Hatching an investment plan to thrive in the new world order

For all their disagreements about how the global economy is rebalancing and what it means for investment, wealth managers know one thing: if they are going to make sense of it all, they have to start with China. 

The country is coming to the end of a period of high growth characterised by strong exports and heavy investment in manufacturing plants and infrastructure. This ebb means not only much lower growth for China, the world’s second largest economy, but also lower growth – or worse – for many emerging market nations that flourished as Chinese demand for raw materials boosted the price of oil and other commodity prices. 

But the closing of one chapter in the global growth story has not left wealth managers downhearted. The golden eggs of investment which wealth managers always seek – those that will produce good long-term returns if wealth managers wait long enough for them to hatch and grow – are different these days. However, they still look promising. 

The discussion of rebalancing has centred largely on how fast China will grow, and what will fuel that growth. 

“The Chinese economy has expanded at double-digit rates for the past couple of decades because of the offshoring of manufacturing from developed markets, but this period is a one-off,” says Cesar Perez, global head of investment strategy at JP Morgan Private Bank in New York. He notes, for example, that about 90 per cent of the world’s apparel manufacturing is already outsourced to China and other emerging markets, leaving little more to come. 

Chinese GDP expansion will slow to 4 or 5 per cent by the end of the decade, he predicts. Official figures currently put it at 7 per cent, though many economists think it is lower in reality. Mr Perez takes a sanguine view of the slowdown in Chinese growth, despite the important role of the China powerhouse in mitigating the global economic effects of the 2008-9 credit crisis. 

“China is the factory of the world, but it doesn’t buy much from Europe or the US,” says Mr Perez. Exports to China account for only about 1.5 per cent of US GDP, according to JP Morgan’s estimates, and not much more for European GDP. Japan is slightly more exposed, dependent on Chinese exports for about 3 per cent of GDP. 

Although some economists put forward the idea that the US and other deindustrialised developed economies are set for a structural acceleration in GDP growth, as rising Chinese labour costs incentivise US and European multinationals to relocate factories back home, Mr Perez is sceptical. 

“I’m not counting on the idea that manufacturing is brought back to the US,” he says. Economists note that Chinese labour costs are still sufficiently cheap to make it cost-efficient to keep production in China than to return it to higher-cost countries. 

However, the ability of Europe and the US to shrug off any slowdown in China will be greater because they are still in the growth stages of their economic cycles, believes Mr Perez. He notes that in the US, “the credit cycle has just started”. On top of this, US employment is growing. Europe, meanwhile, “has just started the upswing of the economic cycle, from very low levels of demand”. Finally, the fall in oil prices, induced by slowing Chinese growth, represents “a huge transfer of wealth from oil-producing to oil-consuming countries” – many of which are in developed markets. 

The price of benchmark front-month Brent crude oil futures fell to a new six-year low below $45 (€40) a barrel in August, from a high of $116 a barrel in June 2014.  Responding to this sense of optimism, JP Morgan Private Bank is heavily overweight equities versus fixed income, and heavily underweight commodities. It has zero exposure to emerging market equities, and a zero weighting in Latin American assets, given the region’s reliance on commodities for economic growth. 

 “Over a one-year horizon economic leadership will shift from East to West,” believes Didier Duret, chief investment officer at ABN Amro Private Banking in Amsterdam, taking a similarly optimistic view about the upturn in developed economies.

“The cyclical forces are really working in favour of developed as opposed to emerging markets,” he adds, a view based largely on the fall in oil prices, which he describes as “a huge tax break for consumers”. This will, according to ABN Amro forecasts, boost eurozone GDP growth from only 0.9 per cent in 2014 to 1.5 per cent this year and 2.2 per cent next year. US growth will, believes ABN Amro, rise from 2.7 per cent this year to 3.1 per cent in 2016. 

ABN Amro is overweight eurozone equities, which Mr Duret sees as benefiting from the fall in oil prices and broad-based cyclical upturn.  

Like JP Morgan’s Mr Perez, Mr Duret is confident the rebalancing in growth from emerging to developed markets is a cyclical rather than a structural phenomenon – although neither believe China can grow at quite the giddy rates of yesteryear.  

His belief is partly based on the view that China will, like other Asian economies in the past, including Japan, South Korea and Taiwan, manage to progress from a middle-income economy based on low-value production to a more high-value operator, competing on technology and quality. 

Within four to five years the price of oil and other commodities will eventually bounce back as demand rises and supply falls in response to price signals, believes Mr Duret. As a result, “in the short to medium term, the rebalancing away from commodity producers to commodity consumers will play to the advantage of developed markets, but there will be a limit to this.” 

But before this bonanza for developed markets ends, it will deliver a huge bounty.  “The first and immediate rebalancing from developing to developed markets is via the energy bill,” says Christian Gattiker, chief strategist and head of research at Bank Julius Baer in Zurich. 

The dive in oil prices from $105 to $70 gave $1.2tn to the global consumer, equivalent to 1.5 per cent of global GDP – or $700 for the average US household, he points out. Oil prices have, in fact, fallen considerably further than that.

The “second wave” of rebalancing will, says Mr Gattiker, be the shift in capital expenditure from commodity-related to consumer-related investment. He cites the global car industry and US homebuilding as examples. This wave will be generated partly by the first rebalancing, from lower energy bills, which will increase household demand. 

In the US, the massive reduction in household debt – down from 100 to 80 per cent of GDP over the past eight years – removes another obstacle to household spending, says Mr Gattiker. However, this wave could take time: current capacity may still take another few quarters to be filled, he thinks. 

The fall in the oil price will also deliver tax cuts to Chinese consumers, who are already on a spending spree as rising wages catapult more of them into the middle class.  Chinese retail sales were up 10.5 per cent on the year in July, and high growth looks likely in future years. Mr Gattiker cites figures from the Organisation for Economic Cooperation and Development showing that China’s middle class will grow from 300m now to 800m in five years’ time. The fall in the oil price will therefore aid the rebalancing within the Chinese economy from investment to consumption. 

But Julius Baer has not reacted to the prospect of ever higher Chinese consumption by investing heavily in Chinese consumption stocks. It has, to the contrary, recently cut its Asia ex-Japan equities portfolio, following the recent market turbulence, from 6 per cent to 3 per cent of clients’ total model portfolio. This Asia ex-Japan constituent is heavily tilted towards Chinese stocks listed in Hong Kong. 

The best way to tap into the Chinese consumer is to stay in the relative safety of developed market stocks, believes Mr Gattiker. “China will be a huge consumer for generations, and if you want to have a proxy for that, you’re best off with German carmakers and some of the affordable luxury goods makers – not necessarily Swiss watches or LVMH but the likes of Nike and Starbucks,” he says. 

“Global consumer franchises present in China offer the best risk-return environment.” 

Julius Baer’s central scenario of a relatively buoyant and deftly rebalancing global economy is reflected in the 49 per cent share of its model portfolio accounted for by equities. The Swiss bank does not have formal under or overweights, but Mr Gattiker describes this 49 per cent mark as “neutral to positive” compared with its historical averages. 

However, a minority of wealth managers are more cautious about the course of global rebalancing, and its effect on markets, than the private banks discussed above. These relative bears include Société Générale Private Banking. 

“One of the big risks is that the structural economic downturn in emerging markets will not be compensated for by the cyclical growth pick-up in emerging markets,” says Xavier Denis, global strategist for SG Private Banking in Hong Kong. 

Developed economies are enjoying a cyclical upswing, he acknowledges, but is unsure how long this will last before their momentum starts easing, given that their potential growth is “certainly lower than before the financial crisis”. 

Mr Denis is more positive about the US upswing than the eurozone upswing – although he notes that US corporate profit growth, and hence US equities, could be hit by the US Federal Reserve’s first rate rise, which will come “sooner rather than later, and no later than December”. 

In the eurozone, the fall in oil prices and in the value of the currency have boosted growth. However, “the impact is likely to fade away in the coming quarters” – the oil price has “probably bottomed out” and the additional boost to exporters from euro weakness is “probably minimal”, he says. SocGen has a euro target of $1.05, compared with $1.11 in early September. 

“The acceleration of developed market growth is cyclical, so at some point within the next one or two years there’s a big question mark about the strength of overallglobal economic growth,” adds Mr Denis. Acting on this balance between optimism and pessimism, SocGen is neutral global equities, with an underweight in emerging market equities. 

Although most wealth managers are underweight emerging markets stocks, private clients’ appetite for them depends on how long-term a view they want to take. Citi Private Bank is also underweight emerging market stocks, with an overweight in developed market equities. The eventual US downswing, culminating in recession, will “probably mark the absolute low in emerging market performance before the decade is out,” warns Steven Wieting, global chief investment strategist at Citi Private Bank in London – athough he sees recession as unlikely before 2017. 

US downturns often, though not always, lead to a global flight to safety and away from risk assets, such as emerging market equities. But despite this prediction, he sees value in emerging market stocks – noting that, with oil prices likely to rise this year, “the bounce back potential is there”. 

His conclusion: “Valuations are only attractive if you want to invest through the cycle, on a longer time frame.”