Private clients looking at the year ahead should expect another year of recovery and relatively solid growth, believe their wealth managers. Emerging markets will continue to be the engine of that growth, but they also hide some not immediately obvious risks.
With a global gross domestic product (GDP) expected to grow at 4.2 per cent, developed markets will rise by 2.2 per cent, with the key laggard being Japan, at 1 per cent. Developing economies are forecast to grow by 6.4 per cent, with China’s economy expected to move forward by 9 per cent, according to Morgan Stanley forecasts, largely in line with analysts’ consensus estimates.
“We have been chronically overweight emerging market equities,” states Jeff Applegate, CIO, Morgan Stanley Smith Barney, the global wealth management business born from the joint venture between Morgan Stanley and Citi.
“The call is very simple. You own equities to have a call on growth and the best growth on the planet has been and will continue to be in emerging market economies. Those will be the equities that will do the best in terms of return,” he says.
Inflation dichotomy
Driving global growth is the global middle class, defined as a family with $10,000 (E7,500) or more in income. Already at the start of the century more than half of global middle class lived in emerging markets. By simply trend lining this growth over the next 20 years, the global middle class is going to be dominated by emerging markets, says Mr Applegate.
“It is the emerging markets consumer that is really driving the bus, in contrast with most business cycles in the post second world war period, where the US consumer was doing the driving. The US consumer no longer has the capacity to do that, nor does the US dollar economy. That has important implications for equity selection, and it is one of the key reasons we are overweight emerging economies.”
Academic studies indicating no real correlation between economy growth and stock performance are dismissed by Mr Applegate, as is evidence that GDP growth typically does not benefit listed equities. The only alternative, unlisted companies, do not enjoy such high standards of governance.
“There is a strong relationship between earnings growth and equity returns and earnings growth is pretty closely tied to the GDP growth,” he believes, adding that, broadly, in emerging markets, corporate governance is vastly improved from 10-20 years ago, as has the state of public finances, with a lot of emerging market multinationals showing better profitability than counterparts in developed economies.
The prospect of two-speed markets is mirrored by expectations of “inflation dichotomy” in the world. If developed economies see no inflation issue, in the near-term, the picture is very different in developing markets, with 5.7 per cent inflation forecast. In particular, China’s inflationary threat, leading to monetary tightening, may impact equity performance in emerging regions.
However, this is not yet a real threat that should be discussed when evaluating overweight positions in emerging markets, according to Chris Godding, Emea CIO, Morgan Stanley Private Wealth Management. The alternatives, he says, are slow-growing, debt-burdened developed markets and most investors are very far from having the benchmark allocation of 14 per cent to these emerging economies.
“At the moment, the growth in China seems to be very robust, export growth is still very strong and the tightening policy does not seem to have dampened the growth prospects by too much,” believes Mr Godding.
That said, inflation protection is a must in clients’ portfolios. “For the first time in history, the Federal Reserve is aiming to increase US inflation and being good bankers they will probably overshoot their goal. We want more protection in our portfolios, so we went from an overweight to an underweight [of inflation-linked products] last autumn,” explains Mr Applegate.
While the US pumped $600bn (E450bn) into the economy through a second round of quantitative easing, Europe embraced austerity as a means to tackling its deficits, but the eurozone sovereign debt crisis continues to represent an area of risk.
“If the sovereign debt problem in the euro area continues to accelerate and spins more out of control, it will definitely have an impact, especially on the global equity markets, as we saw last spring with the Greek crisis, when equity markets sold off pretty dramatically,” says Brent Smith, head of multi asset strategies and fund of funds division at Franklin Templeton. “This is something investors should continue to keep an eye on.”
In the United States, which represents 40 per cent of the global economy, the huge fiscal and monetary stimulus has not generated any real uptake in employment. “In the US, a failure to enter some sort of self sustaining expansion could result in a deflationary environment and possibly, a renewed down lag in the equity market,” he fears.
Given the massive amount of fiscal and monetary stimulus, government bond yields are probably too low at this junction of the recovery. Any significant drop in the price of bonds will be a negative for the housing market in the US and Europe, given how closely mortgage rates are tied to government bond yields, he says.
“The markets are volatile and I think it is appropriate that investors try to gauge the risk. It is not necessarily the potential return they have to focus on,” he says.
