No Armageddon, but Consequences
In a time of severe stress and crisis, it’s easy to come to the conclusion that Armageddon is upon us. Those who believe the European Union is going to split up and China’s growth will come to a screeching halt are probably building bunkers and sharpening their survival skills right about now. Dr. Michael Hasenstab, Senior VP and co-director of Franklin Templeton Fixed Income Group’s® International Bond Department, isn’t in panic mode. In fact, he’s optimistic the eurozone will survive, and that no, China won’t move back into the feudal age. However, he does believe there are some game-changing events taking place in the financial markets and in China today that will have future consequences for investors—some potentially good, but others maybe not so much. As a long-term investor, he’s planning ahead for these potential future consequences, and is seeking out the high ground.
Hasenstab’s assessment of current events, in his words:
- “Things are difficult, but I don’t think we need to believe the Armageddon scenario. Greece appears financially terminal, but in my view, Italy and Spain by no means have to be financially terminal.”
- “A country may print its way out of a liquidity crisis, but it can’t print its way out of a solvency crisis or print its way to lower unemployment rates.”
- “I think there is no question China is in a mini cyclical slowdown, but nowhere near a precipitous drop.”
- “Wage pressures in China have important global implications. Today, I believe China is on the cusp of exporting inflation, a completely different dynamic.”
- “I don’t believe there’s a risk-free asset anymore. The question is whether you are getting rewarded for the risk you are taking. There are always opportunities, and I think if you have a long-term perspective, you can be rewarded.”
We’ve heard Hasenstab’s views before on the European debt crisis. He still believes that should Greece ultimately leave the euro, that the “ring fences” are in place—that is, the European financial system is prepared to weather a “grexit.” In the long-run, he thinks that outcome might not be a bad thing if the alternative is that the rest of the EU has to indefinitely subsidize Greece. He has noted seeing signs of slow progress underway in Spain and Italy, and believes there are reasons to be optimistic about Europe’s future.
“Things are difficult, but I don’t think we need to believe the Armageddon scenario. Greece appears financially terminal, but in my view, Italy and Spain by no means have to be financially terminal.”
Once the panic of the eurozone crisis ebbs a bit, there are two other issues Hasenstab thinks warrant meaningful consideration from a long-term investment perspective: the easy monetary policy many central banks have been engaging in for years, and an economic rebalancing in China.
Since the start of the financial crisis in the U.S. in 2008 – 2009, the Federal Reserve and some other central banks across the globe embarked on a variety of stimulative measures to combat short-term market shocks and boost growth. What does Hasenstab think of the Fed’s prolonged approach to throw dollars at every problem?
“A country may print its way out of a liquidity crisis, but it can’t print its way out of a solvency crisis or print its way to lower unemployment rates. The U.S. unemployment rate is high because it is going through a typical post-financial market crisis crash and recovery, which can take a decade to recover from. Printing money provides liquidity, but doesn’t speed up the process, and I think it’s starting to have more negative than positive consequences in terms of future inflation and capital flows.”
While some of this hot-off-the-presses cash does recapitalize a home country’s sick financial system, some also flows into other markets. Hasenstab believes those money flows can offer some help protecting against a potential credit crunch in the emerging markets, which is positive. However the “monetary tsunami” the U.S. has created could result in inflation washing up first on distant shores as all those dollars flood the system and boost commodity prices.
“When the large economies print money and debase the value of their currencies, people have tended to look for places to store value. I think the financialization of commodities is a direct result of this prolonged quantitative easing policy. Rising commodity prices tend to hit emerging markets first because they are more dependent on commodity consumption and are less able to absorb higher prices. We’ve seen inflation temporarily slow in some of these markets, but inflation is still an underlying issue and one that isn’t likely to disappear. It’s something we have to be very defensive about given this extraordinary easy monetary policy experiment.”
Structural Change in China
There’s no debating the power China exerts on the global economy, and chatter about their economy coming in for a “hard landing” is ubiquitous. In 2010, China’s GDP was 10.5%, and in 2011, 9.2%1. Various forecasters predict growth somewhere around 7 – 8% this year. Hasenstab doesn’t see this gradual decline as a hard landing at all. But what might trigger one?
“There would have to a massive policy error where China over-tightens and engineers a recession. I think that is unlikely. In my mind there is no question China is in a mini cyclical slowdown, but nowhere near a precipitous drop. The second way to trigger a hard landing is a banking system crisis, and a country like China with artificially repressed interest rates can be particularly vulnerable. However, I think China’s $3 trillion in reserves is a huge cushion against a banking system crisis.”
Even if China can engineer some soft landings, Hasenstab thinks China is still facing challenges tied to a necessary economic evolution, the liberalizing of assets in what Hasenstab calls “the factor markets:” land prices, the cost to the environment, and interest rates.
“Think about a typical project that might be going on in China: a coal plant. Right now, the owner can get a 2% loan from the government, build 1950s technology which pollutes the environment massively, and get the land for free. If you liberalize, he now might have an 8% loan, have to use more modern technology, and pay for the land. That’s a very different profitability or cost structure for his company. China looks like it’s on the cusp of embarking on a more efficient allocation of capital; moving from a higher growth rate with what might be considered lower quality of growth, to a lower growth rate but with a higher quality of growth. I think it’s essential to make this transition, but during the process there are a lot of potential vulnerabilities because it’s necessary for the government to kind of take its hands off the controls.”
China is also facing a potential labor shortage, which may seem hard to believe. We often think of China as having an infinite supply of labor, but its one-child policy is working its way through the population. The result? Rising wages.
“You can see this in the most basic of labor prices – migrant labor costs. They had been stagnant despite inflation, despite rising growth, and have begun heading up. Wage pressure in China will likely have important global implications. On the positive side, it will probably help rebalance the Chinese economy. One of China’s main challenges is investment outweighing consumption. How do you get more consumption? One way is to create social safety nets like unemployment insurance, healthcare or education so there is little need for a 40 – 50% savings rate. But that takes time to build out, decades. The other, quicker way is to increase wages so people will spend more. Consumers in China are no different than consumers anywhere. You earn more, you buy more stuff.”
The flip side of these structural changes in China could mean higher prices for the rest of us consumers who are content with inexpensive Chinese goods.
“When you think about one of the most important factors keeping downward pressure on prices, it’s been China. China has been exporting deflation for decades. Today, I believe China is on the cusp of exporting inflation, a completely different dynamic. It’s simply not possible to move China’s entire industrial basis into a country like Vietnam where costs may be lower. So if prices go up in China, the world might simply have to absorb them.”
No More Free Lunch
So where does this all leave an investor today? In Hasenstab’s view: “There’s no such thing as a free lunch.” As an investor, he believes it’s still possible to find opportunities in countries that are growing, appear to have fiscally responsible policies, and are not going through a deleveraging process. And he is! But, he believes the concept of the “risk-free” investment has, at least for now, gone into hiding.
“I don’t think there’s a risk-free asset anymore. The question is whether you are getting rewarded for the risk you are taking. Yes, things are bad, but I don’t think the world is ending either. There are always opportunities, and I think if you have a long-term perspective, you can be rewarded.”
Want more from Dr. Hasenstab? Read “Hasenstab on a Possible Grexit.”
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What are the Risks?
All investments involve risks, including the possible loss of principal. The value of investments can go down as well as up and investors may not get back the full amount invested. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Such investments could experience significant price volatility in any given year.
1. Source: CIA World FactBook. June 2012.