SOME BIG ISSUES AS SEEN FROM ASIA.

I spent much of last week in the booming cities of Hong Kong and Singapore.  Looking at the world through an Asian lens, here is my take on some key matters relevant to the world economy and markets.

GROWTH MARKETS, INVESTING AND RISK.

I went to the region primarily for two purposes.  One was to participate in the anniversary celebrations of one of the most well-known sovereign wealth funds.  The other was to share the Growth Market theme with GSAM’s clients.

The conference surrounding the celebrations was extremely impressive and the audience included some of the top investors from all over the world. I had the privilege of being asked to participate in two of the three panels, one on the state of the world and the other devoted to emerging markets. The third panel was about investing styles and portfolio construction. Watching that session from the audience, I had two really strong takeaways. The first was that there was quite a lot of evidence shown that efforts to achieve superior returns for a given risk, including attempts to diversify portfolio risk away from the US equity markets, generally fail. Linked to this, evidence suggested that unless investment managers have a policy framework that allows them to act promptly in circumstances of extreme valuation moments, it is virtually impossible to outperform. This is something I have believed for a long time, and it was interesting to see this shown quantitatively.

As for presenting on Growth Markets, perhaps not surprisingly given the locations, investors in Hong Kong and Singapore take to the theme more readily than either Europe or the US.  After all, four of the Growth Markets (China, India, Korea and Indonesia) are in Asia. Moreover, since six of the 11 so-called “Next 11” countries are also located in Asia, this investment theme resonates quite well. 

After my trip this week, what is very much top of mind is linking these two concepts – the idea that investors should stop thinking about these eight economies as traditional emerging economies and the notion that diversification globally has often failed to either reduce a portfolio’s volatility or raise its returns.  In this light, I enclose the latest of our Monthly Insights, which Anna and James wrote this past week.

In this week’s Monthly Insights piece, we try to pour some cold water on the notion that there is no correlation between GDP growth and equity returns. While it is true that historical data can present a dubious case for so-called emerging market  investing, the last decade clearly suggests a different environment.  Furthermore, the whole point of the Growth Markets theme is that the future, at least for some of these countries, is going to be different from the past. In any case, as Anna and James show, what really matters is that valuations and accurate expectations about future growth differ from consensus.

THE CHINESE CYCLE.

Within this context, what is happening to China is always critical to my thinking, and should be to everyone. While I can see why some people think China might deliver GDP growth without decent equity market returns, it is also reasonably clear that neither its economy nor its markets live on the US cycle.  While China’s total return underperformed much of the rest of the Growth Market world over the past decade, it vastly outperformed the US. As I have talked about frequently in recent months, China has moved into a phase where policy is oriented towards trying to achieve better quality growth, as opposed to just growth as a goal. Whether this is going to be good or bad for equity returns remains yet to be seen. My guess is that, if they are successful, it will be extremely bullish.

At the same time, China has clearly lost some momentum.  I was a bit surprised that this didn’t come up more in my meetings this week.  This week’s release of April data firmly confirms my hunch that this cyclical slowdown is happening. It certainly shouldn’t be a surprise to anyone that looks at leading indicators.  As shown below, both the GS Financial Conditions Index (GS China FCI) and the GSCA (GS China Activity Index) have forecasted that this was coming. I suspect that Chinese growth in the next few quarters is likely to be in the 7-8 pct vicinity and that inflation will ease. While China might miss this year’s 4 pct CPI target, I think they will achieve it next year.

If I am correct, then the recent decline in commodity prices makes sense and could continue. In addition, given market valuations, a strong recovery led by domestically-oriented Chinese stocks may happen sometime soon. This could lead to a new leg for many markets, and one not led by the US.

EUROPE AND EMU.

It is also interesting to witness the mood of investors about the ongoing trials and tribulations of Europe and EMU from Asia. While many private market players share the skepticism of many Anglo-Saxon investors, the sovereign wealth fund (SWF) entities seem to be more sympathetic to the view that, whatever the challenge, the policymakers will come up with the right solution eventually.  And, it is unlikely that Greece or anyone else will leave.

It was quite a week again for the challenges of EMU, and it is interesting that it ended with the publishing of a gangbuster German Q1 GDP number. As I repeatedly suggest to people, whatever happens to the Club Med countries, so long as Germany keeps humming, the chances of a pan-Euro area recession are slim, never mind this being a source of a black-swan type of event globally. Ironically, it seems to me that Germany’s cyclical strength adds to the challenges facing EMU since it not only drives Germanic types to want to adopt less dovish monetary and fiscal policies, but it also makes German policymakers think that the right solution for troubled countries is to essentially copy the German model. If life were only so easy.

Anyhow, either way, it seems to me that a bigger risk premia is still necessary for the Euro. I can’t see how it can remain at about 1.40.

THE US. THE PAUSE THAT REFRESHES OR SOMETHING MORE?

Finally, what is really going on with the US? The mood amongst Asian investors appears to be quite divided. Many think that after the modest growth spurt induced by the stimulus of QE2 and fiscal policy post election, the US is back stuck with trying to keep growth in a 1-2 pct range for many years, with risks of another recession present at any moment. Others, probably a minority, think that the recent softening of the data is more of a temporary phenomenon, driven partly by the rise in energy prices, as well as reflecting a decrease in the strong momentum seen since last Autumn. I tend to side with the second more cheerful group.  I don’t observe any signals from leading or coincident indicators to suggest more concerns for now (with the possible exception of job claims). As it relates to global markets, what does seem clear is that with the decline in commodity prices and the ongoing talk of fiscal tightening ahead in the US, the Fed is likely to remain very friendly unless the economy surprises significantly on the upside.

Anyhow,  that leaves one last topic. It is nice to be back from travelling for a few days and see the world with a new record championship holder of the top league in England. Stand up for the Champions!

Jim O’Neill
Chairman, Goldman Sachs Asset Management