In the opening months of 2011 fast-moving events have reshaped the three dimensions economic, financial and geopolitical that frame the investment universe
by Christopher Donay, chief strategist, Pictet
In the opening months of 2011 fast-moving events have reshaped the three dimensions – economic, financial and geopolitical – that frame the investment universe. Moreover, their complexity has amplified the sheer intensity of these developments. These events have raised four crucial threats to the recovery scenario which has been confirmed by several strengthening underlying trends in recent months.
Still, our core scenario for 2011 takes these risks fully into account even though the fourth problem – North African unrest – is comparatively recent. These four questions are: (1) What will happen to the exchange rate regime based on the dollar standard? (2) Will inflationary pressures persist and what is likely to be the impact for growth and exchange rates? (3) Will US growth become sustainable? (4) Will the unrest in North Africa destabilise the whole of the Middle East and send the oil price permanently higher?
These risks over our core scenario of growth and rising equity markets are increasing just as a growing number of investors have been turning more optimistic.
Risk 1: heading for two currency regimes to exist side by side
The first question relates to pressures in currency markets. Emerging currencies remain strong against leading developed-world currencies, threatening their exports. This tendency may encourage more emerging governments to adopt an exchange-rate regime similar to that of China. Beijing’s approach is to disconnect movements in the current-account balance from shifts in the trade balance to stop the Yuan from rising.
If several countries, like Brazil, were to adopt this method of managing exchange rates, two currency regimes would end up existing side by side: a forex market with exchange controls alongside one with flexible exchange rates. This twin-track system is highly likely to lead to dislocations in currency markets and a risk of destabilisation of the global economy. While these risks are rising, financial markets do not seem to be that concerned at this point.
Risk 2: mounting inflationary pressures
Fuelled by rising commodity prices, inflation rates globally are now running above the 1% to 3% range targeted by most central bankers worldwide. The US Federal Reserve does not appear to view inflation as a problem in the medium term, whereas other central banks, such as the People’s Bank of China, have been tightening monetary policy. The purpose of this more restrictive stance is not so much to curb growth, but to clamp down on factors such as excessive lending that could lead to higher inflation. In fact, inflation is not the real enemy since recent price rises are almost entirely due to rising commodity and food prices – in other words an exogenous shock over which central banks have virtually no control.
Risk 3: US growth not yet self-sustaining
The third question focuses on the quality of US growth. The US economy has been on a drip-feed since its upturn began in mid-2009. Growth would have dwindled to nothing very quickly without the stimulus from the economic policy mix. It is crucial that the US economy comes off life-support and moves to a sustainable growth path in the months ahead. At present, it lacks the two essential ingredients in a robust new cycle of growth: jobs and credit. We should know by the middle of this year whether self-sustaining growth has indeed begun because, by then, the Fed’s second round of quantitative easing will be coming to an end.
Risk 4: uprisings and the price of oil
The fourth risk is more recent. Since soaring food prices are unaccompanied by rising purchasing power, people are going short, even to the point of starvation. Food shortages and famine often lie at the root of revolutions. Nobody had expected the governments in Tunisia or Egypt to fall. Today, the Libyan regime is precariously balanced, and even Iran may be at risk. If the protest movements witnessed in North Africa were to spread to Middle East oil-producing states, the price of oil would rocket.
The resultant squeeze on purchasing power would damage growth in the developed world and cause inflation to spiral in emerging nations. It is this fear that seems to be haunting financial markets today, as suggested by the flight to classic safe havens such as gold, the Swiss franc and even the US dollar. While recent events have yet to prompt us to modify our recommended asset allocation, we are keeping a close eye on this geostrategic risk factor in view of its likely implications for portfolio performance.
In an environment in which growth is threatened by the risk factors cited above, we favour a tactical approach to investment. While these four factors will need to be monitored very closely, we remain confident that stock markets will extend their rallies for now.