Living in a New World

We are all going to have to adapt to a different world to what we had become accustomed to.  Effectively we have all benefited from a major increase in the value of assets which is unlikely to be repeated in our lifetimes.

Foremost of these is the value of your home.  We have all become use to house prices rising as a matter of course and many people have used these rises to extract capital by either remortgaging or by selling and downsizing.  Relative to earnings the UK residential property market is very overvalued.  Witness the difficulty first time buyers are having.  The only reason prices have not fallen is that Interest Rates are so low.  What do you think would happen if Interest Rates were to rise back to 5%, the pre crisis level?

However, there is some good news for homeowners with mortgages.  Interest Rates are not going up for a long time.  How long?  I think it could be a couple of years and even then rises are likely to be muted.  Some of the more bearish economists such as David Blanchflower and Roger Bootle warn they should not go up for 5 years! However, this news is not good for savers, especially those living off their deposit account interest.  They will have to look for alternatives.  The economy is only recovering slowly and is likely to face the hurdles of substantial tax rises, increasing unemployment and other spending cuts.  Interest Rates rises are not needed and would risk sending the country back into recession.  Japan has had this problem for fifteen years and rates have not got above 1%.

We will all now need to become savers.  First time buyers already have to put down significant deposits when they buy a home.  Everyone will also have to save more towards their retirement.  Companies will have all closed down their Final Salary Pension Schemes and soon the government will be forced to change the way they fund Public Sector Pensions.  This in turn is also going to take money out of the economy that in the past would have gone on consumer spending.

Of course there is an alternative option and that is, the government decides to suspend all spending cuts and tax rises and goes for growth, but that would be difficult to achieve with such poor government finances.  That would risk the return of inflation and the cost of borrowing rising.  Britain could become a new Greece or Argentina with the pound dropping on the foreign exchange market.

So the message is do not rely on what has worked for you in the past.  You will have to save and in different places.  Having been so downbeat there is good news.

Parts of the world are still growing and in fact some areas have the potential to do so for decades.  These are the Emerging Markets.  For 2010 they are forecast to grow their Gross Domestic Product (GDP) by 5.4% on average, whereas the Developed Markets are predicted to grow by only 1.7%.  In reality Emerging Markets growth has been beating forecasts, whereas countries in Europe and the UK will struggle to get anywhere near 1.7%.

Of course Emerging Markets have always been perceived as risky and no doubt there are still issues in some countries.  However, some of the major reasons for considering them risky have disappeared.

It is now developed nations that are the worlds savers with China now having a staggering £2288bn in foreign reserves.  Countries like Russia and Brazil have also built up large reserves.  Overall public debt in the average developed market is 84% of GDP, but in Emerging Markets is only 31%.  Furthermore private debt is also much lower as the lack of social welfare has meant people have had to save for old age and pay for doctors fees.

There are many comprehensive statistics which illustrate the way growth is affecting business.  Over the last 10 years China for instance has quadrupled its Crude Oil imports and over the last 5 years Chinese household income has doubled.

Of course having all your investments in Emerging Markets would be considered risky but there are ways of increasing your exposure to the Emerging Markets story with diversification.  Investing into Equity Funds based in Emerging Markets is probably one of the highest risk / reward strategies.  Currently valuations do not look expensive and are well below levels reached at the peaks of previous Bull Markets.  To reduce risk I am currently spreading investment by putting smaller amounts with a number of managers.

One reason Emerging Markets equities have not performed well in the short term is that investors are concerned that because of the strong growth, authorities will increase Interest Rates to reduce growth and associated inflation.

However, high Interest Rates are very attractive to investors in developed nations, who are struggling with near zero rates at home.  Brazil for instance has just put up its official lending rate to 10.25%.  In addition due to their strong economies and low debts, most Emerging Market currencies are expected to appreciate against indebted Western Currencies enhancing potential returns further.

Another theme to follow which I have mentioned previously is to invest in Western Companies that produce the goods that the developing markets require.  These include the raw materials required by the ever increasing number of factories and increasingly more important the companies that provide the goods and services that the vast emerging middle class want to buy.  Some are what we consider everyday items such as cars, refrigerators and televisions.  The best brands such as Mercedes, Hotpoint and Sony are still based in developed nations.  They also like luxury goods such as Swiss watches, French Wine and Italian designer clothes.

One final ray of sunshine is the American Economy which has recovered much more strongly than European counterparts.  This is because it is a much more dynamic economy with far less red tape.  Companies can reduce work forces if they need to and that is what they have done.  They have not started to hire again and will not do so until they have got as many extra hours out of existing employees as they can.  As a result US productivity costs have fallen 5% this year.

In the Wise Active Growth Fund I am investing in these themes, in Funds like M&G Global Dividend, M&G Global Basis and JPM Global Consumer Trends.  The Fund also has holdings not only in general Asia and Emerging Market Funds but also Country Specific holdings in Brazil, China and Russia.  One significant benefit of this policy has been that we have had very little exposure to BP which has had a very negative effect on the performance of the FTSE 100 and some leading UK Funds.

 
This blog represents David Stephenson’s views as at 18th June, and does not constitute financial advice.