At ABP Investments - part of ABP, the Dutch civil servants pension fund (e160bn) - a disciplined three-stage approach is being used for scanning the future and interpreting current developments on financial markets. Both strategic and tactical asset allocation, asset/liability management, stress testing and the preparation of investment plans, benefit from this process. The three stages are as follows:
q An analysis of the major secular trends (the ‘tide of events’);
q The identification and assessment of the two dimensions of uncertainty that are deemed critical for the medium term investment prospects;
q The actual medium-term assessment of the global economy and financial markets.
Stage one: secular trends
Several long-term tendencies can be identified, but the most important shift in the global environment is comprised of three mutually interacting secular trends.
Firstly, capitalism has become the preferred mode of organising economies and production processes in almost every part of the world. Even countries that are in name still going under the banner of communism or central planning, such as China, are on a steadfast course towards opening up to the world and giving more freedom to reward.
A second major trend is the ongoing information and computer technology, or IT, revolution that is changing the way people communicate and exchange information. Technological progress, when combined with reform, provides companies with ample opportunity to boost productivity, improve on information availability and to produce wherever they choose.
The third secular force, which flows partly from the former two, is the rapid growth and integration of Asia, providing the global economy with an abundant pool of cheap labour.
The combined upshot of these secular changes is a continued strengthening of the productive potential of the world economy. These beneficial changes on the supply side have been very supportive of the fight against inflation that started almost 25 years ago. With inflation broadly under control, central bankers have been able to focus more on the conduct of growth and employment friendly policies.
Low and declining interest rates, falling inflation and greater macro-economic stability have provided a major tailwind for broad asset markets, but have at the same time increased leverage in the private sector and increased the vulnerability of economies to adverse wealth effects. With global supply on a fast growth-path, the major secular worry for the future is that demand will not keep the same pace or, worse, will falter.
The very strong and so far successful policy stimulus that was provided over the period 2001-2004 to the pivotal US economy, has taken interest rates and bond yields to secular lows and has contributed to rich valuations on major asset markets. As a result, strong global supply fundamentals currently go hand in hand with a low real interest rate and tight risk premiums.
Asian governments aiming for the rapid mobilisation of underemployed labour resources (China) or an end to deflation (Japan), are resisting an appreciation of their currencies versus the dollar by recycling huge amounts of dollars back to the US treasury market.
It is doubtful whether this informal agreement between the US and Asia, in which Asian goods are traded for US fixed income securities, is sustainable. Several adjustments are conceivable, comprising currencies, interest rates and (relative) economic growth. An uncontrolled adjustment clearly would hurt financial markets and growth worldwide.
Stage two: critical uncertainties
The first critical uncertainty we distinguish is global GDP growth. Going into 2005 investors are expected to remain focused on the sustainability of the recovery and its implications for interest rates and asset prices. Vulnerabilities have increased with higher leverage and greater global current account imbalances, to name just two.
The second critical uncertainty concerns underlying inflation. If the growth/inflation trade-off which has been very benign since the 1990s deteriorated, monetary policy makers will be compelled to react and push up interest rates more forcefully than currently envisaged. This would have serious ramifications for asset valuations.
Factors that could increase the underlying inflation in the world economy are not inconceivable; just think of an unexpected deceleration of productivity growth, a strong depreciation of the dollar, protectionism, geopolitical pressures or a major spike in oil prices.
Stage three: central medium-term outlook and risks
Given two major uncertainties - global growth and underlying inflation - four medium-term scenarios can be identified (see figure). Pacific prosperity is currently deemed the most likely scenario, combining decent growth, low inflation, supportive monetary policies and a gradual rise of bond yields. In terms of growth, both the US and Asia will continue to outperform the euro area.
The other three scenarios address the main risks and consequently act as stress scenarios. Underlying the Pacific prosperity scenario is the assertion that the identified benign secular tendencies will continue, that productivity growth will remain strong and that inflation will be contained. Factors supporting this fairly optimistic stance on the economy are the strong profit growth and the improved financial position of corporations that should underpin continued growth of investments in employees, machinery, new product and new markets. On the other hand, debt growth among household is likely to decelerate as interest rates head higher, making a prolonged period of above potential growth unlikely.
Inflation is deemed to remain benign, as trend-like growth numbers, fierce international competition, outsourcing and strong productivity numbers, will weigh on the bargaining position of labour versus capital. With inflation under control, central banks have the luxury of patience.
If the general outlook is benign, return expectations are meagre. The gradual transition towards higher interest rates will depress returns on fixed income securities, with credit bonds only slightly outperforming government securities. Real estate valuations have become rich, especially in light of the expected rise in bond yields. Equities will likely provide the best hedge against higher interest rates, supported by continued, albeit only moderate profit growth. Finally, the US dollar will likely weaken versus the euro, with currency adjustments in Asia postponed and Asian central banks continuing to finance US deficits for some time to come.
As indicated above, weaker than expected demand is considered a major risk for the immediate future. This risk is captured in the deficient demand scenario that envisages a slowdown in consumption growth due to falling asset prices and/or continued weakness in the labour markets. The latter factor could reflect a slow speed of adjustment to increased international competition from Asia, while governments, struggling with rising debt and deficits, are not in a position to boost aggregate demand. Bonds will do well in such an environment, strongly outperforming equities.
Inflation flares up in the second alternative scenario fighting inflation, as growth is initially high, productivity growth slows and policy makers seriously misread economic slack. Both bond and equities will be poor in this scenario as interest rates are ramped up overshooting cyclically neutral levels.
The final alternative scenario, combining slow growth and increasing inflation risks, depicts a stagflationary environment reminiscent of the seventies: oil prices spike, productivity performance deteriorates as investment horizons shorten and developments in the Middle East spiral out of control. Only commodities and index-linked bonds give positive returns under these conditions.
ABP employs a diversified strategic asset mix with 36% invested in equities, 44% in fixed income securities and 22% in alternative assets. The aim is to achieve a long-term average portfolio return of 7%. So far actual performance over the last decade is on track. The odds of the 7% target being met over the 2005-2007 period does not seem high. In Pacific prosperity the average total expected return is 5-5.5% (and in the stress scenarios even lower). Low initial interest rates, tight risk premiums and the prospect of capital losses on the fixed income portfolio are likely to add up to a meager medium-term absolute performance.
As rising interest rates are a necessary route away from the current low return environment, there is a silver lining to this story. From an overall balance sheet perspective the main medium-term risk lies with a (conceivable) faltering of global demand. This would hurt both sides of pension funds’ balance sheet, putting downward pressure on funding ratios.
Prepared by the global markets research team at ABP Investments: Wim Beventsen, Onno Steenbeek, Frank van Weegberg and Victor Zanting