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11.10.2010

Recognising growth markets

It is the scale of countries’ economies and their growth that matters for investors’ wealth preservation not simply the scale of the press headlines their problems produce.

Let us imagine such a scale adjusted headline: “Greek economy collapses, Greek GDP falls to $0. Resulting loss of value is equal to 4months growth of GDP in China.” It is the lack of a sense of proportion that, we believe, is creating a huge distortion effect on investors’ priorities. Get your sense of proportion correct and you will see the world as it really is. To act on this different perspective you must look east, but you may need to invest west to do so in a well informed way.
 

Market Uncertainty
Events during the last week, which saw global equity markets fall by over 10%, have contributed to investor uncertainty. This was most evidently marked by a downgrade of US Government debt by Standard and Poor’s to AA+ from AAA.

Greater problems for the markets, however, stemmed from the Euro area and the perceived need for the European Central Bank (ECB) to buy Italian and Spanish bonds. These concerns over government bond markets seems to be sending investors in the direction of what they saw as “safe haven” investments such as gold, the price of which reached a record in excess of $1,700 per oz, and also into Swiss Franc deposits and US government bonds.

Both the US and Euro area issues have shown considerable weakness in political decision making processes which has reinforced the sense of uncertainty and concerns over growth prospects. It can be hoped that the Euro area will develop the institutions necessary to run the Euro area but the fundamental problems created by the different economic performance of euro area countries within a single currency area, will continue.

In the US the downgrade of Federal Government bonds may however have significant indirect economic benefits for China and the USA. China, having dealt with problems of its export led growth policies may begin to focus more on domestic oriented growth. Greater emphasis placed on Chinese consumption resulting from a rising Renminbi / US$ exchange rate would be very positive for the world.

A Focus on Emerging Markets
The world’s emerging market economies have continued to exhibit strong growth over the last 15 years; a period that has seen more of the world’s population raise themselves out of poverty than in the previous half century.

Until 2007 this growth had occurred in both emerging market countries and in developed countries but, as a result of the recession that followed the Lehman Crisis, the world has changed. Whilst the emerging markets have continued to grow rapidly a number of developed markets have entered into a prolonged period of very low growth accompanied by rising levels of national debt and in a number of instances a continuing banking crisis.

Equities
In fast growing economies it can be very difficult to gauge the potential success of any individual company. Information flows on companies quoted on local exchanges can often be much less and of much lower quality than in more developed markets.

Moreover many companies will either be in government or private ownership. Where shares are quoted this may only be a relatively small percentage of the total shares leading to volatile and illiquid securities markets. Shares on emerging markets exchanges also often trade at much higher earnings multiples than those in developed markets.

An alternative strategy for investors considering an emerging markets portfolio is to review companies positioned in developed markets, which have significant exposure to these markets.

Debt
The current debt crisis in Europe and the US is, we suggest, likely to lead to a revision of the way rating agencies look at government debt. The importance of economic growth is likely to become more highly weighted in their analysis to the benefit of the ratings of many emerging markets governments debt.

Emerging market countries such as Indonesia that issue Sukuk may well see their ratings systematically improved if this happens. It is also worth considering which countries have significant exposure to emerging markets though in many cases such as Germany, Canada and Australia this is arguably already priced in and such countries do not issue Sukuk.

Property
In the global property market, emerging and emerged markets have seen significant bubbles burst in commercial property; however this is not a wholly uniform picture. The London market has revived very significantly since the downturn that occurred after 2007.

London is the world’s pre-eminent global financial centre and capital inflows and outflows to emerging markets has grown substantially in recent years. Emerging market banks, insurers, sovereign wealth funds are a growing presence in London and so is their demand for property.

In the office, student and prime residential sector, the UK remains a top location for foreign investment.
 

Soft Commodities
Never before has the issue of food supply been more important in the minds of governments and populations around the world. Erratic weather, a finite amount of arable land, misguided government policies, population growth and diet change have all combined to place huge stress on the food supply.

Price rises last year were fundamentally driven by severe imbalances between supply and demand. In the last 12 months corn prices are up 62%, coffee 52%, sugar 83%, soybeans 38%. Competition for alternative fuels and their respective feed-stocks have combined with politically motivated and misguided government policies to make a bad situation worse.
 Industrial Metals
The exceptional pace of economic growth in the industrializing countries of the Far East has had a major effect on the long term equilibrium price for industrial metals such as copper, nickel, tin, zinc, iron and steel. In non-ferrous metals the far Eastern demand has resulted in pre-recession prices in developed markets whilst iron ore prices have risen well above pre 2007 prices.

Whilst the current pace of such development may slacken off this is unlikely to change the overall outlook as producers have been struggling to increase production to meet the growth in demand. The cost of incremental production has in many areas been rising substantially again contributing to a rising equilibrium price.

A number of globally important mining companies now have very large cash balances in their balance sheets and whereas this is usually associated with acquisition activity it is possible that this may also lead to a substantial improvement in cash returns to shareholders, making mining companies look more like “big oil” a move that would probably lead to a re-rating of the shares, to the benefit of existing investors.
 

Gold
Gold is seen by investors as a safe haven in troubled times, and this role for gold is historic and related to its role to back the value of currency.

Gold still constitutes an element of the reserves of most of the world’s central banks. The economic demand for gold in electronics and in the jewelry trade constitutes about 12% of demand and 27% respectively.

Currently gold prices at more than $1,700 per ounce are at record nominal prices in US dollar terms and those confident in the longer term price outlook for gold might like to look at the share prices of some producers which do not appear to reflect current prices.

Those who wish to trade gold may like to consider exchange traded funds (ETFs).
 

The emerging market economies now account for about 50% of world GDP. Should investors move their investments towards these fast growing economies? Investing in emerging market economies, it seems is not necessarily a simple proposition.

*Brandon Davies is a non-executive director at Gatehouse Bank. He lectures extensively on subjects in banking and risk management and has written numerous papers for Cass Business School, London School of Economics, Lombard Street Research and the Financial Times . Brandon has over 40 years of work experience in the banking sector, his positions included Head of Retail Market Risk and Treasurer of the retail businesses of Barclays Bank, and was also a member of its executive committee.

Disclaimer: Please note that the content of this market report has been prepared for information purposes only and does not constitute legal, investment, tax or any other advice whatsoever. No representation, warranty or undertaking, express or implied, is made and no responsibility is accepted by Gatehouse Bank Plc as to the accuracy or completeness of the information contained or incorporated herein. For the avoidance of doubt, Gatehouse Bank Plc accepts no liability whatsoever in relation to the information contained in this market report. Investors should conduct their own independent assessment and seek professional financial, tax and legal advice in connection with this information. To the extent permitted by relevant laws and regulations, prospective readers agree to waive any rights they may have against Gatehouse Bank Plc arising from or in connection with this market report.