Finance: The new certainty—debt and taxes

The markets are currently a fast-changing place. Here, experts give their take on how to manage money in an environment shaped by the deficits of the “rich” world
August 24, 2011
Emerging economiesJim O’Neill

In view of the considerable fiscal challenges facing both Europe and the US, it is not surprising that investors are searching for alternatives. In addition to providing much better potential for long-term real gross domestic product growth, those countries that I refer to as Growth Economies—the four BRICs, Brazil, Russia, India and China, along with Korea, Indonesia, Mexico and Turkey—all have dramatically better fiscal positions and considerably lower government debt.

One way of thinking about it would be in terms of the Maastricht Treaty, which before 1999 was supposed to determine countries’ fitness for membership of the European Monetary Union. Countries were only allowed to join if they had budget deficits at or below 3 per cent of GDP and government debts that were 60 per cent of GDP or less, or were heading in that direction.

Right now, Finland would be the only eurozone country to meet the Maastricht criteria. Britain, the US and, of course, Japan certainly do not. Among developed world nations only Australia and Sweden would sit alongside Finland.

By contrast, all of the Growth Economies, with the possible exceptions of India and Russia, would easily satisfy the Maastricht criteria. Now that the credit rating agencies have noticed these issues, it is quite likely that more and more investors will want to diversify gradually away to these markets.

Jim O’Neill is chairman of Goldman Sachs Asset Management


Blue chip stocksCatherine Stanley

Markets are dominated by trouble arising from sovereign debt and there is uncertainty around both the impact of this and the global macroeconomic backdrop.

Outside the financial sector most companies are concerned by the threat of weakening demand. Profit warnings have increased recently and trading has become more difficult. Corporate balance sheets have strengthened, however, which has provided some comfort.

In our view, this environment is better for “blue chip” stocks—those of large, respected companies—than it is for the smaller “mid-caps,” which are more sensitive to the cyclical motions of the market.

We are sticking with businesses that have strong balance sheets. We also like to see management teams that are aware of the current uncertainty and are responding by strengthening their businesses with capital cushions. Companies with sound contingency plans for hard times are attractive for investors.

Catherine Stanley, Director, UK Small Cap Equities at F&C

BondsAndrew Balls

Bonds play an important role in an investor’s portfolio. They contribute income and capital appreciation, provide diversification and help to protect wealth. Historically, bonds have cushioned portfolios during stock market declines, while periods of strong stock market returns have cushioned poor periods for bonds. The result of maintaining a core bond allocation: lower overall volatility in your portfolio.

But now there is a challenging investment environment for bonds on several levels. First, the tailwind of gradually falling interest rates that began in the 1980s is now behind us, and while rates are very low now, the likely direction over the next three to five years is higher.

Second, wealthier, developed nations have experienced sharp deterioration in their public debt dynamics, and the process of reducing debt in the public and sometimes private sectors of these economies is going to be long and difficult.

Finally, one of the ways that these governments may try to ease this pain is to try to “inflate” their way of out debt, and that inflation will eat into prices of fixed-payment instruments such as bonds.

At PIMCO, our approach to navigating the long-term investment environment has been to place less emphasis on sovereign bonds from developed countries with low real interest rates or where there is significant risk of default. Instead, we are favouring “safe spread” issues from countries backed by strong balance sheets and which provide additional yield over core government bonds. These may include corporate bonds, select high yield issuers and high-quality asset- and mortgage-backed securities. Emerging markets offer a range of such investment opportunities.

We have long been very cautious on eurozone “peripheral” government bonds and remain so given the difficulties policymakers are facing. In the US and Britain, inflation may be a challenge to returns over time. We stress that investors should think globally, by sector and country. The goal is to diversify your bond market returns and remain sensitive to the threat posed by interest rate risk.

Andrew Balls is a managing director and head of European Portfolio Management in the London office of PIMCO


GoldAlexander Godwin

For investors, it is becoming increasingly difficult to find a safe place to hide. With the risks of owning securities issued by governments and companies increasing, gold could be one of the last assets providing shelter from impending storms.

Western government bonds, traditionally seen as the safest place for your cash, look more risky than at any time in recent memory. The US government’s finances are continuing to deteriorate rapidly, a situation made more threatening by the country’s polarised political situation, and the reduction in the country’s credit rating.

Europe is no better. Attempts by the EU to paper over the cracks of the eurozone have come nowhere near solving the underlying structural problems. Only when German voters accept the necessity of a fiscal transfer and voters in peripheral countries accept the strings that would be attached to such a gift will the end emerge. It is doubtful whether this is likely to happen without further serious instability in financial markets.

Stemming the tide of government deficits will require both tax rises and deep spending cuts, not things that will help economic growth or corporate profitability. And any crisis involving government solvency tends to have a negative effect on the global banking system.

The emerging world, while in better fiscal shape, has its own problems. The most significant of these is that inflation is beginning to take hold, particularly in China, driven by rapid wage growth. More monetary tightening is likely to be necessary.

In a world where securities issued by governments or companies look increasingly unattractive, it is unsurprising that the gold price has performed strongly, rising some 40 per cent in the past 12 months to reach, at the time of writing, over $1,800 per ounce. We believe that gold will continue to appreciate until these storms pass.

Alex Godwin is Global Head of Asset Allocation at Citi Private Bank


CommoditiesVince Heaney

Traditionally, commodities offered investors a way to diversify their portfolio, since they exhibited low correlations with other asset classes. They were, however, not popular with fund managers since commodities generate no income and their inflation-adjusted performance over the very long term has been poor.

More recently, commodities have become both more popular and, thanks to new derivative products, easier to access. But the inflow of short-term money—or “hot money”—has increased their correlations with other risky asset classes, such as equities, thereby reducing their value as ways of spreading risk through diversification. Markets currently flip between “risk-on” or “risk-off.” When investors are worried about sovereign debt they switch to “risk-off” mode and commodities tend to suffer alongside other risky assets.

The potential macroeconomic ramifications of sovereign debt crises could also affect commodities. While the EU has reached a temporary solution in Greece to prevent such contagion, the fiscal austerity required to reduce debt in many countries will weigh on growth and, therefore, demand for commodities.

But it is demand in emerging markets, particularly China, rather than in debt-constrained developed economies, that underpins commodities’ recent popularity.

A full-blown debt crisis, which threatened the financial system, could prompt another recession, which would reduce demand for commodities.

Vince Heaney is a writer and consultant


The dollarDesmond Lachman

In the wake of Standard and Poor’s downgrading of US government debt, it is tempting to write off the dollar’s staying power as the global reserve currency. But before rushing to such a judgment, one needs to ask a fairly basic question. Do the outlooks for the Japanese and European economies really provide the basis for either the Japanese yen or the euro to supplant the US dollar any time soon as the world’s leading international reserve currency?

Standard and Poor’s was certainly right to downgrade the US’s government debt. With a gross government debt of around 90 per cent of GDP and a primary budget deficit of 8.5 per cent of GDP, the US public finances are on an unsustainable path. Indeed, many observers suggest that, absent fundamental policy changes, within three years the US could be approaching Greek-like levels of national debt.

The recent sorry spectacle of the US congressional debate over raising the nation’s debt ceiling offered little assurance that the country has the political will to address its budget deficit problem seriously. For rather than come up with the $4,000bn in budget deficit reduction measures over the next decade that were generally agreed upon as being essential for the restoration of US fiscal order, Congress came up with barely $2,500bn in cuts. And Congress decided to delay any serious attack on the budget deficit until after the 2012 presidential election.

Shaky as the US public finances might be, those in Japan are substantially more alarming. At over 180 per cent of GDP, Japan’s public debt to GDP ratio is already by far the highest amongst the industrialised countries. Japan’s population is also ageing at a considerably faster rate than any of its industrialised country peers, which raises the most fundamental of questions as to how it will be able to finance its persistently high budget deficit. An approaching train wreck in funding its government deficit hardly provides the basis for the Japanese yen to supplant the dollar.

Jean-Claude Trichet is fond of saying how much better Europe’s public finances are than the US on an aggregate basis. However, this self-satisfied view glosses over the fact that it is almost inevitable that within a year or so there will be major sovereign debt defaults in Europe’s over-indebted periphery. The European Central Bank itself acknowledges that should such defaults occur, Europe’s core countries would experience a Lehman-like banking crisis. It is also more than likely that such defaults would pose a threat to the existence of the euro in its present form, which would hardly provide the basis for the currency to offer a serious challenge to the US dollar.

In the kingdom of the blind, the one-eyed man is king. In the global economy, it would seem that warts and all, the US dollar is not nearly in as bad shape as the Japanese yen or the euro. This makes it all too likely that, troubled as the US economy might be, the dollar is unlikely to relinquish its status as the world’s primary international reserve currency any time soon.

Desmond Lachman is a resident fellow of the American Enterprise Institute