Economics is anchored by the concept of equilibrium. From the elegance of those intersecting supply-and-demand curves in freshman economics to the computational heft of mathematical models used by central banks, it is all about equilibrium.
Yet equilibrium continues to elude the global economy. The 2008–2009 financial crisis shattered an old model of global economic and financial relations. But the new paradigm to replace the old order has not emerged.
Almost everyone agrees that global economic rebalancing is a critical component of any new paradigm. Heavily indebted industrial countries must consume less while high-potential, low-debt emerging market countries consume more. This is not a new idea, as any review of IMF communiqués going back to the mid-2000s shows. The problem is despite the recognition that global economic rebalancing is critical for a more sustainable world economy, little actual progress has been made toward that goal.
So how does global economic rebalancing come about? It turns out that the nexus between global economic rebalancing and global portfolio rebalancing is central to bringing forth the elusive equilibrium. In particular, we argue:
(1) Finance played a key role in creating current imbalances, and finance will be a catalyst and conduit for global rebalancing.
(2) Neither the financial industry nor policymakers have yet established the conceptual or institutional apparatus to confront these changes. Effective portfolio management requires an integrated approach that eschews the traditional dichotomy between developed and emerging markets.
(3) A multi-year reallocation by global investors away from excess developed country assets into emerging markets facilitates both global economic and portfolio rebalancing.
If finance got us into this mess, can finance get us out?
Global rebalancing looks easy on paper – industrial countries consume less, emerging countries consume more. But it is difficult in practice. The underlying structure of the global economy has been built around servicing consumers in developed countries, particularly the United States. This is evident in the U.S. labor market, where the high rate of long-term unemployment despite the rebound in job openings points to a structural labor mismatch: Workers trained to produce what pre-crisis U.S. households were consuming (primarily houses and everything related to them) are finding it difficult to re-enter the workforce with skills relevant to a new landscape of household demand.
The extent of global dependence on the U.S. is evident in the striking relationship between growth in emerging markets and the size of the U.S. current account deficit (Figure 1).
On average for the last three decades, a 1 percentage point increase in the U.S. deficit translated into a 1 percentage point increase in EM growth. Unfortunately, global rebalancing implies that process running in reverse, where declines in the U.S. trade deficit – fewer imports from the rest of the world – pull down growth in emerging market countries. Note that the U.S. deficit does not fully determine the rate of EM growth: EM countries can outperform under some circumstances, while at other times they may underperform. But the U.S. external balance historically has exerted a powerful gravitational force on the rate of growth in emerging markets, suggesting that evolving away from dependence on the U.S. requires profound structural changes in the global economy.
The “how” of global rebalancing is the story of what drives decisions about how much and what type of goods to consume, in which countries to locate production of which goods, and into which sectors and countries to channel investment capital. Government policy is a critical part of the equation, but the vast majority of agents that shape global economic outcomes – workers, households, corporations and investors – are outside of the public sector. For these actors, the relative prices of goods, of credit (interest rates) and of currencies (exchange rates) shape the decisions about what gets consumed and where, what gets produced and where, and who borrower and lender be. This is where finance enters the picture.
Finance was critical in generating existing global imbalances. Investment flows into the United States, including large-scale reserve flows, were recycled by U.S. financial institutions into historically unprecedented volumes of cheap credit to U.S. households (Figure 2), supporting excess consumption and a ballooning of the U.S. trade deficit.
When the crisis hit, finance came in again, with the extraordinary levels of household borrowing replaced by the U.S. government going to the market for extraordinary levels of public borrowing, which supported aggregate demand and averted what would have been an even more severe economic contraction.
If exceptional availability of finance to U.S. consumers is one side of the global imbalances coin, insufficient access to finance for some key agents in emerging markets is the other side. For instance, despite the rebound in investment by larger firms, investment ratios for small companies in Asia have stagnated at the low levels following the 1990s Asian financial crisis (Figure 3).
These smaller firms are on average more labor intensive than their larger counterparts, and produce more for the domestic-oriented service side of the economy – in short, exactly the firms that need to play an expanded role as part of the global rebalancing process.
So where finance was part of the problem, it is also part of the solution. The flow of more investment capital to sectors like small enterprises in emerging markets reduces their cost of capital. This encourages more investment and more hiring, which in turn provides more labor income that boosts consumption – a virtuous cycle of rising consumer demand.
A redirection of financial flows to emerging markets has another key influence on global rebalancing, by potentially generating appreciation of emerging market currencies vs. those of industrial countries. On the demand side, this discourages consumption of increasingly expensive imports by developed country consumers, while encouraging emerging markets to consume more imported goods from developed countries. On the production side, stronger currencies help wean emerging market economies off of excessive export dependence, and encourage labor and capital to move to sectors that are serving the needs of domestic EM consumers.
In addition, currency appreciation encourages the migration of production chains between the developed and emerging worlds. For instance, although the U.S. and China have vastly different income levels, the two countries compete in areas like electrical machinery and office and data processing machines (Figure 4).
A recent Harvard Business School survey found that cost differences accounted for 70% of decisions to move production from the U. S. Exchange rate movements are central to relative costs of production.
Are asset managers ready for these changes?
Larger investment flows from developed into emerging markets may well help global rebalancing, but such a redirection is not like flipping a switch. Portfolio allocation decisions are made by individuals and institutions who have established ways of doing business, hard-wired biases, analytical tools, risk management systems and bureaucratic structures.
The mental and organizational infrastructure in the asset management industry has been built for a world with a sharp dichotomy between “developed countries” and “emerging markets.”
A key illustration that goes to the heart of global bond management is the distinction between interest rate risk and credit risk (Figure 5).
The former was regarded as the province of developed markets, while the latter was regarded as the domain of emerging markets. Investors purchasing Italian bonds in 2002 anticipated that their yield was compensation primarily for volatility of interest rates within the eurozone, in contrast to investors in Brazilian bonds in 2002 who demanded higher yields due to the perceived risk that Brazil may have difficulty paying its debt. In 2012, this distinction is obviously no longer valid. An investor in Italian debt today demands additional yield to compensate for the perceived credit risk in Italy, while the investor in Brazilian local currency bonds is focused primarily on the trajectory of central bank policy and its impact on interest rate volatility, compensation for inflation, and currency risk. This allows us to make an important distinction:
For a bond manager, the entire spectrum from strategic portfolio construction (“What bonds should I buy to seek attractive returns under my expected future macro scenario?”) to risk management and portfolio analytics (“How is the portfolio likely to perform quantitatively under a given future scenario?”) relies upon getting right the distinction between “hard” interest rate duration and “soft” credit duration. Get that distinction wrong, and you end up owning the wrong bonds and your risk systems incorrectly evaluate portfolio performance … even if you get the macroeconomic call right.
To illustrate the point, consider the movement of two-year bond yields in a selection of countries during the second half of 2011 (Figure 6), when a wave of risk aversion hit global financial markets.
Yields fell in the “hard” interest rate duration countries on the left – these bonds gained in price because either central banks had scope to cut interest rates (Brazil, Germany, South Africa) or keep them low (U.S.). In contrast, yields rose in the “soft” credit duration countries on the right – these bonds fell in price because either central banks were poised to hike interest rates to stem capital flight (Hungary, Turkey) or credit concerns were increasingly at issue (Italy).
From a portfolio construction point of view, a bond manager expecting a gloom-and-doom market scenario would have benefited last fall from investing in Brazilian two-year bonds, with a currency hedge. But the reflex of most global bond managers was likely not to buy Brazil to position their portfolios for a market sell-off because 1) that would have been a mental leap from the traditional way of thinking about emerging debt in stressed markets, 2) many have strictly separated developed and EM business silos inhibiting the ability to construct portfolios seamlessly across both markets and 3) many risk management systems would have likely penalized a portfolio manager for owning supposedly “unsafe” Brazilian assets on the cusp of a severe risk market sell-off. And yet we believe that reflex and the assumptions behind it were wrong, because Brazilian short-dated bonds provided some of the hardest duration in the world in the second half of 2011, potentially providing the kind of performance and correlation attributes many investors seek from a bond portfolio. In our view, the mistake of equating “hard” vs. “soft” duration with developed market vs. emerging market, rather than economic fundamentals, was the foundation of this error.
Currency strategy also requires new approaches. The traditional emerging market currency crisis was characterized by the vicious circle in which a country borrowed heavily in a foreign currency, subsequently experienced a weakening of the local currency that further increased the debt burden, initiating a feedback spiral between currency depreciation and rising indebtedness. Brazil came perilously close to this default spiral in 2002 when the Brazilian currency (BRL) crashed and the debt burden spiked. Brazil’s currency also experienced sizable depreciations in late 2008 and late 2011, but during these episodes the net public debt burden declined (Figure 7)!
Why? Because Brazil’s accumulated war chest of foreign reserve assets came to exceed its external public debt, meaning that a currency depreciation actually helped Brazil’s public balance sheet at the same time that it cushioned the impact of the global recession on the Brazilian economy. Distinguishing between situations where the currency can act as an adjustment mechanism that preserves macroeconomic flexibility (as in Brazil) vs. the old emerging markets pattern of a crisis-spiral straightjacket is critical.
These changing dynamics have left almost everyone behind the curve, not just asset managers. Regulators utilize concepts like risk-weighted assets that presume industrial countries have no default risk while emerging markets do. Pension funds with large holdings that were supposed to be interest rate risk are now holding assets that are acting like credit risk.
Policymakers themselves – in both the developed and emerging world – are often resistant to some changes needed to enable these transitions. EM policymakers tend to be ambivalent about the prospects for large capital inflows that may increase currency and interest rate volatility, and some have opted for regulatory or other interventions to stem the flow. Many countries have grown accustomed to export-led growth models and have difficulty adopting a new mindset. Even policymakers cognizant of the need for change face the challenge of developing the liquidity, depth, and regulatory foundation that will enable domestic markets to effectively intermediate larger volumes of foreign capital.
The entire global financial complex has a legacy architecture that is increasingly dissonant with the economic realities. Changing that architecture will be neither seamless nor quick.
The Great Migration: portfolio rebalancing ahead.
Notwithstanding these frictions, it would be a mistake to conclude that asset management will remain static amid the fundamental shifts taking place in the global economy. Indeed, according to an IMF survey of asset managers in 2011, the top two factors cited as driving country allocations were “economic growth prospects” and “sovereign debt issues.” The first is a magnet that helps pull capital into emerging market countries, while the second provides an impetus that can push capital out of the developed world.
Lopsided allocations to developed world assets are inconsistent with the weight of emerging markets in global economic activity (Figure 8).
Emerging markets account for about 36% of global output and 68% of global GDP growth, but only represent about 4% of the equity portfolios of U.S. investors. We believe the representation in bond portfolios is even lower. One does not need to be a starry-eyed optimist to conclude that such allocations are imbalanced relative to what might be considered a neutral allocation in today’s world. The existing skew suggests that the reallocation potential is massive.
Portfolio reallocation is poised to be a global phenomenon, spanning retail and institutional investors. In Asia, some central banks are increasing their cross-border investments in the government bonds of their emerging neighbors to diversify away from their dependence on U.S. Treasuries and German bunds. In Europe, both retail investors and institutions have looked to reduce holdings of European peripherals and increase exposures to emerging sovereigns.
At a structural level, many investors are also focusing on the biases that traditional approaches to indexing can impose on their portfolios. Most traditional bond indexes are market capitalization-weighted: The more debt that a country has, the higher its weight in the index. This sounds like a dubious formula for successful investing in a world where sovereign creditworthiness is subject to greater scrutiny.
An alternative gaining more widespread adoption is GDP weighting, where a country’s index weight is proportional to its national income rather than its national debt. This GDP approach produces a dramatically different index profile, with much lower weight to high-debt countries and more weight to low-debt countries, as compared with the market-cap-weighted index (Figure 9).
At the same time, with its larger allocation to lower-debt emerging markets, the 3.18% yield on the representative GDP-weighted government bond index illustrated in Figure 9 is double the 1.58% for the traditional global government index being shown (as of March 2012).
More widespread adoption of alternatives like GDP weighting is likely to be another driver of portfolio rebalancing. Norway’s $600 billion sovereign wealth fund announced in March 2012 a switch to GDP-weighted allocation for its global bond portfolio, boosting its EM investments.
Endowments, pension funds, retail investors, and sovereign investors will likely have to change their approaches to achieve portfolio return objectives in a world where developed countries are likely to grow at chronically slow rates, sovereign creditworthiness is increasingly questioned, and the yield compensation on industrialized government bonds has tended to be exceptionally low.
The rebalancing nexus
Achieving that elusive equilibrium in the global economy relies upon the nexus between two themes: global economic rebalancing and global portfolio rebalancing (Figure 10).
The same economic and debt fundamentals that make economic rebalancing imperative also induce capital to flow from developed countries to emerging markets as part of global portfolio rebalancing. In turn, portfolio reallocation flows affect key prices like exchange rates and interest rates that condition the behavior of households, companies and investors in ways that promote global economic rebalancing.
Policymakers, regulators and investors are only beginning to grapple with the breadth of analytical and institutional changes needed to navigate this profoundly different world. That certainly applies to the asset management industry.
We have embraced numerous changes at PIMCO aimed at overcoming the traditional dichotomy between developed and emerging markets:
Organizing our credit analysis to cut across all companies in an industry, irrespective of their country of domicile
Creating a unified framework for sovereign credit rating that integrates all countries, developed and emerging, on the same scale
Embedding in our portfolio analytics and strategy the concepts of “hard” and “soft” duration
Reorganizing our portfolio committee structure on a regional basis, so that committees like the Asia-Pacific Portfolio Committee frame integrated cross-cutting strategies rather than developed vs. emerging silos
Introducing new investment solutions like the PIMCO Global Advantage bond strategy, which embeds a higher allocation to emerging markets through its GDP weighting and opens the playing field of investment opportunities to the full spectrum of developed and emerging markets
No doubt there is much more to do. In periods of dramatic change, it is often those who figure out the puzzle first who are in the greatest position to benefit. No one has all the answers, and organizations will likely test many “beta” versions along the way. Just like the broader process of global rebalancing, it is easier to predict the destination than all the intermediate steps it may take to get there. Yet ultimately the grinding process of resolving these issues within the financial sector is poised to be an essential catalyst for the broader transformations taking place throughout the globe.
Ramin Toloui
Executive Vice President