After verbal sparring and name-calling throughout the working week, in typical fashion, the People’s Bank of China announced on Saturday that it would proceed with further reform of the renminbi (RMB) exchange rate and that it would enhance RMB’s exchange rate flexibility. What it means for the dollar/RMB exchange rate in coming months is unclear.
Probably, that is how China wanted it. Greater flexibility for the exchange rate, strictly speaking, goes both ways. If the euro/dollar weakens further, China might depreciate its currency against the dollar. This clever ambiguity and the brazenness with which Xinhua, the official news agency, labelled the Congressmen calling for renminbi revaluation baby- kissing (incompetent) politicians, conveys the picture of a nation that is confident and knows what it is after.
In contrast, recent data and other signs from the US are not encouraging. Retail sales in May declined and jobless claims remain high. Housing starts and building permits declined significantly in May and home builders’ confidence took a nosedive. The Federal Reserve, in its meeting during the week, is set to lower its economic growth forecasts for 2010. The Philadelphia “district” of the Federal Reserve saw manufacturing strength tumble in May. It is possible that the recent revival of the euro/dollar and record gains for gold in dollar terms last week were due to investors’ anticipation of revival of quantitative easing in the US as a counter to fresh economic weakness.
These developments confirm the conclusions reached at the annual forum of the world’s largest bond manager in Pimco in May. Some of them are relevant for investors having to choose between the developed and developing world:
•It is a world that calls for a broader investment universe and guidelines and, for those who use them, revamped benchmarks that better capture the world of today and tomorrow rather than that of yesterday
•It is a world where the currencies of the emerging (as opposed to submerging) economies will continue to warrant a greater allocation over time
•The distribution of global outcomes is going through a transformation, in terms of both overall shape (flatter) and tails (fatter)
What does this mean for investment decisions in the next few years? Besides picking emerging economies for a steadily rising allocation to their assets—equities, fixed income and currencies—what does this hold for allocation to commodities or natural resources? The answer to that question depends on the growth and inflation outcomes in developed and developing economies.
A combination of high growth in the developing world and pursuit of high growth in the developed world (it is only a pursuit) in the face of structural growth constraints might produce a combination of high growth in the developing world and high inflation elsewhere.
High inflation would likely result from a combination of both high nominal growth in the developing world leading to demand for resources and monetary growth in the developed world as they pursue growth in vain, without allowing deleveraging to be played out fully.
This is not an immediate prospect, however. For the next year or year and half, deflation risks dominate more than inflation risks as policymakers in the developed world wait before they deploy their ultimate weapon—fiat-money debasement. When that happens, it would call for a higher allocation to natural resources, logically.
There is one catch: natural resources have been “financialized” in the last several years. Hence, they are influenced by speculative and “noisy” investors rather than by long-term investors. They have moved in tandem with equities. The scenario described above might not be good for equities since sovereign risk would rise in the face of active and deliberate fiat-money debasement. That would offset any short-term and possible improvement in nominal gross domestic product (GDP) growth, arising out of another round of attempted reflation.
In such a scenario, the million-dollar question is whether natural resources would move in tandem with equities and thus decline or rise because of the combined force of higher nominal GDP growth in the developing world and fiat-money debasement in the developed world? Bare Talk guesses that they would eventually rise but the operative word is “eventually”.
In the final analysis, investment strategists have to keep in mind that we are in a transition from one phase of the world (greater financialization, falling interest rates, inflation, commodity prices, peace dividend, etc.) to another. What economic, political and ecological landscape would emerge is not easy to fathom. We need to recognize that in our allocations. The search for genuine diversification in portfolios is on but only few would succeed in finding it.
Institutions that develop the right incentives for their portfolio committees stand a better chance of succeeding in this difficult mission. Committees that work only to create consensus and compromises rather than being led by managers with conviction would deliver unsatisfactory investment returns for their clients.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at firstname.lastname@example.org