By Michel Léonard, Ph.D. Chief Economist & Senior Vice President, Alliant Insurance | A Blackstone Group Company

Global Macro & Strategy Outlook: Restructuring Not Recovery

Our theme for 2010 is restructuring not recovery. A recovery implies a return to what existed before, in this case global markets before the Credit Crisis. In our opinion, this will not happen. By the end of 2010, investors will look at a global investment landscape vastly different than what existed prior to 2008 along with new macro economic fundamentals.

The new landscape will be driven by growth shifting from the G20 to Emerging Markets, specifically countries relying on demographics and domestic consumption, not exports, for growth. We call these countries “DHD,” shorthand for Domestic Household Demand. In our view, consumer spending and DHD countries will be an increasingly significant driver of global returns, relative to growth in export based on manufacturing driven Emerging Markets which ultimately have greater dependence on growth in the G20. 

New investment landscape: private equity’s Advantage

Based on our data and input from sources in government and central banks, we expect consumer spending in G20 economies to remain relatively weak. In the sections below, “Don’t look here for growth” and “More like old Europe,” our discussion of the G20 and the US in 2010, we highlight liquidity, rather than CPI-driven inflation, leading to a weakening of US Dollar denominated assets vis-à-vis other countries’.

Because private equity tends to generate rather than simply aggregate data and analysis, we believe PE funds are especially well positioned to harvest growth in the new DHD countries. In “DHD countries not BRIC” and “Data aggregators, generators and the triangulation trap” we identify key portfolio legacy issues hindering investors’ ability to capture the new patterns of growth, including reliance on single-sourced data, which we refer to as data aggregation rather than generation, and stealth index funds, a term we apply to actively managed EM funds with such strong correlation to BRIC indices that they are, by all accounts, indexed funds. 

In “Crisis watch: Dubai & more bubbles to burst,” we focus on misaligned risk/returns expectations based on our own credit risk data for the sovereign debt markets and raise concerns about Brazil and China. Specifically, we discuss how forthcoming liquidations of Bubble-era assets will create short-term market noise and make it harder for investors to price risk/returns based on emerging fundamentals, especially in Brazil.

US & G20: Don’t look here for growth

Our G20 macro economic forecast is rather bearish compared to the consensus view amongst economists as reported by Bloomberg. While we see improvements throughout 2010, we expect growth to be lower than consensus across G20 economies and reach 2% for the year in the US and Canada, and 1% in the EU and Japan. We see little risk of inflation over the next 12 months, with CPI reaching 2% for the year in the US, 1.5% in Canada, 1% in the EU, and -1.40% in Japan. Our view on the UK economy is bleaker: we forecast GDP growth for 2010 to be 1%, inflation 2%, and unemployment to end the year at 8.75%.

Our pessimistic outlook for the US is based on our credit data showing that market sentiment has been, on average, three months ahead of fundamentals over the last 12 months along with our emphasis on housing and credit loss data from banks and insurance companies. Given that we expect economic indicators to be weaker than markets’ short-term expectations, though in line with what we see as strengthening, fundamentals, equity and commodity markets will likely retract in Q1/Q2 in conjunction with a flight to quality, including to Treasuries. However, as economic indicators grow more aligned with market expectations in Q3/Q4, we expect this trend to reverse as liquidity moves out of safe harbors. Against this backdrop, we see commodity and energy prices weakening in Q1/Q2 on a higher dollar and weak growth data. However, as the dollar weakens in the Q3/Q4 and economic data grows more aligned with market expectations, we expect commodity and energy prices to rebound.

EM: DHD countries, not BRIC

Whether or not one forecasts G20 growth above or below consensus for 2010, it’s hard not to agree that the type of growth required to rebuild assets in the aftermath of the Crisis isn’t likely to happen there. The only real growth markets are in the Emerging Markets, but the question remains: which ones? Continuing with restructuring not recovery, we make the case for DHD countries to replace investors’ focus on the BRIC. The BRIC already lost Russia, we have serious concerns with Brazil and China (see “Crisis indicators & more bubble to burst” below), and India alone isn’t a strategy. 

We divide Emerging Markets between countries with growth driven by exports and those relying on increases in domestic household demand, which we call DHD Countries. We further divide the former between commodity exporters and manufacturers. From a structural standpoint, our models indicate that growth will be stronger in DHD Countries, followed by commodity exporters, with manufacturers lagging. We see the top performing DHD economies to be Malaysia, Indonesia, the Philippines and Peru and we forecast GDP growth for 2010 to be 4.5% in Malaysia, 5% in Indonesia, 4.5% in the Philippines and 4% in Peru, at least twice the US average. We are especially bullish on industries fueling growth in DHD countries: real estate, insurance, consumer & domestic credit-focused banks (as opposed to any financials), consumer services & goods, and mobile phone providers. We focus on these industries in DHD Countries, not across EM in general. 

Our trade credit loss data, coupled with feedback from policy makers in central banks, indicate that GDP growth in EM has been recovering earlier and faster than in the G20. While inflation started to pick up in Emerging Markets in Q4 2009, we expect CPI levels to remain within the realm of monetary tools throughout 2010, especially in DHD countries and when using an adjusted CPI that allows for shifting consumer expenses across categories, rather than broad increases in CPI.

Data aggregators, generators, and the triangulation trap

Continuing with restructuring not recovery, we see four impediments to investors capturing the growth laid out above:

• Single sourced data
• Triangulation
• Stealth indexing
• Investment boxes

Single sourced data refers to confusing data aggregators with data generators. A data generator is a government or private sector entity, such as a central bank, bank, or insurance company that produces raw data through direct access to domestic business and economic input, such as mortgage, credit defaults, and investment returns/loss ratios. A data aggregator is a private sector entity, such as research departments at some investment banks, sovereign units at the rating agencies and investment advisors relying on generators for data.

Triangulation is the process by which investors generate forecasts and investment models based on their own top-down and bottom-up data. Investors then compare their assessments to consensus estimates. The goal of triangulation is to separate shifts in fundamentals from market noise and identify long and short opportunities. By definition, data aggregators cannot engage in any triangulation and are vulnerable to group think and herd mentality. Aggregators will either fail to move into new growth areas or miss the early signs of an impending crisis. 

Funds that rely on data aggregation are at best stealth index funds: if they are lucky, they will match benchmarks during Bull markets, rising with the tide, but will almost invariably fail during a crisis. Because their strategy relies on aggregated data, they will fail to capture real returns, as defined as returns over a benchmark, and move into growth markets only once they have become part of the benchmark. Over the last five years, 80% of actively managed EM funds failed to deliver significant returns over a hypothetical portfolio weighted to represent benchmark EM debt and equity indices. Stealth index funds use strategies and portfolio tools, or boxes, lagging behind shifts in fundamentals such as BRIC or EM-wide benchmarks and funds built around a BRIC strategy or large cap EM long funds, rather than strategies focusing on DHD Countries and industries.

Crisis watch: Dubai & more bubbles to burst

For 2010, our Crisis Watch focuses on Brazil and China. Our credit and trade credit data indicates that EM’s contribution to global credit risk has diminished, while G20's, especially the US and UK’s, has increased. However, spreads have yet to adequately price this shift in risk. Specifically, we see large misalignments between macro economic and sovereign risk in Brazil and China. For Brazil, while our trade credit data indicates improving local credit default rates, the improvement is smaller than the reduction in lending rates or expected returns on Brazilian assets following the country becoming investment grade. For China, our data shows no correlation between equity returns and credit default rates, two key indicators of expected market volatility in other countries under our models. Furthermore, 65% of China’s economy is export, manufacturing or government driven, leaving it outside of the DHD camp for now, and pointing to ongoing weakness throughout 2010. 

Alliant Emerging Markets (AEM) is a leading emerging markets risk advisor syndicating more than US$1 billion in risk transfer programs annually. AEM is part of Alliant Insurance, a Blackstone Group Company. Dr. Léonard’s Outlook is available on Bloomberg Professional at ABEM and he can be reached via e-mail at mleonard@alliantinsurance.com.

About the Author

MICHEL LEONARD, Ph.D.
Chief Economist & Senior Vice President, Alliant Insurance | A Blackstone Group Company

Michel Léonard, Ph.D., is Senior Vice President and Chief Economist at Alliant Insurance, a risk advisory firm owned by the Blackstone Group of Companies. Dr. Léonard oversees credit and political risk rating, modeling, and project finance services. His expertise focuses on increasing a firm's returns in high-risk environments through custom risk transfer solutions bridging insurance and capital markets. Dr. Léonard came to Alliant after a decade of involvement in risk management, credit modeling, and cross border risk analysis. He was Chief Economist and Head of Political Risk Consulting at Jardine Lloyd Thompson LLC, and occupied similar positions at Aon. Prior to Aon, he was with Medley Global Advisors, a risk analysis firm founded by George Soros's former Chief Political Strategist. Dr. Léonard started his career as an academic at the University of Virginia. He is a frequent commentator in the financial and news media on political risk assessment, financial risk modeling, and terrorism. His work has been featured in the Financial Times, the Wall Street Journal, Business Week, and Business Insurance, amongst others. A graduate of McGill University, he holds an MTS in Islamic Studies from Harvard University and an MA and Ph.D. in Political Economy from the University of Virginia.

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