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May 8, 2010
Emerging Markets Watch
Ramin Toloui | April 2010
“Region of Reverse Command:” Consequences of the Industrialised Country Debt Explosion

A pilot usually gets a plane to gain altitude by pulling back on the controls to raise the plane’s nose, which directs more engine thrust upward and causes the plane to climb. But as student pilots quickly learn, there is a limit. While raising the plane’s nose causes the plane to climb, it also induces a type of drag that causes the plane to slow down. As a plane slows down, it becomes progressively more difficult to maintain the lift needed to get the plane into a climb. Eventually, the induced drag is so large that it overwhelms the impact of raising the nose, so that pulling back on the controls does the opposite of what it normally does, causing the plane to descend instead of climb. Pilots know this as the “region of reverse command”.

Economic policy has a region of reverse command, too. The standard Keynesian prescription directs governments to increase spending during recessions – when the economy is losing altitude, point the nose up! This has been a successful tool for fighting recessions in industrial countries since the Great Depression. But greater government spending eventually has its own kind of induced drag: namely, rising public debt levels that generate concerns about future higher taxes and government crowding-out of the private sector that impair growth. When government debt reaches extreme levels, concerns about government creditworthiness become so severe that additional government spending produces increases in long-term interest rates that exacerbate, rather than ameliorate, the economic contraction.

Emerging economies have experienced many painful moments with this region of reverse command. When financial crises spread across the emerging world in the 1990s and early 2000s, many emerging governments had to respond to deep recessions by doing exactly the opposite of the Keynesian response:cutting government spending, in order to establish fiscal credibility in the midst of crisis. The accompanying increase in private confidence, along with the breathing room provided by IMF lending, helped bring down interest rates from crisis levels and set the stage for renewed growth.

But this concept is new for the global economy as a whole, specifically for the industrial world. To be sure, we are not as yet in the region of reverse command for the world as a whole. Long-term interest rates in the majority of industrial economies remain low, despite extraordinary levels of government borrowing. But there is growing evidence that the global economy is not operating in the familiar region of “normal command” either. The higher price of insuring against industrial country default in the credit default swap market is one example of the nascent reassessment of sovereign creditworthiness in industrial countries.

This reassessment has far-reaching consequences for financial modelling, economic policy, indexing, and asset allocation that global markets are only beginning to digest. This note examines several such consequences, with a special focus on the implications for investing in emerging markets.

From “It Worked” to “What Next?”
If 2008 showed how quickly financial crisis could push the global economy toward the abyss, 2009 illustrated the potency of a whatever-it-takes government policy in pulling it back from the brink. A year ago, it was almost conventional wisdom that the bulk of the US financial system was insolvent and needed to be nationalised, threatening to create a new wave of uncertainty at a moment when the US economy was shedding jobs at the fastest rate since the Great Depression.

But this didn’t happen. The combination of a massive increase in government spending and zero interest rates alongside over $1 trillion in asset purchases by the Federal Reserve provided direct support to economic activity and – at least as importantly – gave financial markets a perceived government-underwritten green light to add risk. And add risk they did, generating historic increases in equity, corporate bond, and other asset markets that helped repair damaged balance sheets in the financial and household sectors. The financial recovery mitigated the contraction in the real economy, setting the stage for a return to positive growth and finally job creation, albeit limited. In unusually direct language, the leaders of the G-20 group of industrial and emerging market countries declared in September 2009, “It worked”.

The extraordinary effectiveness of government policy in 2009 has given way to a new focus on the limits of government policy in 2010. At the core of the discussion is the extraordinary build-up of government debt in the industrial world. The increases in public debt in the United States and other key industrial countries are without precedent outside of wartime, as illustrated in Chart 1.

While the financial crisis has driven the recent explosion in public indebtedness, longstanding challenges of aging demographics and rising entitlement spending are key structural factors undermining the long-term fiscal situation. The crisis has brought those problems forward in time, complicating the problem while making the action to address deteriorating public finances more urgent.

Four Implications of the Region of Reverse Command
Investors are only beginning to enumerate and understand the full consequences of the debt explosion in industrial countries. We can begin by identifying four such implications.

1. Traditional Asset Pricing and Risk Management Systems

Major asset pricing models that seek to explain differences in expected risk and return across asset classes are built on the foundation of a “risk-free” rate of return. The risk-free rate is conventionally assumed to be the interest rate on government debt. The short-term interest rate on government debt – for example, three-month treasury bills – is considered the ultimate risk-free rate, since the prices of longer-term government bonds are more volatile. But even the volatility in long-term government debt has been presumed to be driven by changes in the expected path of interest rates and uncertainty about that path, rather than questions about government solvency and ability to service government debt.

The financial crisis has ushered in a period where investors discuss not just interest rate risk at the core of the industrial world, but also credit risk. Concerns about the potential for debt servicing problems in industrialised countries is evident in the cost of insuring against default across industrial country sovereigns in the credit default swap market, shown in Chart 2. Although a number of technical factors are also at work, Chart 3 shows the move to negative 10-year swap spreads in the United States – that is, the interest rate on interbank 10-year interest rate swaps is lower than the yield on 10-year US Treasury bonds. This is another sign that the traditional relationships between relative asset prices are being dislocated by developments in government debt markets.

This has several consequences for asset pricing models and risk management systems. It means that such models will have to incorporate various degrees of credit risk as a factor in explaining the slope of government yield curves, the pricing of corporate and other securities relative to sovereigns, and the way asset prices would be expected to move under various stress scenarios. Corporate securities, for example, have typically been priced at a positive yield spread to the sovereign, reflecting the presumption that corporations bear credit risk that government securities do not. That presumption is being challenged in Europe, where multiple corporations are trading at lower credit default swap premiums than the European governments in which they are based.

2. Economic Policymaking, Forecasting and Analysis

Counter-cyclical government policy in the core of the industrialised world has typically been implemented in the “region of normal command,” where the direct stimulative impulse of additional government spending far outweighs the potential contractionary impulse from the resulting higher levels of government debt. This is because under moderate levels of government debt, the induced drag from concerns about repayment capacity is minimal. The overwhelming – and successful – response to the financial crisis by authorities in the United States and other industrial countries is evidence of how potent this tool can be.

Keynes’ advice for managing the economic cycle called upon governments to run surpluses during boom periods of the economic cycle precisely to enable them to run budget deficits and boost aggregate demand during periods of recession. Fiscal austerity during good times provides the degrees of freedom to respond decisively during the down times in the business cycle. As debt levels rise, the degrees of freedom for government action become increasingly reduced.

The problem now confronting the industrialised world is that the increase in debt levels is a secular, not cyclical phenomenon; and it is also increasingly structural in nature. It is not a matter of belt-tightening during the recovery phase to bring debt levels down to pre-crisis levels and pave the way for fiscal policy to come to the rescue during the next downturn. Rather the belt-tightening is needed to prevent the medium-term debt path from becoming explosive. Therefore, even under generous assumptions, the degrees of freedom that industrial countries have to navigate future shocks will be considerably less than has been the case in the past.

This reality is amplified by the international mobility of capital in the modern global economy. Before the collapse of the Bretton Woods system in the 1970s, restrictions on cross-border capital flows gave governments additional freedom of maneuver, since many of the investment funds that they relied upon to finance themselves domestically were captive. Similarly, the home bias of the largest pools of Japanese capital helped Japan’s government finance enormous budget deficits beginning in the 1990s. Combined with zero-interest rate policy and chronic deflation, this helped keep long-term interest rates low despite massive levels of government debt. Investors in industrialised countries, however, are becoming progressively more international in their asset allocations, leaving less cushion for governments.

The upshot is that rising debt levels will increasingly influence the conduct of counter-cyclical policy in industrialised countries. The notion of “limits” and “what the market will bear” will become more salient in discussions among policymakers. There will also be politically induced limits as high debt levels become a populist lightning rod. The reaction function of core governments as they confront future economic disruptions will be constrained in ways they have not experienced in recent history.

Investors analysing the interaction between government policy, economic performance, and financial markets will need to incorporate these new relationships into their formal economic models, as well as qualitative assessments about the execution of economic policy.

3. Rethinking Fixed Income Indexes

Most investment management, whether passive or active, is conducted in reference to an index that is supposed to reflect the market return (beta) for the given asset class. Passive investors seek to replicate the index return (beta only), while active investors seek to add excess return on top of the index return (beta plus alpha). In either case, the selection of the beta is critical.

Nearly all indexes, whether for bonds or stocks, use the organising principle of market capitalisation. That is, the weight of securities in the index is determined by their market value: higher market value means higher weight in the index, lower market value means lower weight.

There are several acknowledged drawbacks of market capitalisation-weighted indexes. For example, market capitalisation indexes tend to increase the weight of securities that may be becoming overvalued. Rising prices mean higher market capitalisation, which increases index weight. The index rules say to buy more of securities that have gone up in price and experienced an increase in market cap weight, and sell securities that have decreased in price and experienced a reduction in market cap weight. The resulting “buy high, sell low” bias is the exactly the opposite of the investment maxim of “buy low, sell high.” This was illustrated most prominently in the late 1990s, when market-cap weighted equity indexes induced investors to increase the weighting of overvalued tech stocks immediately prior to the bursting of the tech bubble.

Market-capitalisation weighted bond indexes have an additional bias: they tend to reward large issuers of debt. Larger issuance is correlated with larger market capitalisation, which means larger weight in the index. Obviously, this may not be an ideal approach for a bond investor that is focused on the creditworthiness of issuers and their ability to service debt in the future.

The focus on sovereign creditworthiness has increased the urgency of this aspect of bond index construction. Industrialised country government debt is by far the largest component of global fixed income indexes. Market capitalisation weighted bond indexes are poised to increase this concentration further, particularly in countries where debt is growing the most.

To provide an alternative to market capitalisation weighting, PIMCO launched the Global Advantage Bond Index in early 2009, following an almost two-year process of designing the new index. The key distinguishing feature of PIMCO Global Advantage is that it uses national income (GDP) to set the weights within the index rather than outstanding stocks of debt. This resonates with the common-sense idea that it is advantageous to lend to countries with high incomes rather than high burdens of debt.

Empirical analysis of investment returns provides support for the favourable performance characteristics of a GDP-weighted approach vs. market capitalisation. Using JPMorgan’s database of industrialised country government bond returns, we find that a GDP-weighted basket of industrialised country bonds outperforms the market-capitalisation weighted version over the twenty-year period 1989-2009 by almost 5% (7.59% annualised return vs. 7.25% annualised return, 34 basis points difference per year). This higher return was achieved at a lower level of volatility, as shown in Chart 4. Moreover, the outperformance of the GDP-weighted basket was remarkably consistent, outperforming the market capitalisation-weighted version in 12 of 16 five-year periods, illustrated in Chart 5.

Historical performance within the industrialised country universe may not fully reflect the potential benefits of a GDP-weighted approach looking ahead. One outcome of a GDP-weighted index is a substantially larger allocation to emerging markets than traditional market capitalisation-weighted fixed income indexes. For the reasons described in the next section, larger allocations to emerging markets are likely to be a key investment theme in the years to come.

4. Global Asset Allocation

Emerging markets played a role in the global economy’s recovery last year that was historically unique. Like industrialised countries, the financial crisis hit emerging markets hard, particularly in the fourth quarter of 2008 and first quarter of 2009 as the collapse in international trade following Lehman’s bankruptcy rippled across the globe.

But unlike in previous episodes of financial distress, emerging market countries generally entered the crisis with strong balance sheets. This was especially true in China, where low levels of government debt enabled an aggressive program of infrastructure investment and government-sponsored credit growth that not only supported economic growth at home, but also had a strong positive spill-over to growth in other emerging markets and commodity-exporting industrial countries like Australia. PIMCO estimates that China contributed more than 1½ percentage points to global GDP growth in the first half of 2009, at a time when the global economy needed such an engine. It was not just China. In the second quarter of 2009, the contribution of the twenty largest emerging markets, excluding China, to global demand growth turned positive, at a time when domestic demand in the United States was still contracting. The emerging world as a whole, with the critical role played by China, was an agent of its own recovery in this crisis to a degree not previously seen.

The reason this occurred is that low levels of public debt gave systemically important emerging markets scope for aggressive fiscal policy to counteract the headwinds from industrialised markets. And debt levels in the major emerging markets are projected to stay manageable. As illustrated in Chart 6, public debt as a percentage of GDP is projected to decline between 2009 and 2014, in sharp contrast to industrialised countries where debt levels are higher and rising sharply.

We believe that the fact that traditional patterns of indebtedness are being turned on their head will have dramatic consequences for asset allocation by global investors. Lower levels of debt give emerging markets the added degrees of freedom to continue financing economic growth. Greater economic dynamism will in turn lead to more attractive investment opportunities and an increasing flow of funds from industrialised country investors that have historically been domestically focused. Home bias will fade because institutional investors, particularly pension funds, will likely find it difficult to meet their return objectives without tapping into the range of investment options in the emerging world.

Implications for Emerging Markets
The large increases in government debt in the industrialised world will reshape the global investment landscape in multiple ways. What are the key implications for emerging market investors?

First, emerging market assets across the board – from external debt, to local currency debt, to local equities – are poised to benefit from portfolio shifts by industrialised country investors into the emerging world. These changes in asset allocation are set to be amplified by the rise of alternative indexes that depart from market capitalisation and embrace concepts like GDP-weighting that increase the weight of emerging markets. Many investors have strategic allocations to emerging market fixed income that are well below optimal levels. Early adopters and first movers in this reallocation process are positioning themselves to benefit from the rest of the market following that trend.

Second, large flows of new capital into the asset class increase the priority for emerging market managers to continue to seek out cutting-edge opportunities. New money gives rise to the potential for overvaluation to develop in particular pockets of the asset class. For example, to the extent that early investment of asset allocation funds flow into sovereign external debt, valuations of sovereign debt may become less compelling relative to opportunities in government-owned quasi-sovereigns and other emerging market corporates. Attractive sectors include state-owned energy companies, financial institutions, and commodity producing corporations in major emerging countries. It also becomes more important for managers to expand into more specialised instruments like high-quality asset-backed securities financing emerging market infrastructure, such as government-guaranteed toll roads in Latin America, where more intensive due diligence requirements are rewarded with higher potential returns.

Third, while the fundamentals for emerging markets as a whole are strong, not all emerging markets are equal. The debt problems affecting some of the peripheral industrialised countries like Greece offer a potent reminder of the importance of credit differentiation within the emerging market space. This means avoiding countries where either the capacity or willingness to service debt is compromised.

Finally, the integral – as opposed to ancillary – role in global economic and financial affairs that emerging markets play in shaping global economic events will need to be incorporated into portfolio strategy. Emerging markets are no longer the passive appendage of the global economy, where outcomes are derivative of those in larger and more powerful industrial countries. Emerging markets now have a seat in the cockpit of global economic governance.

With this greater voice come new responsibilities in the global arena – responsibilities that will shape the policy choices made by emerging market governments and their economic consequences. For example, China’s policymakers can no longer set the country’s monetary and exchange policies without reference to their impact on the global economy and China’s relations with other key countries. Long positions in the Chinese yuan and other Asian currencies like the Korean won, Philippine peso, and Singaporean dollar reflect the thesis that exchange rate appreciation in emerging Asia will have a critical role to play in the rebalancing of global economic activity. This is one example of how the new and more complicated set of strategic interactions among the key players in the global economy will shape investment strategy in dedicated emerging market portfolios and beyond.

For pilots, the prescription for getting out of the region of reverse command back into the region of normal command is simple: push the controls forward to lower the nose, while adding power with the throttle to build up speed that will allow the plane to climb again. It is not that different for the global economy. As the crisis period passes, the focus in industrial countries will shift from fiscal expansion to fiscal retrenchment. The global economy will lose altitude, unless offset by some thrust from other sectors. The private sectors in industrialised countries are part of the story. But more and more, the ability of the global economy to draw power from the emerging world will be decisive in its ability to gain the speed required for a sustained climb.

Ramin Toloui
Executive Vice President


From → Global neh

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