. And the reluctance of policymakers to adopt long-term measures aggravates the loss of confidence in developed-world sovereign debt. A funding crisis looks increasingly likely for some sovereigns, particularly when the scale of debt that is maturing over the next year is taken into account (see Chart 4).“If you think it has been tough to secure funding in Europe this year, it will be even tougher next year,” says Mr Talbut. January 2011 TIPPING POINTS | 07
  • 10. Chart 4 Sovereign gross funding needs as percentage of projected 2011 GDP 70% Debt Maturing Oct 2010 to Dec 2011 (% of projected 2011 GDP) 60% General Government Fiscal Deficit 2011 (% of GDP) 50% 40% 30% 20% 10% 0% n ic m n ay a ria m lia ce es s ly k en ce ia ic da y l nd d nd pa ga nd ai re ar an bl iu Ita bl an do en an rw at ra ee st ed na Sp la Ko nm-10% pu la rtu Ja lg la pu rm St al Au st ov ng No Fr Gr Fin Sw Ire Ca Be er Re Ze Au Re Po De Ge Sl d Ki th ite w ak d h Ne ite Ne ec Un ov Cz Un Sl-20%Source: IMF Global Financial Stability ReportAlthough almost all respondents believe that governments European periphery will face difficulties in funding theirwill be able to finance themselves over the next one to three shortfalls. A similar proportion expects the U.K. to face thebudget cycles, they do not expect the fundraising process same challenges (see Chart 5).to be easy. More than half expect that the nations of theChart 5 your country, will the national government experience a funding shortfall In over the next one to three budget cycles? If yes, how severe will it be? U.K. 55% 11% European periphery 59% 6% Canada 33% 17% Yes, and the government will fund the shortfall,Other (MEA, Latin America, Eastern Europe) 37% 12% but with difficulty Yes, and the government U.S. 34% 14% will be unable to fund the shortfall Asia/Pacific excluding India, China 25% 7% BRICs 23% 9% European ex-periphery 16% 9% 0% 20% 40% 60% 80% Percentage of respondents08 | TIPPING POINTS January 2011
  • 11. The Great Divergence: Currencies Survey respondents and interviewees agree that the euro will “Although I remain convinced that monetary union will survive these uncertain times. Over half put the chances at survive, the notion that the euro will be one of the 20% or less that the union will lose members in the next world’s dominant reserve currencies is now debatable,” three years, while 80% estimate the same low odds – 20% says Jonathan Lemco, a Principal at Vanguard. “To me, or less – for the collapse of the single currency during the it makes the U.S. position as global reserve currency same period (see Chart 6). And Europeans – particularly those of choice even more assured than before, despite in the most troubled countries – say that the probability is its problems.” even lower. Survey respondents agree: 80% expect the dollar to“The assumption that the euro, for all its retain its position as the dominant global reserve currency over the next three years, while 52% expect it to retain flaws, is vulnerable to collapse is not true. this role five years from now. An Economist Intelligence There is no direct link that says just because Unit survey conducted in June 2010, also on behalf of one sovereign country in the Eurozone defaults RBC Capital Markets, found similar sentiment, suggesting that market perceptions of the dollar and euro have on its debt that the euro therefore becomes not changed significantly as a result of the more recent worthless or the European Central Bank ceases strains in the Eurozone. to function.” The dollar’s role allows the U.S. to tolerate higher levels Michael Ben-Gad, of debt than other sovereigns without having its solvency Professor of Economics, City University London called into question. “The U.S. can run massive current account deficits and get away with it and can benefit from But even if the euro survives the current crisis, its long-term much greater economic stability than it would otherwise role in the global economy will have been compromised. have,” says Dr Lemco. Chart 6 What probability would you assign to the following events taking place over the next three years? 40% 45% 35% 40% Percentage of Respondents Percentage of Respondents 30% 35% 30% 25% 25% 20% 20% 15% 15% 10% 10% 5% 5% 0% 0% 1-20% 21-40% 41-60% 61-80% 81-99% 100% 0% 1-20% 21-40% 41-60% 61-80% 81-99% 100% Probability of one or more Eurozone countries Probability that the Eurozone will breakup leaving the monetary union in the next three years during the next three years January 2011 TIPPING POINTS | 09
  • 12. The Great Divergence: Fiscal policyThese are uncharted waters for policymakers as well as According to the Congressional Budget Office, the U.S. debt-investors. Stepping outside the legacy mindset requires to-GDP ratio was 62% in the 2010 fiscal year, and couldcentral banks and other policymakers to enact heterodox and rise to 90% by 2020. A bipartisan commission formed byunprecedented methods to deal with the new reality. There President Obama has proposed US$4tn in savings, whichis no textbook policy prescription for the current situation. would bring down the budget deficit to 2.2% of GDP byAs a result, approaches differ. 2015, but few believe that its proposals will be implemented in a political environment that appears to be in permanentCompared with the approach being taken by heavily indebted gridlock, especially as the 2012 elections draw closer.sovereigns in the Eurozone, the U.S. government has sofar been reluctant to embrace fiscal consolidation and Nevertheless, there is a growing consensus around the needcontinues to pin its hopes on monetary policy to jump-start to tackle the fiscal deficit. “There is a sense in certain partsthe economy (and thereby ameliorate fiscal dynamics). “From of the U.S. that they are not going to be able to get out ofthe administration’s perspective, the implementation of the their current situation relying on the Fed to pump money intostimulus package is the priority and if it means that this will the system and that they will need to address other aspectslead in the short term to a wider deficit, then that seems to that make it unattractive to invest and employ in the U.S.,”be considered an acceptable cost,” says Dr Lemco. says Mr Talbut.More than 60% of U.S. respondents think that the level oftheir country’s external debt is growing at an unsustainablelevel (see Chart 7). And government debt (as opposed tototal external debt, both public and private) is a concern aswell. “Many investors worry about the ability and the politicalwill of the U.S. government to put the public finances on asustainable long-term path,” says Andrew Rozanov, ManagingDirector and Head of Sovereign Advisory at London-basedfund of hedge funds, Permal.Chart 7 your country’s external debt growing at a sustainable level? Is No Yes Europe ex-periphery 24% 74% BRICs 21% 74% Asia/Pacific excluding India and China 28% 70% Canada 23% 79% Other (MEA, Latin America, Eastern Europe) 35% 63% European periphery 38% 56% U.S. 65% 32% U.K. 64% 31% 80% 60% 40% 20% 0% 20% 40% 60% 80% 100% Percentage of respondents (excludes respondents who answered “Don’t know”)10 | TIPPING POINTS January 2011
  • 13. Sovereign wealth funds:A souring love affair with sovereign debt?W ith sovereign issuance ambitious plans to move out of quantitative easing, on the value forecast to increase the dollar and U.S. Treasuries,” of SWF dollar holdings. significantly over says Mr Rozanov. “In fact, all elsethe next few years, government being equal, I would argue this in “The whole idea of moving intodebt managers will be on a charm principle bodes well for government uncharted territory with quantitativeoffensive to attract and retain their debt in developed countries, easing on that scale, from the issuerkey investors. Top of the list for especially the U.S. and Europe.” of the main reserve currency in themany will be the world’s sovereign world, gets a lot of people nervous,wealth funds (SWFs), which But not all developed nations. certainly among sovereign fundscollectively wield about US$4.1tn of For example in November, with seriously large allocations toassets. The largest, the Abu Dhabi Russia’s sovereign wealth funds, these markets,” says Mr Rozanov.Investment Authority, is estimated which control an estimated Survey respondents acknowledgedto hold in excess of US$600bn. US$142.5bn in assets, announced this concern when 60% said that that they would no longer buy foreign holders of U.S. TreasuriesSWFs have traditionally been big the sovereign debt of Ireland and would face losses over the nextbuyers of sovereign debt. In the Spain. The announcement sparked three years.run-up to the financial crisis, many a large increase in borrowingbegan to look further afield into costs for the peripheral countries High debt levels in developedhigher-yielding assets. But the crisis of the Eurozone. countries are also a key concern.has forced a reappraisal of these “SWFs worry about the abilityinvestment strategies, particularly Of course, the true situation is more and political will of the U.S.for newer funds that have a mandate nuanced. Mr Rozanov points out government to put public financesfor economic stabilization. that the Norwegian fund – the second on a sustainable long-term path,” biggest in the world – has stepped says Mr Rozanov. “They are also“Some funds realized that they had up purchases of Irish, Portuguese concerned about the ability ofseverely underestimated the amount and Greek government debt. “There the European Union and its coreof prudential liquidity that they is an important difference between constituents, like Germany, toought to have in their portfolios, ‘pure’ stabilization funds, which resolve the debt problems on theeither to refinance their budgets, are focused on nominal returns and periphery of the Eurozone.”bail out domestic banking systems are very conservative in their assetor support the local economy,” allocation, and those like Norway, So while SWFs are likely to remainsays Andrew Rozanov, Managing that are essentially intergenerational important investors in the world’sDirector and Head of Sovereign wealth transfer funds focusing on sovereign debt, they are payingAdvisory at Permal. “The nature real returns and operating more like close attention to the unfoldingand range of potential calls from a diversified portfolio manager,” economic picture. Indeed, as surveythe government on their capital he explains. respondents suggest, governmentturned out to be much broader debt managers may eventually findand less predictable than they While these trends suggest a that their charm has worn off –had anticipated.” potentially brighter-than-consensus leaving significant shortfalls in their outlook for sovereign debt, there finances and potentially affectingFor many SWFs, a retreat from are clouds on the horizon even for the risks of other country-specificrisk means a bigger allocation to highly rated issuers. A key concern assets as well.sovereign debt. “A number of funds is QE2 and the potential for morehave scaled back some of the more January 2011 TIPPING POINTS | 11
  • 14. Implications for institutional investorsThe events of the past two years have seen long-held attraction of higher real yields, rising domestic asset valuesassumptions about the creditworthiness of developed and appreciating currencies.”and developing economies overturned. Prior to the crisis,investors viewed Eurozone bonds and U.S. Treasuries as The prospects for many emerging markets are almostessentially risk-free, and emerging market debt as needful certainly highly positive over the long term. But someof much greater scrutiny and analysis. (Indeed, Basel III investors worry that there is too much emphasis on short-still weights OECD sovereign debt at zero risk.) Now these term returns. This could lead to investors over-paying forpositions have been reversed. “There has been a challenge assets, especially in countries with flexible exchange rates,to the orthodox way of dividing up the sovereign debt world where large capital inflows have prompted sharp currencybetween developed and developing markets,” says Quentin appreciations. “While on the 20-year view I agree entirelyFitzsimmons, Executive Director and Head of Government that emerging markets will become more economicallyBonds and Foreign Exchange at Threadneedle. significant, my concern is that you need to be careful about the price you pay when you decide to invest,” saysEmerging markets and their risks Mr Talbut. “People have been flooding into emergingOne obvious outcome of this reversal is the interest in markets paying almost any price to get in there but there’sthe emerging markets. Almost three-quarters of survey a danger that they’re paying too much in the short term.”respondents expect an increase in valuation in majorAsian equity markets over the next 12 months (see Chart Another concern is the formation of asset bubbles as8). According to EPFR Global, a financial data provider, net investors rush into these markets in search of yield.inflows to emerging market bond funds reached almost “Investing in emerging markets is not a risk-free strategy,”US$40bn in the first nine months of 2010 – four times the says Ms Komileva. “Because of that one-directional flowprevious record for a complete year. “There is a broad of funds in the global economy, the sovereign crisis insearch among investors for hard assets offering real returns effect encourages global capital imbalances that threatenand this is where the emerging markets come in,” says bubbles in emerging market government bonds whileLena Komileva, Head of G7 Market Economics at Tullet creating sharp liquidity outflows and added volatilityPrebon, an interdealer broker. “They offer the triple in developed markets.”Chart 8 Over the next 12 months, what movement do you expect in the following? Chart shows the percentage of respondents who said “stronger” minus those who said “weaker” Weaker Stronger 66% Major Asian equity markets 58% Oil price in dollars 58% Chinese renminbi 39% Inflation in your country 27% U.S. equity market 21% Major European equity markets 8% Euro 20% U.S. Treasuries 29% Dollar 40% 20% 0% 20% 40% 60% 80% Percentage of respondents saying “stronger” minus those saying “weaker”12 | TIPPING POINTS January 2011
  • 15. Mr Rajan agrees, and says that the signs of potential asset investments, particularly sovereign debt. “We have to takebubbles are already appearing. “You’ve got inflation in countries on a case-by-case basis far more than we did in thebasic commodities and property booms in many emerging past,” he says.markets such as China, and these run-ups in prices arebeing justified on the grounds of strong fundamentals,” “ s best we can, we need to try to avoid Ahe says. “But the macro risk is that, by flooding thesecountries with money they can’t efficiently use, investors generalizations, such as developed or emergingcould ultimately create another global credit bubble, and markets, and really investigate spreads overvaluations could get well beyond the fundamentals before time. There’s obviously short-term volatility,they crack.” but the question for the medium or longerNew skill sets are required term is whether the trends that we’re seeingSovereign debt analysis now requires a much broader set of in the marketplace are consistent with whatskills, given the very different situations in which developedand developing markets find themselves. Analysis of Greek we think of as the fundamentals.”debt, for example, now requires the skills of emerging market Jonathan Lemco, Vanguardexperts with an understanding of how IMF support affectssolvency and economic recovery. It also necessitates the Inputs to credit analysis are also changing. Rather thancombined input of government portfolio managers, bank rely on rating agencies, which one interviewee describedanalysts, credit default swap specialists, European fixed as “entities that have made a business model out ofincome professionals and economists, all focusing on both being behind the curve”, asset managers are increasinglycyclical and structural trends in the markets. recruiting their own credit analysts or assessing other indicators, such as the credit default swap market.Government indebtedness is just one variable among many “The transparency of the CDS market does shine a fairlythat needs to be assessed, including the exposure of the bright light and provides an independent free marketbanking sector, the political situation and the scale of a appraisal of what’s going on,” says a London fixed-incomecountry’s public sector liabilities. “Every country needs executive. “It tends to be sharper in terms of pricing into be considered and analyzed on its own merits because problems a bit quicker as people hedge themselves.”the dynamics facing each country are different,” saysMr Fitzsimmons. “There is no generalized template to say Sharper pricing of riskthat an economy running 10% deficits on a yearly basis For investors in sovereign debt, a fundamental lesson relateswith a 100% debt-to-GDP ratio is more likely to run into to the need to price risk more accurately. The assumptiontrouble than an economy with a smaller deficit and debt-to- that risk can be measured by taking a snapshot assessmentGDP ratio. This is all about confidence and it’s all about of fundamentals, relying on past price history and confidencethe perception of medium to long-term viability of the intervals is now a thing of the past. “For those interestedfinancial system and the nature of the guarantee that any in capital preservation and who want to know they haveparticular sovereign entity is providing to its banking and protected tail risk, it will be worth looking beyond the currentprivate sector.” snapshot of rating agencies, beyond the assumptions of past mean reversion, and beyond the false comfort of confidenceFor Dr Lemco, and many other asset managers, there is intervals and a world with few consequences for profligacy,”now a need to be much more discriminating when selecting says the London executive. January 2011 TIPPING POINTS | 13
  • 16. “When sovereign risk Higher levels of risk in the sovereign debt market can have a profound effect on risk in other asset classes, because of common factors running through the goes up, it can become banking system and other channels of contagion, and because of government’s a contagious factor role as a guarantor of last resort. “Systematic risk is multi-dimensional, and that drives systemic is best described by what we call principal components, which quantify the correlation of security prices stemming from exposure to common risk factors,” risk. And given that says Mr Rajan. “When sovereign risk goes up, it can become a contagious developed government factor that drives systemic risk. And given that developed government guarantees guarantees form the form the foundation of so-called risk-free securities, if governments are risky, that shakes this foundation, forcing investors to re-evaluate other types of foundation of so-called credit risk.” risk-free securities, if governments are The impact of fiduciary frameworks Many institutional investors have investment mandates that prevent them from risky, that shakes investing in debt below a certain credit rating or once yields or credit default this foundation, swaps reach a certain level. As the IMF notes in its Global Financial Stability forcing investors to report: “Investors with strict ratings guidelines in their portfolio mandates (notably central bank reserve managers) may also be less inclined to maintain re-evaluate other types their current allocation to sovereigns where credit spreads imply deteriorating of credit risk.” credit rating prospects.” Arvind Rajan, Prudential Financial If more sovereigns suffer ratings downgrades, this could have a profound impact on the extent to which pension funds and other large institutional investors can hold sovereign debt. “We operate in an economy where there is strict regulation surrounding pension fund liability management, which has tended to favor investing in government bond markets,” says Mr Fitzsimmons. “Now if there was a significant question mark about the solvency of those assets, then it has very nasty implications for the current, legislatively required asset mix. On the other hand, if yields just rise because people are worried about things like inflation, then perversely that can actually reduce liabilities in the short-term because discount rates will be higher.” Emerging regulation will also influence appetite for sovereign debt. The new Basel III accord will require banks to hold larger capital and liquidity buffers and force them into holding some proportion of their capital in supposedly low- risk asset classes, such as sovereign debt. “Regulation will require banks to concentrate their holdings into the higher layer of capital in the markets, which is government debt,” says Ms Komileva. “This will increase the structural demand for banks’ holding of government debt, even if many governments now have poorer credit prospects than corporates.” A cynical interpretation of this quirk of the Basel III rules would be that regulators are pushing banks into holding sovereign debt at a time when demand for the asset class is likely to fall among institutional investors. But just 12% of survey respondents agree that the primary purpose of the higher capital requirements to be imposed under Basel III is to compel the financial sector to fund government deficits. Most think that this is a side effect of the proposals or at most, a secondary objective. 14 | TIPPING POINTS January 2011
  • 17. Assigning a value to liquidity “The crisis has refocusedFor sovereign wealth funds, and asset managers more generally, an important attention on thelesson from the financial crisis has been to build their capital reserves and ensurethat they have a strong balance sheet that can weather unanticipated shocks. question of liquidity.“The crisis has refocused attention on the question of liquidity,” says Mr Rozanov. The majority of“The majority of sovereign funds realized during the crisis that they had severely sovereign funds realizedunderestimated the amount of prudential liquidity that they ought to have intheir portfolios, either to refinance their budgets because oil or other commodity during the crisis thatprices that they rely on collapsed, or to help bail out domestic banking systems they had severelyor support local companies. That led many funds to either scale back some of the underestimated themore ambitious plans to go out of the dollar and out of U.S. Treasuries.” amount of prudentialIn addition to building up capital reserves, asset managers are re-assessing liquidity that theytheir portfolios and subjecting them to a range of possible scenarios. The ought to have inwatchwords are diversification and risk management, on the basis that the rangeof potential outcomes on either side of a central view is so much broader than it their portfolios...”was before. “It is incredibly difficult to build a portfolio based on a single view,” Andrew Rozanov,say Mr Talbut. “What you have to do is build a portfolio that has some insurance Permalto it against some things going badly wrong but also has the ability to takeadvantage if things pan out better than they are being discounted at the momentin the market. That’s not going to be the perfect portfolio for every possibleoutcome but in terms of your risk/reward, it’s still likely to give you a betterreturn than if you bet the whole lot on one single outcome. We’re building in morediversification into our multi-asset portfolios than we’ve ever done before.”Chart 9 what extent do you believe that the higher capital requirements to be imposed To under Basel III are designed to compel the financial sector to fund government deficits? A side effect of Basel III, 41% but not an intended purpose Secondary purpose 25% Primary purpose 11% Basel III will have little or no effect 10% on demand for government debt Don’t know 14% 0% 10% 20% 30% 40% 50% 60% 70% Percentage of respondents January 2011 TIPPING POINTS | 15
  • 18. ConclusionFor asset managers and other institutional investors, the economy goes through a painful period of adjustment.range of possible outcomes in a highly divergent and multi- But even when it subsides, the investment landscape willfaceted global economy has rarely been greater. The role have shifted significantly. Long-held assumptions aboutof sovereign debt within a portfolio has been transformed, the role of sovereign debt in investment portfolios maywhile there has been an inversion of risk profiles between no longer be tenable – or at the very least will be muchdeveloped and developing markets. These are profound, more complex and nuanced than in the past, while highlong-term changes that are likely to force asset managers levels of indebtedness in many developed economies willto re-evaluate accepted wisdom around risk management, raise the prospect of funding shortfalls, restructurings andasset allocation and portfolio construction. even defaults. The period of Great Divergence will be one that is fraught with risks, although the unfamiliarity of theA return to pre-crisis conditions around the world is environment will mean that, for some, this will also be aunlikely. For now, volatility will remain high as the global time of great opportunity.16 | TIPPING POINTS January 2011
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