x Abu Dhabi, UAEFriday 28 July 2017

Drive safely through the fog of uncertainty

If we cannot see the road ahead economically, a reckless approach to investment is not the way to progress. This is a time for prudence.

Economic powerhouse
Economic powerhouse" China will contribute about three times as much as America to global growth next year.

Just as in war, fog complicates investing. All action takes place in a kind of fog that gives things exaggerated dimensions and unnatural appearance, according to Carl von Clausewitz, the military strategist.

After two years of historic fiscal and monetary stimulus that boosted equity and commodity markets, investors will soon enter a thick fog of economic policy uncertainty.

Will developed nations continue to load up on debt to stimulate their ailing economies? While major emerging market policymakers have already raised interest rates to control overheating, rising commodity prices are likely to push regional inflation higher. Even though global growth momentum is likely to spill over into next year, will emerging market overheating force policymakers to tighten policy further, even at the risk of torpedoing growth in the second half of next year?

Investing is always rife with risk. But risk is rapidly rising, since the political appetite for debt-laden stimulus has darkly diminished, as this year's electoral protest votes in the US, UK and Germany indicate. While another round of global stimulus was grudgingly endorsed in recent months at the developed world taxpayer's expense, hopes of further stimulus, should it become necessary, may prove futile as sour politics increasingly override economic imperatives. In the year ahead, policymakers will be constrained by anti-debt politics in the developed world while policymakers in the fast-growing developing world will be challenged by voter angst as rising inflation bites.

The two-track recovery of the past year confirms that the burden of global growth increasingly rests on emerging nations. The dichotomy between the developed and developing world will continue to play out, with the former desiring a slight increase in inflation to escape deflation, pushing for stronger growth and desperately seeking job creation. Meanwhile, the latter will continue to struggle to keep inflation low, keep currencies from appreciating, and target moderated but sustainable growth. Leading economists forecast global growth next year at about 4 to 4.5 per cent, versus an estimated 4.8 per cent this year.

The developed world is likely to grow just over 2 per cent, while the emerging world gallops at above 6 per cent. This means that about half of next year's GDP growth will have to come from China and India, and a full two-thirds from emerging markets, if measured on a purchasing power parity basis. While global economic expansion is likely to continue and drive equity and commodity markets higher in the next quarter, the twin risks of debt problems in the developed world and inflationary pressures in the emerging world elevate risk in the year ahead.

In this bifurcated growth scenario, the pivotal role of China should not be underestimated. China will contribute about three times as much as the US to global growth next year. The Chinese economy has been running hard and fast for a decade, but structural issues, policy constraints and upward pressure on its currency mean that growth in the next few years will be slower than over the past decade. A rebalancing of growth towards domestic consumption and investment is likely, thus lowering the contribution from exports.

Because of the strong inflation control measures and withdrawal of stimulus enacted in the middle of this year, growth is likely to slow to 7 to 8 per cent a year, which is still healthy, but slower than the 9 to 10 per cent normal of the past decade. If government policymakers' attempts are successful, growth will be more targeted towards soft infrastructure after overinvestment in hard infrastructure in recent years.

China's policy is aimed at reducing commodity intensity and import dependency, but it will remain the dominant consumer by far in most commodity categories. Therefore, the outlook for commodity prices, and by extension the earning power of large sectors of the global economy, are strongly tied to China's growth rate and commodity intensity.

In the US, the world's single largest economy, aggressive monetary policy easing has reduced concerns of a double-dip recession, but the recovery will remain subdued and below its growth potential of 2.5 per cent, implying a slack economy. This will mute core inflation and offset rising commodity prices.

The drag from consumer deleveraging will continue but will be less severe than this year, since consumer savings rates are already at comfortably high levels of about 6 per cent of disposable income. However, the consumer is likely to remain cautious and fearful of declines in housing. The credit environment remains weak, especially for small businesses, which will crimp the recovery and shift the burden of growth to the labour market.

Only 1 million of the 8.5 million jobs lost have been regained. There has been enough private-sector hiring to prevent the employment market from worsening, but improvements are likely to be slow because some of these job losses are not cyclical but structural. In each of the past three recessions the recovery has been lacking in job creation as outsourcing has increased, and this recovery might be similar.

In refreshing contrast, in the Middle East the fog of uncertainty is clearing. Sentiment has recently improved because of oil prices remaining well above the US$60 per barrel fiscal budget break-even level, successful debt restructuring and the subsequent raising of capital in the UAE. Importantly, additional evidence that requisite reforms to diversify away from hydrocarbon revenues slowly but surely continue, with Qatar's World Cup bid win being the most recent.

After more than a year of negative surprises on the debt management and economic growth fronts, much of the bad news has already been priced in by the Middle East equity markets. While much remains to be done, including strengthening bank balance sheets in UAE and Bahrain and regulatory reform to make key industries more competitive and efficient in Saudi Arabia and Egypt, we believe that next year we will see sufficient additional progress on these fronts. Most global investors are underweight in this region and are likely to incrementally increase allocation here if reforms continue to progress. However, there is a strong dependency on global growth and risk appetite, again underscoring the pivotal nature of global policymaker actions.

When driving in the fog of global policy uncertainty, it is difficult to look farther than you can see. Hence it will pay to maintain a balanced portfolio that includes a mix of risky assets such as equity and commodities to achieve long-term growth objectives while maintaining a sizeable allocation to safe assets such as deposits, short-term bonds, and income-producing property in populous regions. In the early part of the upcoming year, investors should position their investment portfolios positively to capture the growth momentum generated by the recently extended stimulus policies.

However, as valuations and commodity prices rise, the second half of next year will prove to be challenging. So keep driving through the fog, but also keep one foot on the brake pedal.

 

Rehan Syed is the head of portfolio management at the ABN AMRO private bank in Dubai. The opinion expressed is personal