CHALLENGES IN THE NEW WORLD ORDER AND EGYPT.

Once again, the annual Davos parade takes place against the background of some unanticipated news. This weekend, the thoughts of the great and good will be overshadowed by the events unfolding in Egypt and in the surrounding region.

The Egyptian troubles come towards the end of a January that has seen a marked split in global markets, with the rather unfashionable US and, even less fashionable European peripheral markets, outperforming the very fashionable new world. Even after the sharp drop in the S+P and other major US markets on Friday, they are showing a small gain for the year so far. In contrast, some of last year’s stars from the so-called emerging world are down close to 10 pct. Of course, Egypt, which was closed towards the end of the week, has performed even worse. In the BRIC world, unfashionable Russia is up, while the other three are all down. India is down just over 10 pct. Contrary to popular opinion, China is holding up reasonably well, down only 2 pct.  Within the Next 11(N11) countries, of those with investible indices for most investors, 6 of them are down year-to-date, with Bangladesh the worst aside for Egypt. Four of them are still up, however, with Nigeria up 10.4 pct, joined by Korea, Pakistan and Vietnam. As with many indicators, the N-11 is quite a diverse bunch.

THE CORE G7 ON THE WAY UP.

In an odd way, the biggest immediate dilemma, even before the North African developments of the past week, is the growing evidence of a recovery in the US and the rest of the G7 core economies. We had a lot more evidence last week. While the US Q4 GDP number was not far off consensus, the breakdown was quite different. A large drop in inventories, together with a sharp improvement in the external balance, was both considerably larger than generally expected. Moreover, the inventory decline sets up Q1 for a strong start pending forthcoming data. Another good manufacturing ISM, to be published February 1st, and the mood of an improving US economy will broaden to more observers.

In Germany, the evidence continues to suggest something a boom is taking place -- a point that perpetual European worriers need to still get their minds around. The recent IFO and the flash PMI both suggest acceleration, and the anecdotal evidence is abundant. I had the pleasure of my first ever visit to Mannheim last week and heard plenty of stories of economic life. And, the Financial Times Company section Friday carried an article about remarkable employment expansion plans at Bosch, Siemens and Volkswagen.

Even one or two of Japan’s recent indicators suggest they might be capturing some benefits from this upturn.

When I suggest this is a dilemma for investors, it is because of the “lazy” view that a weak cyclical and structural G7 economy is why it is such a good time to invest in so-called emerging markets, or as we will be referring to the larger ones, Growth Markets.

As always, life is more complicated, and one of the main cyclical characteristics of early 2011 is likely to be an accelerating G7 (including the UK, despite the quite remarkable paranoia here still) and some slowing in key parts of the Growth Market world.

What adds to the dilemma is that inflationary pressures in many Growth Markets are present, which means monetary policy has to tighten. Their challenge is possibly increased by the reluctance of G7 policymakers to be too concerned about rising commodity prices, which for the G7 economies is less problematic, or at least that’s what they perceive.

GROWTH MARKETS AND THE WORLD CYCLE.

As I have to remind both myself and many clients frequently, there is a very close relationship between greed and fear. As it relates to the major topic of our investing era, conservative investors are generally reluctant to embrace the “Growth Market” concept and treat Emerging Markets with the caution that much of the last 40 years would warrant. At the margin, of course, periods of strong outperformance of those investments inevitably drags more into these markets, even those highly dubious. At the other extreme are a few more experienced investors that regard the idea of abandoning the EM (Emerging Market) concept more readily.

As I shall discuss more below, events such as those that broke out in North Africa in the past week, should probably be viewed in this context.

Before I offer some tentative comments about the importance of the Egypt issue, let me remind you of some core views;

1.     The surprise of 2011 might indeed be the recovery of the US economy, and I suspect growth could still be above current consensus estimates. As a result, US equities and the US$ might outperform many other markets, especially early on in the year.

2.     The structural issue of our time however, is the development of the so-called BRIC – Brazil, Russia, India and China – economies, and those of the N11. Moreover, for those of them that are currently experiencing above-trend growth and inflation pressures, it is very important that policymakers slow the momentum of growth in order to support their stronger medium-to-long term outlook. This is especially important for the rise of their consumers.

3.     Within the BRIC equity markets, at current prices, China and Russia are more attractive than Brazil and India. In a new monthly commentary that we will start publishing this week, we will demonstrate these relative valuations for the BRIC economies through an Equity Risk Premia (ERP) approach.

4.     The N11 economies include Egypt, of course, and hence we see once more what a diverse group they are.

5.     We will also publish an article shortly, showing why 4 of the N11 economies, along with the 4 BRIC countries, should be regarded as “Growth Markets” in terms of investing. Egypt is not one of them, as it is not large enough to meet our definition and its Growth Environment Score (GES) is quite low.

 SOME ISSUES SURROUNDING EGYPT.

Egypt is a large country in terms of its population, around 80 million.  That’s why it is one of our N11 economies. A sustained crisis in Egypt that depressed the real economy significantly would certainly be more relevant globally than the troubles of either Greece or Ireland. That being said, the current size of the Egyptian economy is about $200 bn, so, like many of the other shocks that have tested the post-crisis bull market since April 2009, it is emanating from another relatively small economy.

As far as it’s fundamentals are concerned, within the N11 group, Egypt currently has a GES score of around 4.22, the 8th in the ranking of all 11, above only Nigeria, Bangladesh and Pakistan. It scores considerably below the strongest of the group including each of those that we describe as “Growth Economies”. Moreover, it has one of the lowest improvements in its GES scores of any of the BRIC and N11 economies in the past decade.

Within the variables that influence the GES scores, Egypt scores relatively poorly on key macro variables, notably its fiscal position, both its deficit and the amount of government debt. Importantly, its external financing position is not so concerning however, and its current foreign exchange reserves are much bigger – around $38 bn – than overseas investments in interest bearing instruments. Amongst its micro variables, Egypt scores low on a number of technology indicators and, linked to the current crisis, it scores quite low for political stability and other key variables.

Of course, the markets’ concerns about Egypt go well beyond its direct economic importance. A long time key ally for the US, Egypt has played a key role in the complex environment that is the Middle East. And, linked to this, markets will be highly focused on the risks of a further broadening of protests in other countries, and because of the region, oil prices.

In this context, decisions in both DC and Cairo are likely to be similarly important in coming days.

What is so important about the disturbances are that they appear to have originated because of what happened in another country, Tunisia.  So, observers have to consider not only how this will develop in Egypt, but whether it will provoke similar protests in other countries around North Africa, the Middle East, and indeed, elsewhere in the world.

Such uncertainty almost definitely warrants a higher risk premia for all financial markets. However, in the context of how I study these issues, the lasting consequences are what is likely to happen to the variables that influence Egypt’s Growth Environment Scores and those of any other countries embroiled in similar troubles in coming days. As I mentioned earlier, Egypt’s GES scores are both one of the lowest of the N11 Group and one of the least improved. If the consequences of this crisis were to improve this, then the higher risk premia we might now experience would be worthwhile.

A FINAL NOTE ON THE UK.

Last week included a much unexpected 0.5 pct decline in UK Q4 GDP.  Not surprisingly, it was pounced upon by all the gloomier commentators and seemingly gave the hyper-sensitive media another excuse to delve into UK soul searching. While coincident and lead indicators suggest that the UK certainly slowed from the strong momentum of the middle of last year, there are few signs that support the Q4 GDP estimate beyond the atrocious December weather. In fact, the anecdotes I hear from more and more non-financial business people get better. The PMI surveys in the UK this week will be even more interesting than elsewhere.

Jim O’Neill
Chairman, Goldman Sachs Asset Management