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Optimistic About Risk

2011 will be a good year for risky assets, says Simona Paravani, global CIO, Wealth, HSBC…

HSBC expects global growth to exceed 3 per cent this year. It is also optimistic about risky assets such as equities and long-term debt. In this wide-ranging interview, Simona Paravani, global chief investment officer, Wealth, HSBC Global Asset Management, also suggests investing in commodity-rich countries such as Brazil and Russia to benefit from the run-up in commodity prices. Despite the inflation problem in emerging economies, she paints an overall optimistic picture of the global economy and markets in 2011. Excerpts from an interview with Sanjay Kumar Singh.

How positive are the growth prospects for the global economy in 2011?
If you look at the global macro-economic picture, the good news is that in 2011 we are once again expecting positive economic growth. HSBC Research is currently forecasting global growth in 2011 to be in excess of 3 per cent. This is obviously good news, especially because once again we expect emerging markets such as India and China, which are expected to post growth of 8 per cent or higher, to be the engines of global growth.
The other important supporting factor for financial markets is liquidity. First, interest rates in the developed world are likely to stay low. That’s good news not only for economic growth but also because it creates incentive for investors to put their money to work, because the alternative of keeping it in cash, in places like the West or even the Euro zone, is not attractive.
Another important factor for markets across the board is what’s happening to companies’ balance sheets. If we take corporate America’s example, it doesn’t matter what sector we are looking at, currently, corporate America has above-average level of cash in the balance sheet. Why is this a significant factor for both developed- and emerging-market equities? Because what are the potential uses of that cash? Well, companies can use it to buy back their own stock, they can use it to distribute more dividend, or they can engage in mergers and acquisitions (M&A). All these factors are positive for equities. These M&As could have a much broader reach than just the local market, thus potentially benefiting both developed and emerging-market economies.
Furthermore, no matter what market we look at, whether developed or emerging, valuations for equities are generally quite attractive, especially when compared to the yield on some developed market sovereign bonds.
And finally, when we look at expectations of earnings growth, for most developed and emerging markets they are positive. Generally we are talking about earnings growth being in the region of 15-20 per cent, irrespective of the country or the region that we are looking at. That’s a good number in itself, but it’s also not an excessive number. If you compare this year’s forecasts with yesteryear forecasts, this number falls in the middle range. Why do we see this as a positive? Because in Finance, as in anything else in life, the higher you set the bar, the more likely you are to be disappointed. So if forecasts appear realistic, the chances of negative earning surprises are limited.
So bringing it all together, what we have is an environment that is favourable for risky assets in general and equities in particular. And that applies to pretty much all geographies.

But what about some of the recent developments that we are seeing like high inflation in some markets? What according to you is the risk for global growth outlook generally?
Our central scenario, which is one of positive global growth, provides a good backdrop. But we cannot deny that there are some clouds on the horizon that cannot be overlooked as they could have an impact on global markets, including India. There are a few risks that we need to monitor. Specifically there are three. Let me touch each of them one by one.
The first is what I would call labour market issues, particularly in the developed world. We have seen economic activity rebound, no question about that, but we have also not seen much of an improvement within the labour market in places like United States or the Euro zone. That’s obviously a cause for concern because without improvement in the labour market you can actually have a cap on your economic growth.
The second cloud on the horizon has to do with the debt issue. When we talk about debt, we should really be looking at both family debt and government debt. Admittedly, now the focus is more on government debt than family or household debt, but both factors really play a role. When you look at debt-related statistics such as debt as a percentage of GDP, it doesn’t matter whether you’re looking at household debt or government debt, the big issues are not in the emerging markets but in the so-called developed world. For household debt, the top of the charts, if you allow me the expression, will be countries like the US or the UK. Similarly, when we look at the stock of government debt relative to GDP, again, top of the charts are countries such as Japan or Italy. So debt is an issue. Sooner or later both governments and families will have to rediscover what I call the good housekeeping principles, which means that there is a need to save. And while this is the right thing to do, it’s something that, other things being equal, is likely to be detrimental to economic growth. But the debt issue is largely an issue that may have an impact on average or potential growth in the developed world and so will impact the emerging world more indirectly, in terms of their ability to export.
The last very important point in terms of the risk that can come to spoil the party is this inflation versus deflation debate. It’s interesting that we very often get asked the question whether the world has a deflation or an inflation problem, and our answer very much depends on which part of the world we’re talking about. If we look at the inflation picture in the developed world, it’s generally under control. If you are looking at core inflation in places like the Euro zone or the US, it’s actually quite benign and well below the core inflation level of 2 per cent level that central banks may worry about.
But in emerging markets the story is different. India is one example, but we could also look at Brazil or China, and the story is very similar. We have seen inflation rates move higher. What has been the key driver of that increase? Food prices. China is an example. Food prices in China have been increasing to the tune of around 10 per cent per annum. That’s obviously significant because for emerging markets food prices account for a much higher portion of the basket which is used to calculate inflation than would be the case in the US. That’s quite natural, because generally lower-income countries would spend a higher proportion of their income on food than higher-income countries.
The question then is: is inflation something that we should worry about and why? The good news there is that central banks and more generally monetary authorities in the emerging world are already taking steps to fight inflation. We have seen an increase in reserve rates; we have seen an increase in interest rates in places like Brazil, for example. And as we look ahead, we are also expecting more tightening. In India, we expect the central bank to continue to tighten rates this year. The question is how effective would they be. We don’t know yet because monetary policy impacts the real economy with a lag. So the question is largely still out there. If the steps taken so far were not enough to prevent inflation from increasing, there is obviously a risk to economic growth. It obviously means that central banks and possibly governments would have to take more aggressive steps to slow down economic growth, and that would have negative repercussions.
I stress though that I see this as a risk; it is not part of our central scenario. It is an important risk, something to watch. But the central scenario is that because central banks have started acting earlier, hopefully the inflation situation — with a mix of monetary policy and possible price controls and other mechanisms — will be brought under control.

What could investors do to hedge themselves against the current inflationary situation?
First of all, if we start with the traditional or textbook asset allocation story, among many assets, equities, especially over the medium- to long-term, do provide some form of inflation hedge. That’s largely because costs and profits should increase with inflation, so there is an element of inflation hedge over the medium to long term.
One interesting aside is also that clients and investors could seek exposure to those markets that are beneficiaries of strong commodity prices. Brazil and Russia are examples. Another obvious way is to buy outright commodity exposure. Gold also continues to be regarded as a potential inflation hedge.

Do you expect the bull run in gold to continue? Its price has already run up quite a bit.
What factors tend to support gold? Again, from a first principle basis, gold tends to do well in periods of extreme crisis, which is not where we are now. Gold also tends to do well when inflation is a concern, and this is certainly the case in the emerging world. Gold is also effectively driven by jewellery demand, which particularly in Asia remains quite strong. And finally, its price is also affected by central bank activity. Interestingly enough, central banks have recently turned net buyers of gold, so that’s another element of support. The big risk to the price of gold right now would be if inflation were no longer an element of concern. As long as inflation in the emerging world is a concern, gold price is likely to be supported at current levels.

What would your advice to investors in the emerging world be? Should they continue with their normal asset allocation to equities, reduce it or increase it in the light of inflation?
Inflation does pose a risk if not brought under control and if it causes a slowdown in growth. But again, that’s not necessarily our central scenario at this stage. What is important to stress is that the case for emerging markets is not just a 2011 story; it’s a long-term story, which is still powered by a lot of very supportive structural factors, such as labour force growth, urbanisation, and so on. Those are still very much there and they are still going to be important factors going forward.
In terms of specific advice on how to “play” the emerging markets growth story, one of the things which I think is worth highlighting, and it’s sometimes not focused enough on, is that when we talk about investing in emerging markets we tend to focus only on investing in the local emerging market. But there is a different and interesting dimension, which is that you can invest in developed market equities and in reality invest in companies that derive quite a significant portion of their revenues from emerging markets. So there is an emerging market tilt even in the developed market world and that’s something that investors could increasingly try to explore.
There’s a lot of focus on equity markets and that’s understandable, but there are many other emerging market related asset classes that are worth exploring, debt being one. In terms of again the long-term themes, one which is potentially interesting is that of currency. If there is one area where strong economic growth, strong improvement in fiscal as well as external balances and other fundamentals do play out, that is in the currency area. Local currency debt in the emerging world is definitely something that would be a very interesting compliment to a portfolio.

Read the last part of this interview on April 22, 2011