Global economic trends: market outlook


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The financial markets are in turmoil, growth in developed economies has faltered, and in many countries national indebtedness is spiralling out of control. For high net worth individuals (HNWIs) it is a hugely challenging global economic environment in which to manage their wealth. Indeed, in many cases the focus is shifting from obtaining a yield back to preserving existing capital yet again. But, despite the uncertainty, for those with the risk appetite there are still growth opportunities available.

Financial uncertainty

The initial banking crisis may have abated but the global economy is still some way from recapturing its pre-2008 performance. Merrill Lynch Wealth Management’s recently published World Wealth Report 2011, produced in association with Capgemini, highlights a number of risks that could, potentially, derail any weak recovery underway in the developed economies.

Many governments are grappling with the challenge of dealing with huge levels of indebtedness and borrowing, while trying to support a fragile economic revival. Fiscal deficits are being targeted through sharp cutbacks in borrowing and public spending.

“The major fiscal risk is around Europe and the Eurozone,” says Bill O’Neill, Chief Investment Officer at Merrill Lynch Wealth Management. “High levels of private indebtedness disguised an imbalance of spending and taxes in the underlying fiscal position of governments. This has been exposed by the financial crisis. There are countries with a lot of private debt accumulation where the fiscal position looked acceptable, but that is no longer the case and the fiscal position has actually deteriorated. The US, and a number of peripheral economies in Europe, such as Greece, Ireland and Portugal, are examples.”

So current borrowing levels are unsustainable and must be tackled. Governments around the world have embarked on a medium term strategy to control borrowing and cap it at acceptable levels – somewhere below 80 or 90% of debt to GDP. Inflation is another factor for consideration in wealth management strategies. So far the inflation threat is relatively subdued, notes O’Neill, certainly in the developed economies. Headline inflation has picked up, but core inflation has not proved so problematic. Central banks will have to support the revival in the private economy, and take every step to ensure that basic growth gets back on a sustainable path. So the likelihood is that central bank policy will remain very friendly, particularly in those economies experiencing the effects of substantial deleveraging.

“For high net worth individuals, I believe inflation will prove a temporary phenomenon, and don’t see it being a substantial threat over the medium to longer term,” says O’Neill. “The key issue is the extent to which the central banks, when the time is right, are successful in removing the amount of liquidity they put into the system, and how aggressive they are in doing so. That’s important if we are to avoid a similar situation to that of Japan, which has remained in a state of deleveraging and poor growth for a very long time.”

There is a suspicion that inflation may play a part in meeting the key debt reduction challenge for the next five to ten years in the West, says O’Neill, but it is not the only option. There will be austerity measures, pressure on import taxation systems and spending programmes, and probably a devaluation in western currencies relative to the emerging market bloc.

Emerging markets

For equities, which according to the World Wealth Report 2011 remain the largest element of the HNWIs investment portfolio, emerging markets are still attractive, says O’Neill. “Growth in emerging markets will be 6.5%, while growth in the developed world will be somewhere between 1.5% and 2%. That gap in growth rates is driving a strategy that seeks to capture the opportunities in the developing world and emerging market world. That is especially true now that some of the concerns about overheating in the emerging markets may be beginning to subside,” he adds.

“Equities represent good value at current levels, providing that the US does not slip into a recession which we do not expect. Although volatility will remain significant.”

In the debt markets, O’Neill expects a low interest rate environment with flattening yield curves. The market is no longer pricing in significant interest increases over the next one to two years and a sustained low growth, lower inflation, lower interest rate environment has been discounted in fixed income. One trend in the market is a move from sovereign debt risk to corporate debt risk. Emerging market debt is another interesting story, he adds, particularly if interest rates have peaked in emerging markets and the local currencies continue to rise against the dollar over time.

In commodities, the downside in oil looks limited due to supply constraints, but no rebound in oil price is expected. Precious metals, gold principally, may continue to rise in the short term as policy measures become more aggressive, says O’Neill but this asset is beginning to show the characteristics of a bubble. Silver remains a leveraged play on gold and is itself susceptible to supply concerns.

“These commodities are exposed to an emerging market rebound, or a shift in thinking on the risks around emerging market growth,” says O’Neill. “Until recently there were thoughts that the Chinese market was overheating, and that there would be a collapse in growth. That threat appears to be receding and industrial metals, particularly copper, should provide a strong performance based on the fundamentals.”

Elsewhere, O’Neill believes that with currencies, safe haven currencies, particularly the yen and the Swiss franc, look overvalued at the moment, while the dollar will gradually strengthen over the next six months against the euro. Real estate is a yield play in certain markets, although the attractiveness of individual markets varies considerably.

If the financial markets look grim at times, at least HNWIs are able to increase their spending on the things that they really enjoy. The World Wealth Report 2011 reveals that all types of investments of passion (see box) are in demand. However, while seemingly buoyant, record values in many of the investment of passion asset classes are being strongly supported by high net worth buyers from the Asia-Pacific market.

If you are a superyacht fan it may be a good time to buy. While the speculative build market is far less attractive post the 2008 crisis, there is still demand for superyachts, which can be bought for considerably less than their pre-2008 prices. In 2011, as of September, 198 superyachts had been sold with an average sale price of EUR 9.8million, according to boatinternational.com’s market intelligence guide. A good broker will advise on those critical purchase factors, such as brand, technical specifications and boat history.

Unsurprisingly, the banking crisis and economic downturn, and the challenges outlined, have affected the wealth management approach of HNWIs in a number of ways.

“The main impact is that high net worth individuals are much more conservative. They are looking at the composition and level of risk of portfolios and are less inclined to take risk,” says O’Neill. “They want direct access to information, particularly on the downside risk.”

At the same time there is an emphasis on preserving the real value of wealth, so capital preservation strategies have much more prominence. There is also much more sensitivity to illiquid assets. Ready access to liquidity is increasingly important.


Fundamental principles

During periods of great uncertainty and turbulence in the global economy, the fundamental principles of wealth management become all the more important for high net worth individuals.

“The fundamental principles here are that you construct a diversified portfolio in line with what you want as your return objectives – whether that is conservative or aggressive over time. And there must be a proper level of risk diversification that equates with the level of risk appetite you are prepared to accept,” says O’Neill.

“You need diversification in all its forms, whether that’s in terms of drawdown risk and risk of loss, diversification in terms of income source, currency risk, and also in terms of sources of capital gain. Large spikes in volatility lead to sharp setbacks in the market, which, while not sustained can prove problematic, particularly if you want to liquidate assets.”

“Returns should be structured in a way you are happy with, whether that is dividends versus capital growth, or bond coupon versus appreciation on the bond itself.”

One thing is certain. High net worth individuals will be dealing with the challenges of preserving capital and obtaining growth for some time to come, says O’Neill. “Although elements of imbalance are being addressed, the global economy remains very unbalanced. We have had a mammoth asset and debt bubble in Western economies that is still being dealt with by the authorities and by markets,” he adds.

“The recuperation period is not going to be one or two years, it is going to be an extended period of time. We can look forward to another three to five years of convalescence. That doesn’t mean we don’t get any growth, but it does mean that there are headwinds to growth. So it might be mid-decade before we are back to something we could broadly consider normal growth.” ■

The art of investment

The economic gloom did little to dampen the excitement in the art market in 2010. Pablo Picasso’s Nude, Green Leaves and Bust (right) sold for an all-time artwork record of US$106.5m. Not far behind was Alberto Giacometti’s sculpture L’homme Qui Marche I, that fetched US$103.7m. In all, seven works of art broke the US$50m barrier in 2010.

It is not just art that is doing well. As the World Wealth Report 2011 reveals, all types of ’investment of passion’ were in demand, including luxury collectibles such as cars and boats, jewellery, gems and watches, and even sports investments.
“Interest revived in all forms of investments of passion as alternative vehicles for preserving and appreciating capital over time, diversifying portfolio exposure, or capturing short-term speculative gains,” says David Jervis, head of EMEA Wealth Management at Merrill Lynch. “The ‘passion’ aspect is essential, though. If you look at these kinds of items simply on the basis of the fundamental characteristics, they would only play a very modest role in an investment portfolio.”

And, while investments of passion can act as a store of value and a target for safe haven buying, as well as an imperfect inflationary hedge in some instances, they can also prove illiquid and difficult to encash and are subject to the vagaries of fashion. The investments of passion markets in 2010, for example, would have been much weaker without the demand from emerging market high net worth individuals. So buy what you are passionate about – with the help of expert advice – is a useful rule of thumb. That way, at the very least, your purchase provides a level of enjoyment, a so-called psychic income, even if its value as an investment proves less rewarding.

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