Tipping Points Global perspectives on navigating “The Great Divergence” A survey and report created with Printed January 2011 Table of Contents Foreword Executive Summary Introduction + About the survey The Great Divergence: Economic growth The Great Divergence: Sovereign debt The Great Divergence: Currencies The Great Divergence: Fiscal policy Sovereign wealth funds Implications for investors + Emerging markets and their risks + New skill sets are required + Sharper pricing of risk + The impact of fiduciary frameworks + Assigning a value to liquidity Conclusion 4 10 11 12 12 13 13 14 15 16 About RBC Capital Markets RBC 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 and Australasia, 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, and acquire 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 Aa1 and Standard & Poor’s AA- About The Economist Intelligence Unit The Economist Intelligence Unit is the business information and research arm of The Economist Group, publisher of The Economist Through its global network of 650 analysts, it continuously assesses and forecasts political, economic and business conditions in more than 200 countries As the world’s leading provider of country intelligence, it helps executives make better business decisions by providing timely, reliable and impartial analysis on worldwide market trends and business strategies Foreword Our economic landscape has been evolving at a rapid pace over the last three years As the global community becomes more intertwined, institutional investors and corporate executives must address the increasingly complex implications of local and regional challenges around the world At RBC Capital Markets, we strive to provide our clients with the most relevant 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 markets participants to gather sentiment as the industry moves away from the legacy mindset of the past 30 years The purpose of our poll was to gauge the consensus outlook, examine deviations from the consensus and discover how investors plan to 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 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 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 London Quentin Fitzsimmons, Executive Director and Head of Government Bonds and Foreign Exchange, Threadneedle Lena Komileva, Head of G7 Market Economics, Tullet Prebon Jonathan Lemco, Principal, Vanguard Pippa Malmgren, President and Founder, Canonbury Group and Principalis Asset Management Arvind Rajan, Managing Director and Head of Quantitative Research and Risk Management, Prudential Financial Andrew Rozanov, Managing Director and Head of Sovereign Advisory, Permal Robert Talbut, Chief Investment Officer, Royal London Asset Management We hope you will find the report insightful Marc Harris Co-Head of Global Research RBC Capital Markets Richard Talbot Co-Head of Global Research RBC Capital Markets January 2011 TIPPING POINTS | 01 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: • To what extent will the large gap in growth between emerging and 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: Raising Capital in a New Era (September 2009) and The New “Normal”: Implications of Sovereign Debt and the Competition for Capital (June 2010) 02 | TIPPING POINTS January 2011 Emerging markets and their risks In both the survey and the interviews, location predicts sentiment Optimism abounds on prospects for emerging and resource-rich economies, with the highest hopes focused on the non-BRIC frontier markets The consensus is so strong that it lends credence to the idea of an emerging markets bubble, with a fire hose of capital aimed at a limited pool of financial assets If the emerging markets are flooded with more capital than they can immediately use, valuations will outrun fundamentals and the markets will eventually drop New skill sets are required In contrast to the situation a year ago, much of today’s portfolio risk is driven by sovereign risk Prudential Financial Managing Director Arvind Rajan points out that as sovereign risk rises, it tends to become the common factor that drives all other portfolio risks Therefore, the ability to analyze sovereign risk is essential – and it requires a broader base of skills than many portfolio management firms currently possess The skill set includes expertise in government financing strategies, multilateral lending agencies, the banking sector, the CDS market and political scenarios In addition, the loss of credibility by rating agencies has contributed to a trend of bringing more credit analysis in-house 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 Sharper pricing of risk Risk has not been priced accurately in the past, to put it mildly, and skepticism has grown around traditional methods of evaluating risk, including snapshots of fundamentals, rating agency judgments, confidence intervals and assumptions about government backstops Capital preservation requires a more conservative approach to the potential for extreme events The impact of fiduciary frameworks Downgrades could limit the ability to hold sovereign debt among large institutional investors facing investment mandates On the other hand, the new Basel III accord will require banks to hold more capital and liquidity buffers, which will result in a mandate to hold more asset classes that have historically presented low risks, such as sovereign debt This change would boost the demand for bank holdings of government 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 has a higher value than it used to, which explains the reluctance of many sovereign wealth funds to dramatically scale back their holdings of the dollar and U.S Treasuries Portfolios are judged to be more volatile than they used to be, 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 – for instance, to bail out local banks, companies or governments Fund managers are building in more diversification to stabilize values, and they are placing more weight on liquidity January 2011 TIPPING POINTS | 03 Introduction Although the economic crisis appears to have passed, the nations of the world are diverging on multiple levels From the dynamic BRIC economies to the debt-burdened nations of the European periphery, economies are diverging in terms of economic growth, creditworthiness and fiscal policies And in this two-track global economy, it is the slower-growing developed nations that are the most fiscally constrained, have the greatest need for austerity and face the most difficult prospects for regaining their economic health As a result, investors are breaking free of past orthodoxy and viewing alternatives in light of new realities One manifestation is capital chasing higher yields, rising asset values and appreciating currencies of emerging markets Another is the skepticism around notions such as confidence intervals and mean reversion, which offer the promise of mitigating risk but become difficult to apply in the face of fundamental shifts in market conditions Also under fire is the notion of – in the words of a fixed-income executive at a large London asset manager – “a world where friendly, big-brother style bailouts always happen.” The fuel for financial markets is confidence, an ingredient in short supply when asset values are diverging By assessing the fundamental factors driving this Great Divergence, and taking the pulse of the market via survey results and interviews, this report aims to clarify the decisions faced by 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 • Within financial services, 31% are from commercial banks, 26% from asset management firms or institutional investors and 18% from investment banks; the rest work at hedge funds or private equity funds The average asset size is US$275bn 04 | TIPPING POINTS • The top industries among non-financial respondents are manufacturing, the public sector, professional services, energy and technology Average annual revenues are US$3-4bn, with a range of US$750m to over US$100bn January 2011 • The executives polled are quite senior, with 36% coming from the C-suite and another 58% at or above the VP/Director level • Respondents came primarily from North America and Western Europe, with 38% from each region 14% reside in the Asia/Pacific region, and 9% came from Eastern Europe, Latin America, the Middle East and Africa The Great Divergence: Economic growth The most obvious divergence is in economic growth rates In its December 2010 Global Outlook, the Economist Intelligence Unit highlighted the varying pace of the recovery Although global growth is forecast at 3.8% in 2011, stark underlying differences 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.3 Among respondents to the survey, a greater proportion expects conditions to improve rather than deteriorate in major regions of the world – with the exception of Japan (see Chart 1) But it is clear that the recovery will proceed at multiple speeds While respondents are in strong agreement that the prospects for China, India and developed Asia remain bright, there is much greater ambiguity about the outlook for the rest of the world Survey respondents are less sanguine with respect to the developed world With the exception of Japan, pluralities – not majorities – expect better prospects for 2011 in the developed world In Japan, a plurality expects no change, and more think that the economy will deteriorate than improve Organisation for Economic Co-operation and Development Economist Intelligence Unit forecasts as of January 2011 Chart 1 Over the next year, what change 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 (Hong Kong, Singapore, South Korea) 71% India 70% China 65% 32% Russia 31% Africa Middle East 30% North America 19% Europe Japan 10% 4% –3% 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 Chart 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 you expect this rate to change, if at all? 2% Much higher Higher 14% 18% No change 53% Lower Much lower 12% Don’t know 1% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% Percentage of respondents expectation of below-trend growth rates in the U.S., as well as the European periphery and the rest of Western Europe The reverse is true for Asia-Pacific, Canada, the BRICs and other emerging markets There is also a clear bifurcation between developed and developing economies Chart shows that most market participants think that U.S growth in the coming decade will be below that of the last decade Chart confirms the Chart How 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% European periphery 16% 35% Europe ex-periphery 37% U.S 53% U.K 60% 40% 20% 0% 20% 40% Proportion of respondents that expects a higher than average rate minus respondents that expect a lower than average rate 06 | TIPPING POINTS January 2011 60% The Great Divergence: Sovereign debt The imposition of fiscal austerity measures, of the scale required to service debt in Greece and Ireland, means that it will be difficult for those countries to grow 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, resulting in more losses on bank balance sheets “What these EU and IMF bail-outs are essentially asking those countries to is to put their economies into permafrost for a very long period of time,” says Robert Talbut, Chief Investment Officer at Royal London Asset Management “What’s more, there is no guarantee that, in three years’ time, those economies 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 have to occur.” 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 contract between the public and government is being renegotiated,” says Pippa Malmgren, President and Founder of the Canonbury Group and Principalis Asset Management “The scale of the problem means that many people will be forced to retire later than they expected for a lower standard of living than they 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 “While [Greek] 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.” Arvind Rajan, Prudential Financial 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 Chart 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% n es pa Ja at ce ite d St ly Ita Gr ee m iu ce lg Be l ga an Fr n Po rtu s la er th Un Ne Sp nd nd da la Ire m Ca ng Ki d Un ite h ec Cz na ic bl an pu Re rm bl Ge pu Re ak Sl -20% y ic k d ar nm ov al an De nd la Ne w Ze st ia ria Fin Au en en ov Sl ed Sw lia a st Au re rw No -10% Ko ay 0% Source: IMF Global Financial Stability Report European periphery will face difficulties in funding their shortfalls A similar proportion expects the U.K to face the same challenges (see Chart 5) Although almost all respondents believe that governments will be able to finance themselves over the next one to three budget cycles, they not expect the fundraising process to be easy More than half expect that the nations of the Chart 5 In your country, will the national government experience a funding shortfall over the next one to three budget cycles? If yes, how severe will it be? U.K 55% 11% 59% European periphery 33% Canada Other (MEA, Latin America, Eastern Europe) 17% 37% 34% U.S 25% Asia/Pacific excluding India, China 23% BRICs 16% European ex-periphery 0% January 2011 Yes, and the government will fund the shortfall, but with difficulty 12% Yes, and the government will be unable to fund the shortfall 14% 7% 9% 9% 20% 40% Percentage of respondents 08 | TIPPING POINTS 6% 60% 80% The Great Divergence: Currencies Survey respondents and interviewees agree that the euro will survive these uncertain times Over half put the chances at 20% or less that the union will lose members in the next three years, while 80% estimate the same low odds – 20% or less – for the collapse of the single currency during the same period (see Chart 6) And Europeans – particularly those in the most troubled countries – say that the probability is even lower “The assumption that the euro, for all its flaws, is vulnerable to collapse is not true There is no direct link that says just because one sovereign country in the Eurozone defaults on its debt that the euro therefore becomes worthless or the European Central Bank ceases to function.” Michael Ben-Gad, Professor of Economics, City University London But even if the euro survives the current crisis, its long-term role in the global economy will have been compromised “Although I remain convinced that monetary union will survive, the notion that the euro will be one of the world’s dominant reserve currencies is now debatable,” says Jonathan Lemco, a Principal at Vanguard “To me, it makes the U.S position as global reserve currency of choice even more assured than before, despite its problems.” Survey respondents agree: 80% expect the dollar to retain its position as the dominant global reserve currency over the next three years, while 52% expect it to retain this role five years from now An Economist Intelligence Unit survey conducted in June 2010, also on behalf of RBC Capital Markets, found similar sentiment, suggesting that market perceptions of the dollar and euro have not changed significantly as a result of the more recent strains in the Eurozone The dollar’s role allows the U.S to tolerate higher levels of debt than other sovereigns without having its solvency called into question “The U.S can run massive current account deficits and get away with it and can benefit from much greater economic stability than it would otherwise have,” says Dr Lemco 40% 45% 35% 40% Percentage of Respondents Percentage of Respondents Chart What probability would you assign to the following events taking place over the next three years? 30% 25% 20% 15% 10% 5% 35% 30% 25% 20% 15% 10% 5% 0% 0% 1-20% 21-40% 41-60% 61-80% 81-99% Probability of one or more Eurozone countries leaving the monetary union in the next three years 100% 0% 1-20% 21-40% 41-60% 61-80% 81-99% 100% Probability that the Eurozone will breakup during the next three years January 2011 TIPPING POINTS | 09 The Great Divergence: Fiscal policy These are uncharted waters for policymakers as well as investors Stepping outside the legacy mindset requires central banks and other policymakers to enact heterodox and unprecedented methods to deal with the new reality There is no textbook policy prescription for the current situation As a result, approaches differ Compared with the approach being taken by heavily indebted sovereigns in the Eurozone, the U.S government has so far been reluctant to embrace fiscal consolidation and continues to pin its hopes on monetary policy to jump-start the economy (and thereby ameliorate fiscal dynamics) “From the administration’s perspective, the implementation of the stimulus package is the priority and if it means that this will lead in the short term to a wider deficit, then that seems to be considered an acceptable cost,” says Dr Lemco According to the Congressional Budget Office, the U.S debtto-GDP ratio was 62% in the 2010 fiscal year, and could rise to 90% by 2020 A bipartisan commission formed by President Obama has proposed US$4tn in savings, which would bring down the budget deficit to 2.2% of GDP by 2015, but few believe that its proposals will be implemented in a political environment that appears to be in permanent gridlock, especially as the 2012 elections draw closer Nevertheless, there is a growing consensus around the need to tackle the fiscal deficit “There is a sense in certain parts of the U.S that they are not going to be able to get out of their current situation relying on the Fed to pump money into the system and that they will need to address other aspects that make it unattractive to invest and employ in the U.S.,” says Mr Talbut More than 60% of U.S respondents think that the level of their country’s external debt is growing at an unsustainable level (see Chart 7) And government debt (as opposed to total external debt, both public and private) is a concern as well “Many investors worry about the ability and the political will of the U.S government to put the public finances on a sustainable long-term path,” says Andrew Rozanov, Managing Director and Head of Sovereign Advisory at London-based fund of hedge funds, Permal Chart 7 Is your country’s external debt growing at a sustainable level? 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% Percentage of respondents (excludes respondents who answered “Don’t know”) 10 | TIPPING POINTS January 2011 100% Sovereign wealth funds: A souring love affair with sovereign debt? W ith sovereign issuance forecast to increase significantly over the next few years, government debt managers will be on a charm offensive to attract and retain their key investors Top of the list for many will be the world’s sovereign wealth funds (SWFs), which collectively wield about US$4.1tn of assets The largest, the Abu Dhabi Investment Authority, is estimated to hold in excess of US$600bn SWFs have traditionally been big buyers of sovereign debt In the run-up to the financial crisis, many began to look further afield into higher-yielding assets But the crisis has forced a reappraisal of these investment strategies, particularly for newer funds that have a mandate for economic stabilization “Some funds realized that they had severely underestimated the amount of prudential liquidity that they ought to have in their portfolios, either to refinance their budgets, bail out domestic banking systems or support the local economy,” says Andrew Rozanov, Managing Director and Head of Sovereign Advisory at Permal “The nature and range of potential calls from the government on their capital turned out to be much broader and less predictable than they had anticipated.” For many SWFs, a retreat from risk means a bigger allocation to sovereign debt “A number of funds have scaled back some of the more ambitious plans to move out of the dollar and U.S Treasuries,” says Mr Rozanov “In fact, all else being equal, I would argue this in principle bodes well for government debt in developed countries, especially the U.S and Europe.” But not all developed nations For example in November, Russia’s sovereign wealth funds, which control an estimated US$142.5bn in assets, announced that they would no longer buy the sovereign debt of Ireland and Spain The announcement sparked a large increase in borrowing costs for the peripheral countries of the Eurozone Of course, the true situation is more nuanced Mr Rozanov points out that the Norwegian fund – the second biggest in the world – has stepped up purchases of Irish, Portuguese and Greek government debt “There is an important difference between ‘pure’ stabilization funds, which are focused on nominal returns and are very conservative in their asset allocation, and those like Norway, that are essentially intergenerational wealth transfer funds focusing on real returns and operating more like a diversified portfolio manager,” he explains While these trends suggest a potentially brighter-than-consensus outlook for sovereign debt, there are clouds on the horizon even for highly rated issuers A key concern is QE2 and the potential for more quantitative easing, on the value of SWF dollar holdings “The whole idea of moving into uncharted territory with quantitative easing on that scale, from the issuer of the main reserve currency in the world, gets a lot of people nervous, certainly among sovereign funds with seriously large allocations to these markets,” says Mr Rozanov Survey respondents acknowledged this concern when 60% said that foreign holders of U.S Treasuries would face losses over the next three years High debt levels in developed countries are also a key concern “SWFs worry about the ability and political will of the U.S government to put public finances on a sustainable long-term path,” says Mr Rozanov “They are also concerned about the ability of the European Union and its core constituents, like Germany, to resolve the debt problems on the periphery of the Eurozone.” So while SWFs are likely to remain important investors in the world’s sovereign debt, they are paying close attention to the unfolding economic picture Indeed, as survey respondents suggest, government debt managers may eventually find that their charm has worn off – leaving significant shortfalls in their finances and potentially affecting the risks of other country-specific assets as well January 2011 TIPPING POINTS | 11 Implications for institutional investors The events of the past two years have seen long-held assumptions about the creditworthiness of developed and developing economies overturned Prior to the crisis, investors viewed Eurozone bonds and U.S Treasuries as essentially risk-free, and emerging market debt as needful of much greater scrutiny and analysis (Indeed, Basel III still weights OECD sovereign debt at zero risk.) Now these positions have been reversed “There has been a challenge to the orthodox way of dividing up the sovereign debt world between developed and developing markets,” says Quentin Fitzsimmons, Executive Director and Head of Government Bonds and Foreign Exchange at Threadneedle Emerging markets and their risks One obvious outcome of this reversal is the interest in the emerging markets Almost three-quarters of survey respondents expect an increase in valuation in major Asian equity markets over the next 12 months (see Chart 8) According to EPFR Global, a financial data provider, net inflows to emerging market bond funds reached almost US$40bn in the first nine months of 2010 – four times the previous record for a complete year “There is a broad search among investors for hard assets offering real returns and this is where the emerging markets come in,” says Lena Komileva, Head of G7 Market Economics at Tullet Prebon, an interdealer broker “They offer the triple attraction of higher real yields, rising domestic asset values and appreciating currencies.” The prospects for many emerging markets are almost certainly highly positive over the long term But some investors worry that there is too much emphasis on shortterm returns This could lead to investors over-paying for assets, especially in countries with flexible exchange rates, where large capital inflows have prompted sharp currency appreciations “While on the 20-year view I agree entirely that emerging markets will become more economically significant, my concern is that you need to be careful about the price you pay when you decide to invest,” says Mr Talbut “People have been flooding into emerging markets paying almost any price to get in there but there’s a danger that they’re paying too much in the short term.” Another concern is the formation of asset bubbles as investors rush into these markets in search of yield “Investing in emerging markets is not a risk-free strategy,” says Ms Komileva “Because of that one-directional flow of funds in the global economy, the sovereign crisis in effect encourages global capital imbalances that threaten bubbles in emerging market government bonds while creating sharp liquidity outflows and added volatility in developed markets.” Chart 8 Over the next 12 months, what movement you expect in the following? Chart shows the percentage of respondents who said “stronger” minus those who said “weaker” Weaker Stronger 66% 58% Oil price in dollars 58% Chinese renminbi 39% Inflation in your country U.S equity market 27% 21% Major European equity markets 8% Euro U.S Treasuries 20% 29% 40% Major Asian equity markets Dollar 20% 12 | TIPPING POINTS 0% 20% 40% Percentage of respondents saying “stronger” minus those saying “weaker” January 2011 60% 80% Mr Rajan agrees, and says that the signs of potential asset bubbles are already appearing “You’ve got inflation in basic commodities and property booms in many emerging markets such as China, and these run-ups in prices are being justified on the grounds of strong fundamentals,” he says “But the macro risk is that, by flooding these countries with money they can’t efficiently use, investors could ultimately create another global credit bubble, and valuations could get well beyond the fundamentals before they crack.” New skill sets are required Sovereign debt analysis now requires a much broader set of skills, given the very different situations in which developed and developing markets find themselves Analysis of Greek debt, for example, now requires the skills of emerging market experts with an understanding of how IMF support affects solvency and economic recovery It also necessitates the combined input of government portfolio managers, bank analysts, credit default swap specialists, European fixed income professionals and economists, all focusing on both cyclical and structural trends in the markets Government indebtedness is just one variable among many that needs to be assessed, including the exposure of the banking sector, the political situation and the scale of a country’s public sector liabilities “Every country needs to be considered and analyzed on its own merits because the dynamics facing each country are different,” says Mr Fitzsimmons “There is no generalized template to say that an economy running 10% deficits on a yearly basis with a 100% debt-to-GDP ratio is more likely to run into trouble than an economy with a smaller deficit and debt-toGDP ratio This is all about confidence and it’s all about the perception of medium to long-term viability of the financial system and the nature of the guarantee that any particular sovereign entity is providing to its banking and private sector.” For Dr Lemco, and many other asset managers, there is now a need to be much more discriminating when selecting investments, particularly sovereign debt “We have to take countries on a case-by-case basis far more than we did in the past,” he says “As best we can, we need to try to avoid generalizations, such as developed or emerging markets, and really investigate spreads over time There’s obviously short-term volatility, but the question for the medium or longer term is whether the trends that we’re seeing in the marketplace are consistent with what we think of as the fundamentals.” Jonathan Lemco, Vanguard Inputs to credit analysis are also changing Rather than rely on rating agencies, which one interviewee described as “entities that have made a business model out of being behind the curve”, asset managers are increasingly recruiting their own credit analysts or assessing other indicators, such as the credit default swap market “The transparency of the CDS market does shine a fairly bright light and provides an independent free market appraisal of what’s going on,” says a London fixed-income executive “It tends to be sharper in terms of pricing in problems a bit quicker as people hedge themselves.” Sharper pricing of risk For investors in sovereign debt, a fundamental lesson relates to the need to price risk more accurately The assumption that risk can be measured by taking a snapshot assessment of fundamentals, relying on past price history and confidence intervals is now a thing of the past “For those interested in capital preservation and who want to know they have protected tail risk, it will be worth looking beyond the current snapshot of rating agencies, beyond the assumptions of past mean reversion, and beyond the false comfort of confidence intervals and a world with few consequences for profligacy,” says the London executive January 2011 TIPPING POINTS | 13 “When sovereign risk goes up, it can become a contagious factor that drives systemic risk And given that developed government guarantees 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 credit risk.” Arvind Rajan, Prudential Financial 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 banking system and other channels of contagion, and because of government’s role as a guarantor of last resort “Systematic risk is multi-dimensional, and is best described by what we call principal components, which quantify the correlation of security prices stemming from exposure to common risk factors,” says Mr Rajan “When sovereign risk goes up, it can become a contagious factor that drives systemic risk And given that developed government guarantees 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 credit risk.” The impact of fiduciary frameworks Many institutional investors have investment mandates that prevent them from investing in debt below a certain credit rating or once yields or credit default swaps reach a certain level As the IMF notes in its Global Financial Stability report: “Investors with strict ratings guidelines in their portfolio mandates (notably central bank reserve managers) may also be less inclined to maintain their current allocation to sovereigns where credit spreads imply deteriorating credit rating prospects.” 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 lowrisk 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 “The crisis has refocused attention on the question of liquidity The majority of sovereign funds realized during the crisis that they had severely underestimated the amount of prudential liquidity that they ought to have in their portfolios ” Assigning a value to liquidity For sovereign wealth funds, and asset managers more generally, an important lesson from the financial crisis has been to build their capital reserves and ensure that they have a strong balance sheet that can weather unanticipated shocks “The crisis has refocused attention on the question of liquidity,” says Mr Rozanov “The majority of sovereign funds realized during the crisis that they had severely underestimated the amount of prudential liquidity that they ought to have in their portfolios, either to refinance their budgets because oil or other commodity prices that they rely on collapsed, or to help bail out domestic banking systems or support local companies That led many funds to either scale back some of the more ambitious plans to go out of the dollar and out of U.S Treasuries.” In addition to building up capital reserves, asset managers are re-assessing their portfolios and subjecting them to a range of possible scenarios The watchwords are diversification and risk management, on the basis that the range of potential outcomes on either side of a central view is so much broader than it was before “It is incredibly difficult to build a portfolio based on a single view,” say Mr Talbut “What you have to is build a portfolio that has some insurance to it against some things going badly wrong but also has the ability to take advantage if things pan out better than they are being discounted at the moment in the market That’s not going to be the perfect portfolio for every possible outcome but in terms of your risk/reward, it’s still likely to give you a better return than if you bet the whole lot on one single outcome We’re building in more diversification into our multi-asset portfolios than we’ve ever done before.” Andrew Rozanov, Permal Chart 9 To what extent you believe that the higher capital requirements to be imposed under Basel III are designed to compel the financial sector to fund government deficits? A side effect of Basel III, but not an intended purpose 41% Secondary purpose 25% Primary purpose 11% Basel III will have little or no effect on demand for government debt 10% Don’t know 14% 0% 10% 20% 30% 40% 50% 60% 70% Percentage of respondents January 2011 TIPPING POINTS | 15 Conclusion For asset managers and other institutional investors, the range of possible outcomes in a highly divergent and multifaceted global economy has rarely been greater The role of sovereign debt within a portfolio has been transformed, while there has been an inversion of risk profiles between developed and developing markets These are profound, long-term changes that are likely to force asset managers to re-evaluate accepted wisdom around risk management, asset allocation and portfolio construction A return to pre-crisis conditions around the world is unlikely For now, volatility will remain high as the global 16 | TIPPING POINTS January 2011 economy goes through a painful period of adjustment But even when it subsides, the investment landscape will have shifted significantly Long-held assumptions about the role of sovereign debt in investment portfolios may no longer be tenable – or at the very least will be much more complex and nuanced than in the past, while high levels of indebtedness in many developed economies will raise the prospect of funding shortfalls, restructurings and even defaults The period of Great Divergence will be one that is fraught with risks, although the unfamiliarity of the environment will mean that, for some, this will also be a time of great opportunity RBC Capital Markets is the business name used by certain subsidiaries of Royal Bank of Canada, including RBC Dominion Securities Inc., RBC Capital Markets, LLC, Royal Bank of Canada Europe Limited and Royal Bank of Canada - 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Member SIPC Copyright © RBC Dominion Securities Inc 2011 - Member CIPF Copyright © Royal Bank of Canada Europe Limited 2011 Copyright © Royal Bank of Canada 2011 All rights reserved [...]... sovereigns in the Eurozone, the U.S government has so far been reluctant to embrace fiscal consolidation and continues to pin its hopes on monetary policy to jump-start the economy (and thereby ameliorate fiscal dynamics) “From the administration’s perspective, the implementation of the stimulus package is the priority and if it means that this will lead in the short term to a wider deficit, then that... political environment that appears to be in permanent gridlock, especially as the 2012 elections draw closer Nevertheless, there is a growing consensus around the need to tackle the fiscal deficit “There is a sense in certain parts of the U.S that they are not going to be able to get out of their current situation relying on the Fed to pump money into the system and that they will need to address other aspects... sustainable long-term path,” says Mr Rozanov “They are also concerned about the ability of the European Union and its core constituents, like Germany, to resolve the debt problems on the periphery of the Eurozone.” So while SWFs are likely to remain important investors in the world’s sovereign debt, they are paying close attention to the unfolding economic picture Indeed, as survey respondents suggest,... London But even if the euro survives the current crisis, its long-term role in the global economy will have been compromised “Although I remain convinced that monetary union will survive, the notion that the euro will be one of the world’s dominant reserve currencies is now debatable,” says Jonathan Lemco, a Principal at Vanguard “To me, it makes the U.S position as global reserve currency of choice even... that the probability is even lower The assumption that the euro, for all its flaws, is vulnerable to collapse is not true There is no direct link that says just because one sovereign country in the Eurozone defaults on its debt that the euro therefore becomes worthless or the European Central Bank ceases to function.” Michael Ben-Gad, Professor of Economics, City University London But even if the euro... general circulation and does not take into account the objectives, financial situation, or needs of any recipient Hong Kong persons wishing to obtain further information on any of the securities mentioned in this publication should contact RBC Investment Services (Asia) Limited, RBC Investment Management (Asia) Limited or Royal Bank of Canada, Hong Kong Branch at 17/Floor, Cheung Kong Center, 2 Queen’s... While these trends suggest a potentially brighter-than-consensus outlook for sovereign debt, there are clouds on the horizon even for highly rated issuers A key concern is QE2 and the potential for more quantitative easing, on the value of SWF dollar holdings The whole idea of moving into uncharted territory with quantitative easing on that scale, from the issuer of the main reserve currency in the. . .The Great Divergence: Currencies Survey respondents and interviewees agree that the euro will survive these uncertain times Over half put the chances at 20% or less that the union will lose members in the next three years, while 80% estimate the same low odds – 20% or less – for the collapse of the single currency during the same period (see Chart 6) And Europeans – particularly those in the most... eventually find that their charm has worn off – leaving significant shortfalls in their finances and potentially affecting the risks of other country-specific assets as well January 2011 TIPPING POINTS | 11 Implications for institutional investors The events of the past two years have seen long-held assumptions about the creditworthiness of developed and developing economies overturned Prior to the crisis,... inflation in basic commodities and property booms in many emerging markets such as China, and these run-ups in prices are being justified on the grounds of strong fundamentals,” he says “But the macro risk is that, by flooding these countries with money they can’t efficiently use, investors could ultimately create another global credit bubble, and valuations could get well beyond the fundamentals before they ... of Contents Foreword Executive Summary Introduction + About the survey The Great Divergence: Economic growth The Great Divergence: Sovereign debt The Great Divergence: Currencies The Great Divergence: ... January 2011 TIPPING POINTS | 03 Introduction Although the economic crisis appears to have passed, the nations of the world are diverging on multiple levels From the dynamic BRIC economies to the debt-burdened... crisis, its long-term role in the global economy will have been compromised “Although I remain convinced that monetary union will survive, the notion that the euro will be one of the world’s dominant