The Holy Grail

Rapid economic growth is the Holy Grail for policy makers. Achieving high rates of economic growth, preferably in a low inflationary environment, is the stuff that generally keeps voters happy and gets politicians re-elected. From an investor perspective as well, strong economic growth, or its absence, can have a big influence on short-term portfolio returns, although the impact on corporate profitability and dividend payments is not always clear cut. Faltering developed world economies and rapidly expanding emerging economies have, together, already produced a dramatic shift in the centre of gravity of the global economy. Populous emerging markets have been instrumental in driving global growth in recent years with countries like China, India and Indonesia growing much more rapidly than developed world economies. We believe this is likely to continue to be the case with the developed world effectively locked into low growth for an extended period. Much of the eurozone risks a re-run of the Japanese post-1980s' experience with a decade (maybe more) of low growth, even if structural reforms are enacted to improve competitiveness. This fate also looks to be on the cards for the UK. Despite a corresponding need for fiscal consolidation, the future for the US looks brighter. They have their own challenges but we believe emerging economies are likely to grow more rapidly than the developed world. More positive demographics and rapid urbanisation are likely to continue to support growth prospects relative to the developed world, although to be sustainable these economies will need to enact structural reforms to raise productivity.
Somewhat counter-intuitively and contrary to popular opinion, there is not always a clear link from economic growth to the performance of equity markets. Strong economic growth is often good for corporate profitability because in such circumstances corporate pricing power generally improves, helping to support corporate earnings but the starting valuation for an investment is also critical to eventual long-term returns from stocks. Because of a positive growth differential as well as current undervaluation in some cases, we expect that many emerging currencies are likely to appreciate against developed world currencies over the longer term. We believe that this appreciation is likely to add to the attraction of local currency denominated equity and bond holdings in emerging markets for developed market investors.


'Abenomics' - a new phenomenon in Japan

Japan's government strategy to overcome deflation and promote economic growth is gradually being put in place. The openended, large scale quantitative easing program announced by the Bank of Japan in early April, according to which the monetary base will be increased by about JPY140 trillion, or USD1.5 trillion, by end-2014, is meant to be the cornerstone of what is being referred to as 'Abenomics', after prime minister Shinzo Abe. We believe it has a reasonable chance of curbing deflation and yen appreciation expectations, which in turn will have a positive impact on expected asset returns, at least for the time being. However, 'Abenomics' is essentially a demand-side policy that doesn't address the key supply-side bottlenecks in the economy, especially the very adverse demographic situation. Not only is the working age population shrinking, so is the total population. For this reason, to be successful in the longer term it needs to be accompanied by fundamental economic reforms.


Focus on 'frontier markets'

The term 'frontier markets' is commonly used to refer to economies that are capable of becoming the next generation of emerging markets. They are countries that have typically enjoyed high economic growth rates but have made limited progress towards either political or economic stability, or in developing liquid and efficient capital markets. Since global frontier markets have historically been among the least correlated with other equity classes, and are also lowly correlated between individual constituent countries, they can provide diversification benefits. This is appealing from an asset allocation perspective as it provides an opportunity to improve the risk/return profile of overall emerging markets portfolios.


Ask the expert - forecasting foreign exchange rate

At HSBC Global Asset Management our interest in foreign exchange (FX) rates stems mainly from their impact on our investors' returns when they buy assets outside their home country. For this reason our focus is on forecasting changes in spot FX rates over a 5-10 year horizon. In this article we describe our approach to forecasting changes in FX rates. The approach is based on a modified form of so-called 'purchasing power parity' (PPP), the idea that the same basket of goods and services should cost the same in different countries. We modify this approach to take into account the tendency for the currencies of emerging market countries to persistently trade below their PPP values. Using current estimates for PPP FX rates and GDP per capita with forecasts for inflation and economic growth we forecast future 'fair value' exchange rates. The best estimate of the change in the market FX rate over a multi-year horizon is that it will move from its current level to this fair value level.


Navigating markets

Overall, global equity markets traded higher in the first quarter of 2013, as at the end of last year the US Congress eventually came to an agreement over how to deal with the 'fiscal cliff' and given a general improvement in global economic data. Various indications from leading central bankers that monetary policy is likely to remain extremely loose also helped to support risk appetite. However, there was divergence in performance between regions. Japan was the best performing major advanced economy stock market on expectations of aggressive policy stimulus and the US also performed well, hitting fresh all-time record highs. In Europe stock market performance was more mixed as economies in the region continue to struggle. We maintain our view that current valuations appear to bode well for long-term equity market returns, especially relative to core government bonds. In addition, the underlying fundamentals for the US economy are gradually improving and central banks are likely to continue to provide substantial liquidity, for example, with the Bank of Japan having recently announced much more aggressive monetary easing.


Global data watch

In our global data watch section we review how economic data releases have been coming through, how consensus economic forecasts have changed and how financial markets have performed. Growth in the US came in slightly weaker in Q4 2012 and conditions in the eurozone deteriorated further. Consumer spending in much of the developed world has weakened from already low levels, being particularly anaemic in the eurozone. Although US unemployment is off its highs, it remains elevated relative to the Fed's explicit target of 6.5%. Emerging markets growth has stabilised somewhat and a number of key economies, including China, posted higher growth rates in Q4 2012. Latest consensus forecast data shows downward revisions to economic growth expectations for the US and the eurozone in 2013. By contrast, in Japan growth rates for 2013 and 2014 have been revised up since our previous publication was released. After performing well in 2012, risk assets mostly put in a decent performance again in Q1 this year. Improving macro data out of the US coupled with Congress eventually coming to an agreement in regard to dealing with the fiscal cliff helped risk appetite. Expectations of further monetary and fiscal stimulus measures from Japan also helped market sentiment.