A Stay-Rich View of the New Global Economy

By AGB    //    Volume 19,  Number 3   //    May/June 2011
A Stay-Rich View of the New Global Economy, May/June 2011

Major demographic changes around the world. Disproportionate sovereign debt. A shift from North America, Western Europe, and Japan to emerging economies as centers of growth. Unprecedented levels of market risk and volatility. The structure of the global economy is undergoing significant changes.

University and foundation boards of trustees will need to take all these factors and many other international trends into consideration as they think through decisions about their institutions’ endowments as well as their long-term business models, recruitment and financial-aid practices, and a host of other strategic issues.

At AGB’s Foundation Leadership Forum in January, Michael Oyster, managing principal of Fund Evaluation Group, explored this topic with Sam DeRosa-Farag, principal of the investment team at Morgan Creek Capital Management, and Stephen Wood, chief market strategist at Russell Investments. DeRosa-Farag and Wood each made brief introductory remarks and then responded to questions from Oyster and the audience. Trusteeship has excerpted part of the session below.

DeRosa-Farag: Today’s global economy is especially difficult for Americans because it is unfamiliar. We’re used to cyclical trends; we’ve seen at least a few of them in our lifetimes. But the challenge now is that we are dealing with structural trends, which can take anywhere between 30 to 70 years to repeat.

Our history in America has been one of robust economic growth. When I was a kid, I was told, “When America sneezes, the world catches a cold.” We were the Big Kahuna, and all the other countries followed us. If America eased interest rates, liquidity would flush through the global economic system. When the American economy expanded, the global economic system expanded.

Those of us in the United States and the other G-7 countries (Canada, France, Germany, Great Britain, Italy, and Japan) have grown up in an environment in which interest rates have been declining for 30 years. We have had a charmed life. The last time we had deflation was World War II.

Over the last few years, however, we’ve accumulated a considerable amount of debt. That, coupled with the recent economic crisis, has put us in a deleveraging phase—which means we’re going to have below-average growth.

The repercussions of below-average growth are considerable. America, Europe, and Japan are tending to experience asset deflation, and we are trying to stop or limit it by increasing our liquidity and lowering interest rates. Our asset-allocation models were developed in a period of growth with declining risk. Today there is a great amount of market volatility, and financial risk is increasing rapidly.

The flipside is what’s happening in emerging markets. Such countries have been the underdogs, and all of a sudden life has been kind to them. Their economic development is going berserk. They’re facing what’s called “acceleration theory,” which means basically that when you hit $1,000 of disposable income for the first time, you buy a TV; when you hit $10,000, you buy a car; and when you hit $15,000, you start traveling outside the country.

Those nations are confronting asset appreciation. They are trying to limit liquidity because they need to control inflation. It’s exactly the opposite of what we are confronting. They are faced with an appreciation of their currencies; we’re faced with the depreciation of our currencies. While we’re trying to reduce interest rates, they’re trying to increase them. And both of us want to go the other way around.

But the real issue here is that none of us are familiar with the environment in which we find ourselves.

Wood: We Americans have to accept the fact that we will have a lower standard of living. We will have to work harder to get less, while China and other emerging markets are going to get more for what they’re already doing. That’s called rebalancing the imbalances in the system. It will be quite unsavory and difficult for us.

Since 1980, after Paul Volcker became chairman of the Federal Reserve, our nation has experienced a disinflationary boom. For most of the last three decades, what has happened to inflation? It’s gone down. What has happened to interest rates? They’ve gone down. What has happened to asset prices and living standards? They’ve gone up. It’s been a golden era.

But those rules have changed since 2008. As we move into Medicare reform, into state pension reform, and into Social Security reform, we are going to see significant structural changes.

It’s going to happen at the university level. For instance, is higher education going to have to rethink its pricing, given the job market teenagers and young adults are likely to face? There are going to be real challenges in an environment of dwindling resources.

That said, American corporations are amazingly profitable. They’ve never been leaner or meaner. They’ve never been more cash rich. They’ve never been better able to issue or refinance debt. Their balance sheets are clean.

That financial health has been at the expense of the unemployed. If you take 2007 as the peak in staffing, corporations are probably anywhere from 10 to 12 percent below that. In some industries, it could be as much 30 to 35 percent below. So if you’re the average business person, you’re now driving about 105 to 108 percent of revenue off of 89 percent of your previous staffing. And what is going to be your incentive to staff up when you don’t know what Obamacare or the tax code is going to look like and your company has never been more profitable?

Margins will probably continue to improve. Profitability is going up anywhere from 10 to 14 percent over the next six to 18 months. Price/earnings ratios will probably stay reasonably close to market multiples going forward.

Is there going to be an inflation scare? At Russell Investments, we don’t think so. Is there going to be an interest-rate spike? We don’t think so. We expect stable multiples, noticeable increases in earnings, and dividend yields in the high single digits— probably about 9 percent. There’s going to be no glitz, no glamour, but 12 to 18 months from now, we will probably be in a stronger economic environment.

Unemployment will remain a chronic condition; it won’t get better, it won’t get worse. Housing will also be a chronic condition, neither better nor worse. The economy in Europe will be a chronic condition. All these trends are like needing a pair of eyeglasses— we just have to get used to them.

Robust, globally diversified, sophisticated portfolios are going to become standard. The portfolios that the average person will need going into retirement will have to be far more sophisticated, far more international, far more robust than ever imagined. The best portfolio in the future? It’s going to be global, it’s going to be emergingmarket debt, it’s going to be commodities, it’s going to be private equity, it’s going to be alternative space—not in just the glamorous hedge funds but in the broad sweep of what alternative space means. It’s going to be fixed income of a kind that people never thought of before, and it’s going to be equity strategies that I don’t think they’ve anticipated.

And, in this environment, if you need cheaply priced, freely flowing, accessible credit to consume, to invest, or produce, you’re in a bad way. That part of the market is not coming back.

Oyster: We are seeing that more people want to put more money into emerging economies through investments in equities and fixed income. I get a bit squeamish when I see a lot of people pushing money in the same direction. It also gives me pause to think of how important food and energy are to those emerging markets, more so than to the G7 countries.

DeRosa-Farag: Let’s put things into perspective. First, there are about 100 million middle-income households in all the G7 countries. Between now and 2016, the growth of middle-income households in China and India together is going to be 100 million households—the same amount for either the United States or Europe in just five years. That is what we call “wow growth.”

America’s net growth over the last 30 or 40 years has been around 3.8 percent. The emerging countries are having a sustainable growth of around 8 to 10 percent because the number of consumers almost doubles every year. The number of cars in Shanghai back in 1982 was very small. Today, Shanghai has millions and millions of cars. So just imagine what people in China and other emerging countries will consume as they move into the middle income brackets.

The other key point is that 55 percent of the S&P is really outside the United States. The majority of large corporations are expanding outside America.

When it comes to investing, emerging market equities are going to grow astronomically but with enormous volatility. We’ve all lived through investing in emerging markets: Every year your investment may go up 15 or 25 percent, but when it goes down, it drops 50 or 60 percent. So our number-one job is going to be managing volatility, not managing growth.

We also have to realize that, while the world may seem unfamiliar now, it is actually quite normal. In the 1500s, India and China produced 45 percent of the global gross domestic product, while the G7 accounted for just 7.5 percent of global GDP. Over the last 500 years, the Industrial Revolution and other historical anomalies have shifted things, but now we’re just going back to normal.

So we need to adjust to the real world. We develop asset-allocation models based on three variables: growth, volatility, and correlations (or the extent to which values of different types of investments move together in response to different economic and market conditions). Unfortunately, all three have changed over the last five to seven years. So we have to rethink our approaches to assets—their characteristics, their behavior, and, hence, what it means to invest.

Oyster: The United States is 3 percent of global population and now represents about 40 percent of global market capitalization. How much would you advise an organization like a college or university to invest in emerging countries as opposed to in America and G7 countries?

DeRosa-Farag: In the past, we looked at America and the G7 and saw it was around 85 percent of the global financial market, and emerging markets were a quite small number. So, on a pro rata basis, that’s how we invested.

Now, imagine that you don’t want to invest according to history; you want to invest according to how the future might look. China will pass the United States as the world’s largest economy around 2018. India will be larger than the United States by around 2035. By 2050, China and India alone will be around 55 percent of the global economy.

So if I’m looking forward rather than back, I shouldn’t be investing 15 percent in those countries but rather somewhere in excess of 25 to 40 percent. Whether I invest directly or indirectly through American companies that sell into them, that is ultimately the exposure I want.

Again, the problem is managing the risk. All these cross-currents have an enormous amount of volatility that we’re not familiar with. It’s not as if we don’t have growth; it’s just that we’ve discovered that volatility can rob us of all that growth.

So the art here is to keep what you make and manage your risk. Are we in the getrich business or in the stay-rich business? In the get-rich business, you take the risk. In the stay-rich business, you have a dollar and you say, “OK, I might never make another dollar again, so how do I keep it?” That’s a very different approach. We’ve all grown up in the get-rich business. Guess what? We’re in the stay-rich business now.

Oyster: Over the past 30 years or so, declining interest rates have encouraged investments in financial assets, but now we’re moving into an environment that may be more beneficial to real assets. Financial assets are enormously overweighted in investment portfolios today relative to real assets. What percentage of a portfolio should be shifted from financial assets to real assets?

Wood: China’s massive economy is growing but it’s a tiny equity market. So people say, “I want to invest in China,” and then my next question is, “OK, and how do you plan to do that?” Good global investment management is relatively new. But as that capacity—the trading systems, the skill set among investment managers—comes along, it will become more common.

In terms of financial versus real assets, what have Baby Boomers done in the last three decades? They have done what portfolio managers call “economizing cash”— they’ve drawn down the cash in their portfolios. The attitude has been, “Who would be so imprudent and unwise as to actually save money?” The Boomers had cash-like equivalents and invested in financial assets that they thought would move up to the right on the charts endlessly. They over-weighted these financial assets in their portfolios, banking on that unending trend up to the right and assuming that they would just sell their houses to each other in retirement for increasingly higher prices. What could possibly go wrong?

But then we had the massive shock of 2008, and now the demand for cash and liquid assets is historic. Baby Boomers have to save double-time if they want to retire even at 70 or 72—forget 62, 65, or 67.

Then again, if you go back to the 1930s, people didn’t retire with the expectation of having 10, 20, or 30 years in retirement. They certainly didn’t go into retirement assuming that they would spend more time enjoying the fruits of their work than working for those fruits. “Grandpa retired last night, and we’ll bury him tomorrow,” was how retirement worked back then.

So this shift—where retirement has gone from a couple of years, if you’re lucky, to 20, 30, 40 years—is creating significant mismatches with people’s investment portfolios. And one of the solutions will be the creation of more globally oriented portfolios.

At the same time, as you go further abroad into more distant markets, information becomes scarcer. So the talent of people who gather that scarce information and act upon it becomes that much more important. That speaks to the quality of professional investment management.

Question from the audience: In the early 1980s, we heard a lot about how smart the Japanese were and how much we should learn from them. Yet from 1990 to today, they’ve been in a pretty bad place. Who is to say that 20 years from now we will not be saying the same thing about China and India?

Wood: If China continues to do what it’s doing, it will become Japan. Unless it finds a way to transition from focusing on export-oriented growth at any cost to a true consumer-aggregate, demand-based economy, it will fail. I am reasonably confident that—not in four years, but in 40 years—they will make that transition. I bet they won’t go the way of Japan.

Also, the Chinese are not playing the same game we’re playing. People look at China from a western portfolio manager’s perspective. So they’re going to say China did this, China did that, there was a loss of X percent in that quarter, Y percent in that year. That was a bad investment or good investment. They’ll run the numbers.

But the Chinese take a far longer-term approach. Right now, they are buying Greek bonds. Will the total return be positive or negative? The Chinese are saying that’s irrelevant, irrelevant, irrelevant. They are asking, “What is the real collateral behind those bonds?” And the answer is: “Shipping lanes.”

Also, whatever happens, China and America will continue working together. What does the Chinese government want more than anything? Tranquility and harmony. It does not want a billion people upset in Tiananmen Square. How much will the Chinese pay for social harmony and tranquility? Answer: a lot. For how long will the Chinese continue to pay a lot? Answer: a long time. We serve their purpose. They lend us the money that we need so we can keep their factories humming and their standard of living rising.

In some ways America and China are like two drunks trying to hold each other up. We’re just kind of stumbling through this global economy. Another way to look at it is that it’s a bad relationship, but there’s nobody else to date; we’re all we’ve got.

Plus, if I owe the bank $10,000, they got me. If I owe the bank $100 million, I got them. We owe them a trillion bucks. They need us to be successful; otherwise, we’ll never make good on those debts. So they’re going to continue to lend us money. This relationship is going to go on for a long time.

DeRosa-Farag: By 2040 both China and India are going to be larger than the United States, if things continue as they are now. But what will the world look like? America will still have the highest per capita income in the world. And America is a unique culture. It’s the only place that has a German sensibility of precision and workmanship, the rule of commerce of Great Britain, and a continuous rejuvenation of its population through immigration.

The United States is also the biggest producer of food anywhere in the world. Meanwhile, China and India have considerable issues regarding resources— whether such resources are education and innovation, in the ground, or, most important, water. America has all those resources.

When you fast-forward to 2050, the only two economies that will experience population growth are going to be India and the United States. China will actually lose population by about 2 percent.

So let’s not get too excited about China. China is an amazing story, but it will have its peak. And at the end of the day, will I still suggest to my son that he immigrate to Shanghai? No, I think New York is a decent place.