Looking Forward

Boston CFA Institute Conference assures investors things will get better

Despite the endless stream of weak economic data from around the world, experts want to assure investors things are better than in 2008.

At the recent two-day CFA Institute Conference in Boston,Mass., the industry’s brightest sliced and diced turmoil in Europe and the U.S., and the topic of capital controls. Discussions were based on worst-case scenarios, but instilled hope for the future.

European trouble

Central bank and policy responses came faster this time around, said Andrew Gordon, managing director and portfolio manager in the European and non-dollar group within the fundamental fixed-income division of BlackRock.

He notes the business sector panicked in 2008, and “did everything to shed a lot of jobs quickly.” This time, the corporate sector globally is in better shape, and there won’t be that kind of job shedding.

RESERVE CURRENCY

Prior to the onset of Europe’s sovereign debt crisis, there were frequent rumblings from Beijing to Tripoli that the Euro should supplant the U.S. dollar as the world’s reserve currency. That debate has ended, and the option of a basket of currencies also appears to be off the table.

“It’s very difficult to supplant the hegemonic status of the U.S. dollar,” said Stephen Yung-li Jen, managing partner of SLJ Macro Partners LLP. He likened it to the globe embracing the English language despite some arguing that “French or Mandarin Chinese are better, technically.”

However, Stephen Yung-li Jen,managing partner of SLJ Macro Partners LLP, said there’s no magic bullet for Europe. “European banks are highly leveraged. The average loan-to-deposit ratio for European banks is about 1:2; they have more loans than deposits,” he said.

Jen likened this scenario to the one plaguing the U.S. “We have a problem of overleverage in the U.S. household sector. [Similarly,] we have an overleveraged European banking sector, and in the coming years it will need to deleverage.”

Trouble is, policy measures employed in the U.S. and Europe are reactions to symptoms rather than true resolutions of root causes like the high U.S. unemployment rate.

“How can one say this is due to insufficient demand, and a little bit of a stimulus and economic [tweaking] will solve the problem?” asked Jen. “We’ve been cutting interest rates, deploying quantitative easing, [but] not addressing the root cause of the problem [crippling levels of government debt].”

What will happen?

So to what extent should we expect further policy action in Europe?

“The last 18 months have shown us it’s hard to have confidence that the policymakers are going to get ahead of the situation,” said Gordon. “But ultimately, [the] answer is common fiscal policy, and common issuance.”

The ECB also needs to deploy quantitative easing, he added.

Industry experts appear united in their view EU policymakers will make the correct decisions when pressed to the extreme. Jen says with the right policy and structural reforms, European bonds will be good investments in five years’ time. “Europe, as opposed to the U.S., has undergone a tremendous amount of structural reform.The crisis has done something that wouldn’t have been possible under any other circumstances.”

Similarly, the 1997 Asian financial crisis “forced Asian countries to start accumulating reserves and cleaning house,” said Jen. “This cleansing process is very important; in the short run you may see pain, but if you do the right structural reforms you will reap the benefits in the long run. I see that [happening] in Europe, despite the complaints coming from Greece.”

Capital controls

Investors should be aware of how countries implement capital controls, so they can anticipate effects on cross-border fixed-income portfolios. Things are changing quickly, notes Tina Vandersteel, fixed-income portfolio manager at Grantham,Mayo,Van Otterloo & Company.

Countries can use a combination of fixed exchange rates, free capital movement and independent monetary policy to enforce capital controls.

“In the first group we have the open capital account inflation targeters—countries whose monetary policy frameworks are designed around domestic infl ation targets,” she said. For the most part, they have open capital accounts and include the G10 countries.

In the second group are the open capital account exchange rate targeters: Hong Kong, Singapore, the Euro constituents, and possibly Switzerland. “Their monetary policy frameworks are a byproduct of their exchange rate targets, not the other way around,” said Vandersteel.

The final group consists of the closed capital account multiple price targeters: China, India and some other emerging markets. “Closing your capital account is about maintaining control,” she said. “In the last crisis they felt like the whole thing was out of control;they like having control.”

After the 2008 crisis, policymakers got concerned about its spread to other parts of the world and added a new goal: domestic financial stability.

Countries that have open capital accounts are enforcing financial stability-oriented rules, generally framed as macro-credential measures. “These […] measures in many cases have the same effect as capital controls,” she said.

On the other hand, closed-capital-account countries have pretty much everything at their disposal. “When a country’s capital accounts are hard- or soft-closed, all of the tools, including fiscal policy, become fair game.”

The aim for closed-capital account countries, she said, is to have two interest rates—one for foreigners and another for locals.

“They can do this through price restrictions [or] through quantity restrictions,” she said. “We’re all offshore investors [and] face difficulties when trying to access these markets.”

Vandersteel likens policy frameworks to fashion. “In the 1997 Asian financial crisis, the IMF was lambasting all of the countries for using capital controls; now it says there are circumstances in which you should use capital controls,” she said. “That’s not new; the IMF has supported them in the past, didn’t support them for a while; and support them again now.”

Anticipating the type and timing of these restrictions is hard and leads to high turnover in the index. “If a country introduces a restriction, they get slashed from the index [such as GBI-EM indices, comprehensive emerging market debt benchmarks that track local currency bonds issued by emerging market governments], and as they take away the restriction they go back in the index.”

Active managers, therefore, need a broad toolkit, which includes onshore bonds, offshore bonds and a whole host of derivatives, to deal with these complications.

Vikram Barhat is Content Editor of Advisor Group.