Europe’s woes to continue

The debt crisis in the Eurozone periphery and the political debate over the debt ceiling in the U.S. are a “hangover from a rip-roaring, pre-crisis party” in much of the developed world.

In a reversal of fortunes, many troubles of the developing economies are now the plights of the developed world, according to Philip Poole, Global Head of Macro & Investment Strategy, HSBC Global Asset Management.

Poole identified these issues as fiscal irresponsibility, high levels of government indebtedness, weak banking systems and central banks that directly monetise government deficits.

“As a result, sovereign risk has become a key concern for the developed world with sovereign debt ratings under pressure in both the periphery and the core,” he said. “Following the debt crisis of the 1980s, emerging market recovery was littered with crises and defaults; the risk is increasing that this will also be a feature of the future adjustment path in the developed world.”

European woes to continue

The Eurozone periphery has been the major focus of investor angst so far this year. The austerity programme for Greece failed to restore market interest in the country’s debt, hence the need for an additional bailout package.

“In the absence of a comprehensive, sustainable solution to the problems in the periphery, the risk of contagion is likely to remain an overhang for markets for years to come,” said Poole.

Unfortunately, he added, the problem of leverage in the government sector is not limited to the Eurozone periphery; it is also a problem for the core of the developed world. While European governments are at least starting to tackle the issue by curbing fiscal deficits, the U.S. has so far failed to act.

“Rather than addressing the disturbing deterioration in fiscal and debt metrics the U.S. administration has continued to spend,” he said. “This is a much bigger concern than the short-term focus on raising the debt ceiling and rating agencies are now threatening to downgrade the U.S.”

Low political will, high dependency

This U.S. deterioration is the culmination of more than 10 years of fiscal laxity from a combination of tax cuts and spending increases, aggravated by the impact of deep recession which further cut revenues and increased spending, he said.

“The U.S. has been in denial; the U.S. fiscal deficit will remain at an unhealthy 11% of GDP this year (IMF forecast.),” said Poole, adding that the fiscal implications of an ageing population add a disturbing structural component to the longer-term challenge of reining in the deficit.

An ageing population increases dependency ratios, pushing up the cost of entitlement programmes and eroding the tax base as the proportion of workers in the population falls. Poole warns this will happen quite rapidly and will have investment implications.

“With roughly 50% of marketable Treasury securities held abroad, the dollar will likely be vulnerable to negative developments on the debt front, but failure to generate a credible plan to stabilise U.S. government debt ratios would likely have a negative impact on risk appetite more generally,” he said.

Emerging markets story

Given the debt problems of the developed world, Poole is bullish on emerging markets debt and equity themes. “Quality emerging market corporate and, in selective cases, sovereign credit spreads still also have room to tighten further in our view as investors search for yield, once risk appetite returns,” he said.

So far this year developed world stocks have outperformed emerging markets stocks. Poole considers it a “one-off rotation as a result of investors re-pricing an improved view of the sustainability of developed world growth.” In the future, he said, the developed world’s need to deleverage is likely to have negative implications for companies operating there.

Given the very high levels of volatility, he recommended investors seek out thematic anchors where the fundamental rationale is strong. “These are likely to be mostly emerging market themes but should be played through a global portfolio,” he said.

Such themes include overweighting emerging consumption via emerging and developed market stocks exposed to the theme. This can be done by identifying sectors and companies that will perform well/poorly as a result of this trend and bias the portfolio to overweight/underweight accordingly, he said. The same approach should be used to play the emerging infrastructure story.

“In markets like India, Indonesia and Russia there will need to be huge infrastructure spending if growth rates are to be sustained,” said Poole. “Rapid urbanization will also power the investment process in many of these markets.”