Jeremy Lawson

Standard Life Investments, the global investment manager, believes that differences in financial vulnerabilities can help investors choose which emerging market to invest in for 2016.

Emerging markets have experienced several years of relative underperformance. In 2016, they will face considerable external headwinds such as China’s slowdown and rebalancing, weak commodity prices, higher short-term US interest rates, and possibly further US dollar appreciation. Countries will react in different ways to these pressures depending on the extent of any imbalances and their own economic and institutional characteristics.

In the latest update of the Standard Life Investments emerging markets heat map (page 3 in the attached report), Chief Economist Jeremy Lawson and Emerging Market Economist Nicolas Jaquier highlight important differences in their risk ratings of individual countries:

Jeremy Lawson said: “In May our heat map proved to be a useful indicator of subsequent asset price movements. Countries like Hungary, Korea and Russia showed relatively low risk and generally fared better than those at the higher end of the spectrum such as Brazil, Turkey and Peru. Looking forward, widespread currency depreciation has helped to reduce external imbalances in many countries, although domestic imbalances remain widespread and will take much longer to be addressed.

“Venezuela and Egypt, with pegged or inflexible exchange rate regimes, remain the countries where our heat map shows risks are highest. Brazil and Malaysia have lowered their risk score after seeing their basic balances improve during the year, though risk is still high. Turkey’s external vulnerabilities are unchanged broadly, despite the benefits of the drop in oil prices.

“Whilst Colombia’s external variables improved marginally, this was offset by rising domestic imbalances. The outlook for fiscal balances has deteriorated notably in Latin America and Russia, and a marginal worsening of domestic balances led to a slight increase in risk for India, Indonesia, Mexico and The Philippines.”

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Jeremy Lawson

The quarterly Global Outlook from Standard Life Investments considers how investors’ portfolios should be positioned for the next phase of the cycle, after a prolonged period of financial stress.

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Jeremy Lawson

Standard Life Investments, the global investment manager, has investigated the unprecedented factors keeping US bond yields so low. In the latest edition of Global Horizons, “A Brave New World for Bond Markets”, Jeremy Lawson and Sebastian Mackay look at whether bond markets are pricing in a great stagnation and how yields are likely to evolve through the rest of the business cycle.

Jeremy Lawson, Chief Economist, Standard Life Investments said: “These are highly unusual times in the world of fixed income. The factors weighing on bond yields are numerous, complex and in some cases, unprecedented. In this paper we take a deep dive into what determined the shifts, and identify the structural and cyclical drivers restraining bond yields. Our analysis has uncovered a number of important economic and policy drivers of this low US and global interest rate environment.

“Aftershocks of the financial crisis are still being felt, seven years after Lehman Brothers collapsed. Our analysis shows that the scarring from the crisis and prolonged private sector deleveraging has raised desired savings, weighing on domestic demand and inflation. Weakness in domestic demand in advanced economies has been amplified by policy mistakes and this has depressed labour markets, discouraged firms from investing, and held down inflation. Productivity growth, which had been in decline even before the crisis, has weakened further, underpinned by the drought in private and public capital spending.

“Both by accident and design, central banks and regulators have been pursuing policies that lower real interest rates and term premia, enhancing the demand for all income yielding assets. Central banks have been forced to keep short term interest rates at or even below the zero lower bound, and to put in place unconventional policy measures aimed at suppressing real interest rates along the entire yield curve.”

Jeremy Lawson continues: “Looking ahead and taking account of these special factors – why should the market change its mind and begin to anticipate higher long term interest rates? We examine the potential triggers for long-term bond yields to shift in the US. If recoveries in the advanced economies become more self-sustaining and if emerging market economic and financial conditions do not deteriorate further, inflation expectations could pick up. The Fed should be willing to accommodate some increase in real interest rates. Investors might also demand more compensation for holding long-term interest rate risk.

“We conclude that it is unlikely that the long term interest rates will return to their pre-crisis norms. Our research suggests that the benchmark US 10 year government bond yield will peak at 3 to 4% during the current business cycle. This would be above today’s levels but well below the peak of previous business cycles.”

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Jeremy Lawson

Research from Standard Life Investments, the global investment manager, suggests that the biggest threat to the global economy is currently China.

In the latest edition of Global Outlook, Standard Life Investments investigates what is driving China’s growth slow-down and looks beyond simple GDP figures.

Jeremy Lawson, Chief Economist, Standard Life Investments, said: “China is seeing its slowest rate of economic growth since the financial crisis, along with rapidly declining commodity prices, falling export trade and a dramatic deterioration in nominal activity. However, the epicentres of China’s economic problems are the industrial and property sectors.

“Growth of industrial output has declined from 14% in 2011 to around 6% in 2015, whilst industrial electricity consumption is in outright decline. China’s trade with the outside world is falling, and real estate investment – the primary engine of growth until last year – is going through a prolonged slump.

“The main components of activity preventing a deeper downturn are: private spending on financial services, government-led spending on transport infrastructure, retail sales and services-led electricity consumption. This suggests that China has begun the rebalancing towards a more sustainable, consumption-led growth model – although it’s too early to claim success.

“A hard landing in China would obviously be a large negative shock for the global economy, representing as it does 12% of global GDP and 18% of global manufacturing exports. Some countries stand to lose the most from any failure of China to stabilise growth. On the commodities front, countries like Australia, Brazil, Canada, Chile and Peru stand out. In manufacturing – Hong Kong, Korea, Malaysia, Singapore and Taiwan are most exposed. Whilst developed economies like Germany export a sizable amount of capital goods to China.

“There is good news – our research shows that most of the emerging markets are in a much better position to withstand external shocks than they were in the 1990, thanks to improved fiscal and monetary frameworks.

“Overall, the government has stepped up the pace of structural reforms – liberalising the financial system, cracking down on corruption and loosening fiscal policy, albeit in a targeted way. As a result we expect there to be modest success in boosting GDP although the longer-term glide path is towards slower growth.”

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Countries such as Mexico and India generally look safer now, while conditions in already risky countries like Brazil and Malaysia have deteriorated further. The largest reduction in vulnerability was in Ukraine and Russia, thanks partly to better management of monetary policy, although this could change if there is a re-escalation of conflict between the two countries.

Investing in Emerging Markets continues to prove challenging and volatile, but Standard Life Investments has produced a heat map to assess the vulnerability of emerging market economies to future shocks. The map and research will be updated every six months to help investors and fund managers improve their understanding of the large amounts of economic and financial data and potential threats currently facing emerging markets.

Jeremy Lawson, Chief Economist, and Nicolas Jaquier, Emerging Markets Economist for the Emerging Market Debt team created the heat map in October 2014 and produced an update in May 2015 which incorporates data following the two main shocks in recent months – the collapse in oil prices and sharp rise of the dollar (page 5 in attached Global Strategy PDF).

Jeremy Lawson, Chief Economist, Standard Life Investments said: “Risk improvement was particularly prevalent in Eastern European countries such as Poland, Hungary and the Czech Republic, thanks to improving fiscal policy and falling inflation. Mexico and the Philippines which scored amongst the most resilient back in October also continued to strengthen – as a large oil importer the Philippines benefitted from falling oil prices. India and Indonesia were also out-performers, cutting fuel subsidies and spending more on infrastructure.

“At the other end of the spectrum, vulnerabilities are heightened in economies with large macroeconomic imbalances or reliance on exporting commodities, such as Brazil, Chile, Malaysia and Turkey.

“The dispersion of risk highlights that emerging markets should not be analysed as a homogenous group, it’s essential that investors adopt an active unconstrained approach. Whilst emerging market risk remains well below pre-Asian crisis levels, the next challenge ahead will be the beginning of the Federal Reserve’s rate hiking expected in the second half of 2015 – it’s the pace of this that will prove critical.”

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Standard Life Investments Global Perspectives.

Standard Life Investments, the global investment manager, has examined the long-term drivers of the changing share of national income between labour and capital.

While some of the factors affecting income shares and income inequality may reverse in coming years, pressures are growing on politicians to act. Governments should keep in mind that they are best pursuing policies that have the double dividend of lowering inequality and boosting economic growth.

The latest edition of Global Perspective examines changes in the way that national income is distributed within the developed world. Not only has labour’s share of national income fallen in most OECD countries, but there has also been a widespread increase in income inequality. Both country-specific and global factors lie behind these trends. The key factors include globalisation, technological change, tax policy and changes in workers’ bargaining power.

Jeremy Lawson, Chief Economist, Standard Life Investments, said: “Our findings show that there are significant implications for financial markets, not only as the economic cycle moves forward and structural drivers alter but also as pressures grow on governments to act.  We expect the economic recoveries taking place in most countries to generate a modest increase in labour income shares as unemployment falls away,  although it is unlikely to make up for the losses of previous decades. That implies that the corporate profit share of income should fall but not far.

“If market forces are not able to generate a more equitable distribution of society’s resources, governments will come under pressure to act. For example, earned-income tax credits, other well targeted fiscal transfers, and active labour market policies all strengthen the incentives to work, or rewards from employment, and are therefore more likely to have a positive growth trade-off than sharply raising marginal income tax rates or strengthening employment protection. Slower acting but equally important are educational and training policies that raise the human capital/skills of lower income workers.”

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Speaking yesterday in Sydney, Jeremy Lawson, Chief Economist, Standard Life Investments said: “Australia should act now to reverse its structural fiscal slippage, with a rise in taxes and a drop in spending both necessary for better fiscal control.”

Australian governments have rested on their fiscal laurels during the commodity price boom and rather than squirrel large surpluses away for a rainy day, governments have satisfied voters’ appetite for lower taxes and more generous spending.

“Australia’s tax share of GDP has declined by 1.3 percentage points (ppts) since 2003, despite the increase in government finances generated by the commodity boom and rapid income growth before the global financial crisis. Only five other OECD countries have seen larger falls. Meanwhile, Australia’s government spending share of GDP has increased by 2 percentage points over the past decade, slightly above the OECD average, and could continue to rise.

“Australia’s aging population alone could add more than 5 percentage points to the budget deficit over the next 40 years, mostly due to rising health care spending. Australia’s public finances will deteriorate over time without action to raise taxes and restrain spending.

“Our view is that long-term fiscal consolidation of the magnitude required will have to involve rising taxes as well as greater spending discipline. The states and the Commonwealth must work more cooperatively for the fiscal situation to improve. The states cannot raise enough revenue to meet all of their spending obligations and rely heavily on tied grants from the federal government, as well as GST revenue, to make up the difference.

“Although centralising more spending responsibilities within the federal government structure would better align revenue raising powers with spending responsibilities, a superior course of action would be to devolve more revenue raising powers to the states. That would better provide them with the means and incentives to appropriately manage their fiscal arrangements.

“Moreover, the management of the federal budget has been poor for more than a decade. The Parliamentary Budget Office should be given more formal responsibility for monitoring the federal budget and ensuring that policy is consistent with longer-term fiscal sustainability.

“We recognise that there are no easy solutions to this problem. If, however, governments and oppositions wait too long to confront the country’s long-term fiscal challenges, Australia could eventually lose its safe haven status. That would raise government and private sector borrowing costs, as well as reduce demand for riskier Australian assets, making everyone worse off.”

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More reform needed: Standard Life Investments

Standard Life Investments, the global investment manager, believes the underwhelming response of Japanese exports to the plunge in the yen should serve as a warning sign to Japanese policymakers that more reforms are needed, both at government and corporate levels.

The latest edition of Global Perspective examines why the recent sizeable depreciation of the yen has not had more of an impact on Japanese exports. Detailed analysis shows a range of long term factors at work.

The report highlights that widespread structural reforms, including changes to the tax system, labour market institutions, innovation policies, product market regulations and corporate governance, must be recognised as being just as essential for restoring Japan’s external competitiveness as they are for revitalising the domestic economy. If the so-called third-arrow agenda continues to disappoint, then the long-term decline in Japan’s export market share is unlikely to be reversed, regardless of the future path of the currency. This has implications for domestic growth and therefore portfolio investment in Japanese companies.

Jeremy Lawson, Chief Economist, Standard Life Investments, said: “Japan’s weak export performance under the Abe government suggests that the country’s problems have been misdiagnosed.

Structural reforms are the key to boosting exports in the longer term, as well as unlocking domestic growth potential and encouraging portfolio investment in Japanese companies. Currency devaluation can only ever be a stop-gap measure.

“The implications of Japan’s experience should not be lost on those nations considering currency devaluations as a short-cut to regaining international competitiveness. While facilitating depreciation can be an effective way of absorbing negative external shocks, in the long-run it does not boost living standards or prevent the erosion of export market share, particularly when the supply side of the economy is the real problem.”

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Interest rates expected to remain the same into 2014.

Standard Life Investments, the global asset manager, believes the Reserve Bank of Australia is likely to keep interest rates on hold well into 2014, with the strength of the housing market giving the central bank little room to lower rates despite its desire for a lower exchange rate.

Speaking yesterday in Sydney, Jeremy Lawson, Chief Economist, Standard Life Investments, said: “The Reserve Bank of Australia’s (RBA) decision to leave interest rates unchanged in December highlights the policy tightrope the authorities are walking. On one hand, the central bank needs ultra-low interest rates to drive the Australian dollar lower and help rebalance economic activity away from mining activity. On the other, cutting rates too far could fuel an unsustainable housing boom that eventually undermines both financial and price stability.

“In our view, the RBA is now likely to keep interest rates on hold well into 2014, with the relative magnitudes of the mining investment cliff and any housing induced surge in domestic demand determining whether the next rate move is up or down. The RBA has been keen to point out that it is not worried about the latest annualised price increases in the housing market.

“However, I believe that if house prices nationwide were to jump by another, say 10 per cent, over the next year, and underlying inflation remains around the middle of the RBA’s target band, the central bank could face some uncomfortable choices.

“Historically, strong home price growth in Australia has been associated with stronger domestic activity, suggesting that there may be some upside risks to the RBA’s economic forecasts for 2014. Moreover, as the US Federal Reserve, as well as the Spanish and Irish governments can attest, identifying when house prices are overvalued is difficult at the best of times.

“In those circumstances, will the RBA begin pre-emptively increasing interest rates to cool off the housing market at the cost of seeing the exchange rate move higher? Or will they stay their hand and risk a destabilising housing bubble developing?

“Fortunately, I believe that a third option does exist. In conjunction with the Australian Prudential Regulatory Authority, the central bank could choose to deploy macro-prudential tools such as lowering maximum loan-to-valuation ratios on mortgages or counter cyclical capital buffers. That would allow the RBA to tighten lending conditions in the housing sector without raising its policy rate, better targeting the problem at its source and thereby avoiding a sharp exchange rate appreciation.

“In the past, the RBA has chosen not to go down this route, preferring to jawbone the housing market and target housing with its traditional policy instruments; 2014 may well test that preference.”

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Increasing uncertainty about growth in China.

In the latest edition of Global Perspective Standard Life Investments, the global investment manager, examines the range of complex issues facing the Chinese authorities, warns about major downside risk, and looks ahead to a series of important structural reforms which are required to rebalance growth.

Standard Life Investments’ report highlights that economists’ forecasts for Chinese growth are likely to be downgraded further over the next year. The investment manager believes that while a genuine near-term hard landing is still a risk rather than a central scenario, the risks have increased and the widespread confidence that the central authorities can effectively choose how quickly the economy will grow has been exaggerated.

Jeremy Lawson, Senior International Economist, Standard Life Investments, said: “The growth model that has served China so well over the past two decades is certainly breaking down and there is more uncertainty that the improvement in employment prospects and real incomes that have been promised will ultimately come through.

Moreover, at some point a “reset” may be necessary to put the economy on a more sustainable path, even if it means a short period of very weak growth. “The implications of this new reality are currently being priced into financial markets; our House View has been tactically Light in emerging Asian assets for some time. As far as the Chinese stock market itself is concerned, our view is that as long as a major crisis is averted, then much bad news is already priced into the local stock market.”

The nature of the structural reforms that are announced at this autumn’s party conferences will be an important trigger for investors to assess where next to position their portfolios for the China story. A cautious approach to reform may help prop up growth in the very near term but it would probably come at the cost of making internal imbalances worse and thus the eventual unwind more economically and socially disruptive.

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